By Stefan Larsen
No period in history better demonstrates the need for portfolio diversification than the late 90s Tech Bubble and the March 2000 crash. In the public markets and at the height of the bubble, speculators were in such a frenzy to get a hold of technology stocks that any newly listed stock with the word “tech” or “.com” in their name could shoot up over 100% in one day. Many of these companies had yet to properly develop their products and their financial health was often very uncertain, yet they commanded prices at very high price to earnings multiples. In private markets there was also a strong appetite among VC firms to invest in the technology sector and bring the burgeoning amount of tech startups to public markets in IPO exits.
VC firms like Big Sur Ventures were heavily invested in startups in the semiconductor and internet sectors, with two-thirds of their portfolio and 92% percent of their top ten holdings in semiconductors on a cost basis. The eventual crash in public markets saw the value of Big Sur’s portfolio fall to 38% below its cost and its top ten holdings lost 80% of their value. By 2002, after having been battered by the crash, Big Sur were making efforts to diversify their portfolio, and a study of these efforts here helps to make an important demonstration of what dimensions of diversification are considered when managing a private equity portfolio’s risk.
The first and simplest dimension of diversification, applicable in both public and private asset management, is limiting the concentration of holdings in highly correlated sectors. For example, Big Sur reduced its holdings in the semiconductor industry to 51% of their top ten holdings at cost, while pre-crash they had 92% of their top holdings invested in semiconductors. Much of the rest of their allocations were made towards financial services software, which move rather independently of the semiconductor industry but nonetheless were covered by the partners’ expertise. Like sector diversification, there is also geographic diversification, whereby portfolio companies are subject to a diversified set of macroeconomic environments, similarly reducing the volatility of the portfolio.
Another consideration is limiting the concentration of holdings in companies at a certain stage of their life. A private equity portfolio that has a high concentration of allocations in early stage firms will generally be much more volatile and exits will lie further in the future, reducing liquidity. Just as importantly, undiversified stage risk means an inordinate amount of the general partners’ time will be invested into early-stage ventures, which are inherently more time consuming are far more likely to fail. According to Alec Dysart, senior partner at Big Sur, “time became the limiting factor more than anything when we held too many early stage companies.” When the general partners are overstretched they cannot add much value to these smaller companies, increasing the likelihood of their failure. With this insight Big Sur thought it best to reduce its holdings of pre-revenue companies from 75% of the portfolio pre-crash to only one pre-revenue company among its top-ten holdings as a means of increasing stage diversification, sacrificing some interest carry.
Finally, private equity firms can also choose to diversify by a time factor, which is investing at different points in time for different lengths of time. By investing in portfolio companies at different points in time during the life of a fund, private equity firms reduce the concentration of holdings bought into at a specific point in the private equity activity cycle. This limits the amount of companies in the portfolio that may have been bought into at extended prices, if the market were overheated, and leaves some unallocated capital to take advantage of discount deals when private equity activity declines. Implementing an investment policy like this will also stop the firm from trying to allocate all its capital at once, avoiding investments in middling companies and freeing up time for the general partners to add more value to the current investments.
By structuring and selecting investments in portfolio companies such that investments can be redeemed after different lengths of time, private equity firms can reduce the concentration of exits made at a specific point in the private equity activity cycle. For example, when the tech bubble burst, VC firms like Big Sur which were heavily invested in tech companies that were to be brought to market, had to accept very unfavourable exits, since the dry up of IPO activity meant that there were much fewer opportunities for liquidity events. Therefore, diversifying the timing and length of investments is another way to reduce the volatility of the portfolio.
In an industry where investments are rarely marked to market, and hence volatility data is impossible to collect, an understanding of the possible dimensions of diversification, as demonstrated by the post-crash investment management of Big Sur, serves as an important starting point to the private equity firms that are looking to reduce the risk of their portfolio, and reduce the chance that they are subject again to such declines in value as seen in the market crash of March 2000.
Authors: Stefan Larsen
Venture Capital and Private Equity: A Casebook by Lerner, Hardymon, Leamon
Editor Responsible: Edoardo Cogliati