Portfolio Concentration

What is fund concentration?

Fund concentration is how much of a fund's capital sits in its largest positions. A concentrated fund writes fewer, larger checks, so one outcome can move the whole result; a diversified fund spreads the same capital wider, so none can. It is a construction choice, often capped by contract or tax law.

Two different quantities, both called concentration

Practitioners use the word for two things, and they behave differently.

• Position concentration. The share of the fund's cost or value held in one company, or in the top few. This is what a limit in a fund agreement regulates.
• Exposure concentration. The share of the fund clustered by sector, stage, geography, vintage or even by a shared dependency such as one cloud platform or one regulatory regime. Ten separate positions can be one bet.

A fund can look diversified on the first measure and be highly concentrated on the second. Venture Lending and Leasing VIII's registration statement treats them as separate policies: it sets out issuer diversification standards, and separately states that it will seek to build a diversified portfolio by investing in a large number of technology companies across a broad range of industry segments, naming enterprise software, online consumer services, healthcare, medical devices, biotechnology, security technology and internet-enabled businesses among them.

Where concentration limits actually come from

Three sources, in ascending order of how binding they are.

The fund agreement. Private funds cap concentration in their investment policies, often as a percentage of aggregate cost measured cumulatively over the fund's life rather than as a point-in-time percentage of value, which prevents a rising markup from forcing a sale. The same registration statement uses exactly that construction for its category limits: up to 20 percent of the aggregate cost of all investments of the fund, determined cumulatively over the fund's life, may go to special situation investments, and direct equity purchases are limited to an aggregate cost of up to 10 percent of all investments, with shares acquired by exercising warrants received on its loans excluded from that 10 percent test.

Investment company classification. A fund registered under the Investment Company Act of 1940 is either diversified or non-diversified, and that status is disclosed. The fund above is classified as a non-diversified closed-end investment company.

Tax law. This is the hard constraint, and it applies only to funds that elect regulated investment company status. Section 851(b)(3) of the Internal Revenue Code requires, at the close of each quarter of the taxable year, that at least 50 percent of the value of total assets be represented by cash and cash items including receivables, government securities and securities of other regulated investment companies, plus other securities limited for this purpose to not more than 5 percent of total assets in any one issuer and not more than 10 percent of that issuer's outstanding voting securities; and that not more than 25 percent of the value of total assets be invested in the securities, other than government securities or the securities of other regulated investment companies, of any one issuer, in two or more controlled issuers in the same or related trades or businesses, or in one or more qualified publicly traded partnerships.

A conventional venture partnership is none of these things. It is not registered, not a regulated investment company, and its only concentration limits are the ones its own agreement imposes. That is why the codified tests are useful as a reference point rather than as a rule a venture general partner has to obey.

A worked example with the arithmetic shown

Take two hypothetical funds with $200,000,000 of committed capital each, both fully invested, and ignore fees to isolate the construction effect. All figures here are hypothetical.

• Fund A holds 40 companies at $5,000,000 of total cost each. 40 times 5,000,000 equals $200,000,000.
• Fund B holds 10 companies at $20,000,000 of total cost each. 10 times 20,000,000 equals $200,000,000.

Now suppose one company in each fund returns 25 times its invested cost.

• Fund A. $5,000,000 times 25 equals $125,000,000, which is 125,000,000 divided by 200,000,000, or 0.625 times the fund.
• Fund B. $20,000,000 times 25 equals $500,000,000, which is 500,000,000 divided by 200,000,000, or 2.5 times the fund.

To return three times committed capital, each fund needs $600,000,000 of total proceeds.

• Fund A needs 600,000,000 divided by 125,000,000 equals 4.8 such outcomes.
• Fund B needs 600,000,000 divided by 500,000,000 equals 1.2 such outcomes.

The symmetric cost of that leverage is what a single zero does.

• Fund A. One total loss costs 5,000,000 divided by 200,000,000, or 2.5 percent of the fund.
• Fund B. One total loss costs 20,000,000 divided by 200,000,000, or 10.0 percent of the fund.

Re-add all of it. 40 x 5,000,000 = 200,000,000 and 10 x 20,000,000 = 200,000,000. 5,000,000 x 25 = 125,000,000 and 125,000,000 / 200,000,000 = 0.625. 20,000,000 x 25 = 500,000,000 and 500,000,000 / 200,000,000 = 2.5. 600,000,000 / 125,000,000 = 4.8 and 4.8 x 125,000,000 = 600,000,000. 600,000,000 / 500,000,000 = 1.2 and 1.2 x 500,000,000 = 600,000,000. 5,000,000 / 200,000,000 = 0.025 and 20,000,000 / 200,000,000 = 0.10.

Concentration does not raise the expected value of any individual investment. It raises the variance of the fund, and it raises how much the manager's selection skill is worth, because being right about one name out of ten matters four times as much as being right about one out of forty.

For contrast, run the regulated investment company tests on a $200,000,000 portfolio. The 25 percent single-issuer ceiling is 0.25 times 200,000,000, or $50,000,000. The 50 percent bucket is different from how it is usually summarized: cash and cash items, government securities and securities of other regulated investment companies fill it without any per-issuer cap, and only the other securities counted toward it are limited to 0.05 times 200,000,000, or $10,000,000, per issuer. So a fund holding ten $20,000,000 positions and no cash could not use any of them toward that half of the test, because each one exceeds the 5 percent ceiling. Fund B would fail, which means it could not elect regulated investment company status, not that the portfolio is unlawful.

Where it shows up in documents

In a private fund agreement, look for an investment policies, investment guidelines or investment limitations section, usually close to the statement of investment objective and well before the capital and distribution articles. Read four things.

• The denominator. Aggregate cost of all investments, committed capital, or total assets at the time of investment are three different tests.
• The measurement date. Cumulatively over the life of the fund versus at the time of each investment versus at each quarter end.
• Whether follow-ons count. A limit that counts follow-on investments against the same cap constrains reserves; one that excludes them does not.
• Whether the limit can be waived, and by whom. Advisory committee consent is common.

In a registered fund, the diversification status and the concentration policy appear in the registration statement's investment policies section, and the fund's classification as diversified or non-diversified is stated explicitly.

Common mistakes

Confusing position count with diversification. Forty seed checks into companies selling the same software to the same buyer is a concentrated bet with good optics.

Measuring concentration on marked value. A position that has been marked up looks like a concentration problem it may not be, since the cost basis and the capital at risk have not changed. This is why fund agreements usually test cost, not value.

Ignoring reserves. Concentration is decided by the follow-on strategy more than by the initial check. A fund that writes 40 small initial checks and then concentrates its reserves into 6 names is a concentrated fund with a diversified entry page.

Borrowing the regulated-investment-company tests as though they applied. The 25 percent and 5 percent tests are conditions of a tax election, not portfolio rules for a venture partnership, and quoting them as industry limits is the mistake to avoid.

How it relates to adjacent terms

A concentration limit is the contractual expression of this term: the specific numeric cap in the fund's investment policies. If you want to know a fund's real concentration discipline, read the limit and its denominator rather than the pitch.

Portfolio construction is the design decision that sets concentration before any investment is made, together with check size, ownership target and reserve ratio.

Reserve capital is where concentration is actually implemented. Since follow-on dollars are allocated with information the initial check did not have, a fund's reserve policy determines whether it ends the decade concentrated or diversified.