October 1, 2024

Raising an Alternative Capital Fund Series - 4 of 4

Happy Tuesday, friends! Today we are at the last part of our 4-part series and this will be where I write down my (controversial) take on different approaches to portfolio construction as it relates to raising an alternative capital fund.

Portfolio construction offers a variety of approaches, but let's stick to the basics and discuss deal types and structures, and I’ll tell you what I think works, and what simply doesn’t. Ready? Off we go.

Like I said, I have a strong bias here. I think (as you’ve read in earlier newsletters) that you can be really good at one thing, but that you can be only good at more than one thing. And that might even be a stretch. We’re humans, and while I believe we have a very high capacity for excellence, I believe we can only be excellent at one thing at a time. That translates to a belief I have yet to be disabused of: investors have to be careful about blending deal structures and asset types in a portfolio because if they try to do too many things, they will do those things marginally well at best, and that will lead to only marginal outcomes. Said another way: I like a portfolio with a focus - one with a particular kind of asset and structure.

Yes, there are ways around this. If you have a fund with multiple investors, one can be good at (for example) VC investing and other can be good at RBF. But that’s a difficult blend no matter how you slice it.

In my experience, LPs want singular focus. That is, they want you to do one thing extraordinarily well. Maybe you’re a great RBF investor. Great! Build a portfolio of those assets and deliver superior risk-adjusted returns. Or maybe you’re a great VC investor. Awesome! That’s a totally different point of view on the world and approach to portfolio construction. But go build that portfolio and deliver returns.

LPs are usually trying to fill a certain bucket in their portfolios. Maybe they need long-term capital gains. Maybe they need fixed income or high yield. At the earliest stages of building a funding platform, the temptation is to be both of those things, or to be everything to everyone.

It won’t work. It just won’t.

I’ve seen several funds struggle because their portfolio construction approach was muddled. I typically see instances where some portion will be VC and some will be alternative capital (RBF, self-liquidating equity, etc.). I don’t think that’s feasible. I think LPs likely read this approach as basically saying, “I’ll do any deal that looks good”. Now, I get it…it’s great to have more than one funding mechanism in your toolbox. I definitely understand that — this is why I left VC to build something in this space.

But without conviction that this one thing you’re doing (whatever structure you’re selling) will deliver the returns you’re targeting, then it comes off as undisciplined and scattershot. Trust me. I heard this from LPs when I first started exploring this space, and it’s why I decided not to have a Swiss-army knife approach. I decided to use one structure and to bet on it. That conviction helped us raise our first fund, and it continues to help us today.

But, Keith, my spreadsheet says I can deliver better returns with a blended portfolio. Sure it does! But I don’t think that’s realistic. Leave it to your LPs to blend their own portfolios, get conviction about your structure and approach, and deliver returns that get people excited.

There you have it. I'm looking forward to hearing your perspective on this topic that's sure to spark interesting discussions!