Diversification vs. Concentration in Early-Stage Investing: Max Pog’s Analysis

In a recent LinkedIn post, Max Pog delves into a critical debate within the venture capital world: the merits of diversified versus concentrated portfolios for Limited Partners (LPs) and General Partners (GPs) at the pre-seed and seed stages. Pog highlights analysis from Stefano Bernardi, questioning the conventional LP push for concentration and suggesting that diversification might offer a more compelling mathematical and logical advantage for early-stage funds.

Challenging Conventional Wisdom on Concentration

Pog begins by challenging the prevailing logic that favors concentrated portfolios, typically ranging from 15 to 20 companies with provisions for follow-on investments. He posits that this approach might be counterintuitive for early-stage investing. According to Pog, a Fund of Funds (FoF) employing a concentrated strategy with 15-20 funds, each holding 15-20 companies, ends up with a total exposure of 150-300 companies. The risk here, as Pog points out, is significant:

“If the vintage winner isn’t there, the entire FoF underperforms.”

In contrast, a diversified fund approach, holding 50-70 companies, offers broader exposure (500-700 companies). Pog argues that at the pre-seed stage, the math favors a different outcome. He suggests that

“several funds with 2-4% at $5-10M valuations might beat one fund with 15% at $20M.”

The core of this argument, as Pog explains, is to “don’t optimize for look-through ownership – optimize for ‘don’t miss the winner.'”

The Importance of ‘Reason to Win’ and Practical Constraints

Pog then shifts focus to what he terms the “reason to win,” an often-overlooked variable in investment strategy. He contrasts the requirements for concentrated versus diversified funds. For concentrated portfolios, the pressure is on GPs to

“Need to be chosen as lead, show ability to win.”

This path, Pog notes, necessitates winning numerous competitive battles. In contrast, a diversified approach emphasizes being “friendly, fast, well-loved by co-investors.” Pog questions which of these strategies is more realistically deliverable by fund managers.

Furthermore, Pog addresses practical market realities. He argues that the market may not consistently supply the desired number of in-thesis companies for highly concentrated portfolios. Even if a GP identifies excellent deals and believes they can win them, the availability of 20 quality companies within a specific thesis over a 2-3 year period, coupled with the bandwidth to manage them, can be a significant constraint.

Rethinking Ownership, Reserves, and Bandwidth

Pog also tackles the concept of ownership, stating it should be a result, not a primary input. He advises GPs to design their strategy around achievable check sizes, valuation access, and their unique “reason to win,” rather than fixating on a target ownership percentage.

The post further scrutinizes the hidden costs associated with follow-on reserves. Pog illustrates that even doubling fundraising efforts and navigating the complexities of predicting winners and securing allocations might not drastically alter the ultimate outcome compared to a strategy with no reserves.

Addressing the operational challenges, particularly for solo GPs, Pog suggests that a diversified strategy offers “essentially infinite capacity.” This contrasts sharply with the bandwidth limitations solo GPs face as their fund sizes and portfolio commitments grow, especially if they are consistently taking lead positions.

Historical Precedents and the Power of Volume

Pog supports his argument by referencing historical data, noting that many top-performing early-stage funds achieved success through volume rather than solely through prediction accuracy. He cites examples like Lowercase I (around 80 investments), First Round (20-25 per year), and SV Angel (hundreds of investments), suggesting that

“Power laws reward surface area, not magic.”

Ultimately, Max Pog’s analysis on LinkedIn provides a compelling case for LPs and GPs to reconsider the traditional emphasis on portfolio concentration in pre-seed and seed investing, advocating for a more diversified approach that maximizes exposure and opportunities to capture top-tier returns.