Optionality in venture funds

It also means that one cannot afford to create static strategies in a backward-looking way and expect venture-scale returns, rather bet on discontinuities and update the strategy and the resulting portfolio along with the market shifts.

On the other hand, when many market actors do so to catch a few companies, this deprives the investment of its optionality, creating regression to the mean. When it becomes systematic, overpaying is an effective way to kill the whole portfolio’s optionality. While one can only hypothetically argue that the chances of a better outcome tomorrow incre... See more

However, one needs to consider that these markets might have matured and are not as high-volatility environments they once were whereas early-stage companies instead thrive in market dislocation that creates high volatility and high chances of multiple right-tail outcomes.

Investing where cards are being shuffled

The same applies to the value of venture portfolios as they have convex pay-off structures like call options, built to capture right-tail events.

Similarly, most venture funds perform better in a market of steep ups and downs rather than steady growth. If you own something worth nothing, the dispersion of the potential outcome increases the likelihood that this will be worth something.

Similar to the strike price (K) of a call option, for an early-stage company to be worth something, it is required to hit a minimum threshold of de-risking and size.

Far out-the-money options are where the security price is further away from the strike price (K), hence possessing a low likelihood of paying out anything. That makes them cheap but with an asymmetrically rich upside relative to their initial cost in case of a payout—in a way that’s quite similar to investing in early-stage startups.