The Institutional Playbook for Self-Funding Portfolios

Diversification is a fundamental concept in constructing an investment portfolio. In VC/PE, investors can diversify across stages (from pre-seed VC to PE), strategies (growth, turnaround, LBO), sectors (deep tech, health, consumer), and vintage years.

While stage, strategy, and sector diversification have equivalents in listed equity markets, vintage year diversification is unique to VC/PE. Each vintage year represents a distinct cohort of funds that acquires companies, adds value, and exits over different time periods, thus weathering unique market conditions.

Since VC/PE funds deliver results over extended timeframes, ‘market timing’ is less feasible, prompting institutional investors to commit to funds systematically across vintage years. This approach of making annual commitments ultimately leads to a compelling outcome: the creation of a self-funding VC/PE portfolio.

Let us see how this comes about:

Chart 1 displays the annual cash flows (bars) alongside the cumulative cash flows, or J-Curve (line), for a typical Fund. Initially, the investor experiences negative annual cash flow during the first four years, as capital calls are met without any cash returned from exits. By the fifth year, the Fund begins making exits, and the cash returned from these exits surpasses the capital calls, resulting in a positive cash flow for the investor. From years six through ten, further exits continue, sustaining the positive cash flow.”

In Chart 1, the investor reaches the peak of negative aggregate cash flow at year four, marking the lowest point of the J-Curve. By year five, DPI turns positive with the first exits, and by the end of year six, the J-Curve crosses the x-axis—indicating that all capital has been returned and DPI has reached 1x. From year seven onward, all cash flows are profit, pushing DPI above 1.

Chart 2 demonstrates the sequence of J-Curves resulting from an investor making annual commitments to a series of Funds, beginning in Year 1 and concluding in Year 9.

If we aggregate these J-Curves and the associated cash flows, we get Chart 3, which displays the cash flows and the J-Curve for the total portfolio of nine funds.

Chart 3 illustrates that by year seven, the investor becomes cash flow positive; in other words, the cash from exits now exceeds ongoing capital calls for the portfolio’s funds. Additionally, between years eight and nine, the cumulative cash returned to the investor grows enough to cover all capital calls made up to that point. From year nine onward, not only is the investor able to meet new capital calls with profits from the portfolio, but they also have their original capital back, making the portfolio entirely self-funding.

What’s the catch?

Charts 1 to 3 assume a gross IRR of 25% and a five-year holding period, which are reasonable benchmarks for top-half funds, though not universal across all funds or vintage years. If the gross IRR is lower or the holding period longer, the portfolio will take more time to become self-funding.

Additionally, adverse events could delay exits, potentially disrupting the portfolio’s ability to sustain itself. Chart 4 illustrates this by showing the impact of a complete exit freeze for two years. Here, the portfolio reaches self-funding by year nine, but a significant event halts all exits in years ten and eleven. Without exit-generated cash to cover new capital calls, the investor would need to find alternate funding sources for those years. When exits return to normal in year twelve, the portfolio resumes covering capital calls through cash from exits.

Many institutional investors rely on their VC/PE portfolios to be self-funding. When this expectation isn’t met, it can complicate their plans to commit to new funds. With fewer exits recycling capital, investors grow less confident in meeting new commitments without disrupting their overall portfolio allocations. This could mean reallocating from public equities or bonds to cover VC/PE capital calls—a challenging choice that often leads to reduced allocations for new VC/PE funds, making the fundraising environment even more competitive.

Frequently Asked Questions