In the world of venture capital (VC), Fund of Funds (FoFs) are a somewhat enigmatic entity, often shrouded in misconceptions and scepticism. While the benefits of diversification are widely acknowledged, many investors still have concerns about their fee structures, perceived complexity or performance potential.
To address these concerns, we want to highlight different aspects of FoFs and provide investors with the necessary context to reevaluate some of their existing assumptions about them.
Diversification & Risk Mitigation
VC is a unique asset class characterised by its high-risk nature, making FoFs an ideal strategy for diversification and risk mitigation. While they can be found in different industries from hedge funds to real estate, FoFs make the most sense in power-law driven asset classes such as venture capital.
Instead of exposing investors to a significant risk of failure by only investing in a handful of companies, FoFs enable investors to achieve a broad exposure to VC, thereby reducing the impact of a single investment’s failure on the overall portfolio, while increasing the probability of capturing outlier investments that deliver exceptional returns.
Naturally, direct investments carry the highest risk for investors with a 30% probability of a total loss and a 42% probability of a partial loss. However, by investing in a VC fund, some of this risk can be alleviated. Only 1% of VC funds experience a total loss, while the risk of a partial loss stands at 30%. In case of a loss, investors experienced an average investment decline of 29%, compared to an 85% decline in direct investments.
FoFs, on the other hand, are much more effective in reducing the risk of venture capital, as the probability of a negative FoF performance tends to zero. No FoF has ever experienced a total loss, while the likelihood of a partial loss is at a mere 1%, with an average investment decline of 4% in case of a loss.
In addition to their superior risk profile, FoFs also yield higher returns when compared to direct investments and VC funds. The median multiple of FoFs is at 1.7x, surpassing the 1.5x multiple of direct investments and the 1.3x multiple of fund investments.
But, diversification in VC goes beyond simply investing in a large number of companies. While having a diverse portfolio of startups is crucial, true diversification also encompasses spreading investments across various geographies, industries and vintages.
Access & Knowledge
FoFs have unparalleled access to top VC funds, leveraging their well-established networks and relationships within the investment community to identify new opportunities ahead of competitors. They stand out as one of the most coveted limited partners (LPs) in the VC industry, offering unique advantages that other investors cannot match.
Fund managers highly value FoFs for their ability to make substantial commitments, as well as their signalling power as institutional investors specialised in venture capital. This significantly contributes to enhancing the credibility of their funds. Additionally, FoFs serve as valuable sources of advice, utilising their networks of LPs, service providers, and VC funds to support their portfolio.
Combined with the extensive industry experience and expertise of FoF teams on manager selection, portfolio construction, and regulation across different jurisdictions, as well as market trends and industry developments, FoFs possess sourcing capabilities that are very difficult to replicate.
Democratisation
FoFs play a crucial role in making venture capital more accessible to investors. While other asset classes like the public stock market have been largely democratised through trading apps and the introduction of exchange-traded funds (ETFs), venture capital has remained relatively inaccessible.
For smaller investors, it is almost impossible to invest directly into a startup, despite the absence of regulatory hurdles. In order to have a chance of getting an allocation in a funding round of a promising startup, they have to be an angel investor with knowledge of the industry, time to source deals, and most importantly, the ability to add value to the business.
Investing in VC funds might seem like the obvious solution to this problem, but even they are not as accessible to smaller investors as one might expect. Due to regulatory requirements, VC funds are not allowed to accept investors below the minimum threshold of their jurisdiction, usually around 100k to 200k with most funds opting for a 250k minimum for private investors. This acts as a barrier of entry to investors for whom it is increasingly more expensive to build a diversified venture portfolio that aligns with their personal risk preferences.
In contrast, FoFs enable smaller investors to gain diversified exposure to VC and significantly reduce the investment thresholds for funds. With a €250k investment in a FoF, for example, a small investor could gain exposure to 30 different VC funds, which is equivalent to about €8,300 per fund or around €250 per startup.
Fund Duration
While a standard VC fund typically spans ten years, often with the possibility of two one-year extensions, FoFs have a longer duration of twelve years with the same extension options. Some investors may perceive this as a drawback and harbour concerns about FoFs due to the lock-up period and the illiquid nature of venture capital. However, the twelve-year fund duration is actually a benefit to investors, as it enables them to mitigate market timing risk.
FoFs make commitments in VC funds for about two years which, in turn, invest in startups for two to three years. This provides investors with broad exposure to multiple vintages through a single investment.
Should investors decide to build such a portfolio by themselves, they will most likely have the same or an even longer investment horizon. Assuming that they aim for a minimum diversification of ten funds, it will take them about two years to make their final commitment at which point the earliest time their portfolio wraps up will be an additional ten to twelve years.
This does not even include the time it would take investors to start the process of creating such a portfolio by building a team, establishing a network in VC, acquiring the necessary investment knowledge, and so on.
Reducing Administrative Hassle
FoFs play a vital role in reducing the administrative hassle for individual investors, enabling them to participate in VC without extensive knowledge of complex legal and regulatory frameworks. They assume responsibilities and streamline processes, allowing investors to focus on strategic decisions rather than administrative tasks.
New investors often underestimate how challenging investing in VC funds can be, especially when dealing with an extensive portfolio like the one of a FoF. In addition to sourcing investments, investors must for each fund conduct due diligence, review numerous legal documents, align global tax implications and go through rigorous KYC and AML checks.
Beyond that, each investment requires ongoing management. This includes various tasks from monitoring the funds’ performances, achievement of ownership and valuation targets to the frequent payments of capital calls.
(Double) Fee Structure
The fee structure of FoFs is undoubtedly the biggest concern for most investors. FoFs usually apply a 1% annual management fee and a 10% carried interest fee, in addition to the fees from their underlying portfolio (typically 2 and 20). As a result, this setup is often believed to have a negative impact on overall returns. However, this is not true.
FoFs have demonstrated a significant reduction in the likelihood of total and partial losses as well as better median multiples compared to VC funds and direct investments (as previously shown).
Investors should also take into consideration how much time and resources are required to build and manage an extensive portfolio of VC funds. Trying to replicate the abilities and diversification levels of a FoF is practically impossible, especially for smaller investors. It would require a minimum allocation of €10M before an investor could feasibly build a FoF portfolio at a similar cost ratio of 1% p.a. (or 100k/year).
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Very good - particularly the 12 year+ duration.