Of Fund-of-Funds and Super LPs

Some large, really large institutional investors (like pension funds and endowments) invest in venture capital funds using an indirect investment approach. They pick an intermediary - a Fund-of-Funds -  as opposed to investing in VC funds directly.

Now the obvious question is why do smart, institutional investors bother adding a layer in this mix? After all, they could bypass this step and invest in VC Funds directly. The fund-of-funds model (FoF) emerged in the late 1980s to meet the asset allocation and diversification demands of larger financial institutions. OK, let's try  that in plain english - large multi-billion dollar institutional investors have to sprinkle money in different buckets. Each bucket is an asset class. There are many buckets like stocks, bonds, real estate etc. out there - even Bitcoins. VC is one such bucket. Its a small-ish bucket when you compare it with other buckets.

 Chris "SuperLP" Duovos  once told me that "If public markets are like an ocean—multi-trillions of dollars at work—and private equity is a bath tub ... say $300 billion a year ... venture capital is like a small sink."  Indeed - the VC bucket attracts about $60bn a year (2014). A decade ago Dick Kramlich, founder of NEA, said, "As an industry we are only raising $20–30 billion, while private equity as an industry is raising $300 billion. And there's two trillion dollars worth of hedge funds. All of these resources are within the same purview ... and there's a whole different definition of how rates of return are obtained and who you compete with." So not only VC is small bucket, it competes with a lot of other buckets for attention.  The pie-chart shows what a typical asset allocation looks like - as you can see VC is a "sub-asset" of Private Equity (PE) which is clubbed under "Private Investments" 

Northwestern university endowment asset allocation. VC and PE are clubbed under Private investments

And that "Private Investments" bucket, which is 20% of the portfolio has several mini-buckets.  These are sliced into categories like Buyout Funds, Distressed Debt Funds, Middle Market Funds and so on. On top of that is the geographic axis - US, Europe, Japan and Asia. An institutional investor has to assess risk/returns from these ever-changing asset buckets and then make some intelligent bets. Some buckets have lower returns but are considered less riskier - for example, money market funds or bonds are as good as cash. In my badly drawn graphical format, risk (Y axis) and returns (X axis) looks like this:

As a result of this risk / reward dynamic, not all buckets are equal. VC is the riskiest of them all - indeed, we often brag that 9 out of 10 companies in any fund's portfolio will fail. Thats 90% of your LP capital that's lost on cat-video sharing apps. VC is risky but also suffers from lack of consistency of returns. The standard deviation ( which is a fancy term for a measure of risk) varies as much as 150% in VC asset classes and thats a big headache for investors. And on top of that, every VC claims to be a top performer. FLAG Capital, a fund-of-funds bemoaned in one of their newsletters that VCs sound like "Lake Wobegon, where all the women are strong, all the men are good looking, and all the children are above average." Another FoF manager told me when every VC fund walks in and tells us "they are all top quartile. I wonder where the rest of three quartiles managers are - I just cannot seem to find them." So when you have (a) high risk and inconsistent returns coupled with (b) less than 10% of your assets allocated to VC and (c) everyone is a rock star VC, you end up with a challenging situation. Hence, institutional investors have "outsourced" the selection process of VC Funds to Fund-of-Funds.  

To institutional investors, FoFs offer the following advantages:

Efficiency: FoF's are an efficient mechanism to access various asset classes/venture funds. Institutional investors have optimum resources to research or manage certain asset classes. For example, a $50 billion pension fund may have less than 10 percent of its assets in private equity. This could be further sliced into mezzanine, buyouts, and VC. Apply another set of layers of risk diversification—sectors, geography, size, and vintage year—and what you have is a fairly complex matrix of relatively small investments. The ability to manage such investments effectively becomes a challenge for the pension fund managers. In such situations, FoFs allow for larger institutions to efficiently participate in the venture capital asset class without substantially increasing their overhead. 

Access: FoFs offer access to elite funds and have deeper knowledge of emerging funds with higher potential for performance. As FoFs are often keeping a close eye on the market dynamics, emerging managers and high performers, FoFs are domain experts in such asset classes. While institutional investors may be experienced in private equity, they often lack the abilities or resources to conduct research and proactively build relationships. FoFs also offer specialized expertise to track and monitor industry trends, identify leading funds, build relationships with key managers, and staying current with investment terms.

Diversification: The universe of the private equity and venture capital fund managers evolves with the ebb and flow of economic trends and opportunities: venture, distressed, real estate, sector-focused funds and turnaround funds. FoFs are attractive investment strategies because they enable investors to diversify and spread out risk over a range of different assets (e.g., a typical FoF will invest in 10 to 20 underlying funds, which in turn are investing in hundreds of portfolio companies). 

Cost structure: FoFs are cost-effective solutions for institutional investors because the due diligence, negotiations, and post-investment portfolio management is outsourced to the FoF managers. A typical FoF fee structure is 5 % carried interest combined with approximately 0.75 % annual management fee. Institutional investors effectively pay two layers of fees in such a structure: one at the FoF level and another at the PE/VC fund level.

FoFs raise approximately $30 billion in any year. The first FoF, a firm that would eventually become Adams Street Partners, raised a mere $60 million. Today, Adams Street Partners manages $25+ billion and raises about $2 billion each year to be deployed in 15 to 30 new partnership commitments. Its target allocation typically includes 30 percent in venture capital, with the largest slice allocated to buyout funds 40 percent and the rest being set aside for mezzanine and distressed debt funds. 

 Variation of a theme

Each FoF is designed to accomplish certain goals for its investors and for any venture fund seeking capital from these FoFs. Its important to identify how their own fund strategy aligns with the FoF’s strategy. Here are three FoFs all investing in venture capital funds, yet their investment strategy differs substantially.

Top Tier Capital Partners

  • Strategy = Focussed on proven VC fund managers with established track record
  • Average investment = $25 million / fund
  • Assets under management = $2.6 billion
  • Geography = US only

Cendana Capital

  • Strategy = Focussed on micro-VCs
  • Average investment = $1million to $5 million / fund
  • Assets under management = $130+ million across three funds
  • Geography = US - Primarily Silicon Valley and New York

Renaissance VC Fund

  • Strategy = Focussed on bicoastal funds investing in Michigan
  • Average investment = $5 million / fund
  • Assets under management = $100 million 
  • Geography = US & Midwest

So as you build your LP target list, ask the following: Are we a good fit for this LP? Consider:

  • Timing: Are they investing in VC funds? Not now, later?
  • Portfolio: Are they planning on re-upping with existing funds? Or bring on new funds in their portfolio?
  • Experience of fund managers: Does this LP invest in noob / emerging versus proven managers?
  • Sector and Stage: Does this LP typically invest in {sector / stage / geography of your fund} ?
  • Amount of investment: Large multi-billion LPs do not cut smaller $1m checks - it's a lot more work and they don't get paid for it.
  • Process: Investment committees, votes, memos, diligence...why do LPs take so long? 
  • Timelines: This can range from a few weeks to a few years. One LP told me that they watch a fund manager complete an entire cycle (raising a fund, building a portfolio, exits and performance) - that's like a 3-5 year dance. 
  • Expectations: What constitutes a good relationship for them? How do they succeed? Ask them. Please. 

In comparing all LP types, the Fund-of-Funds stand apart from classical institutional LPs (such as endowments / pension funds). This is because the FoF Managers  (a) Can guide VCs on various best practices / processes (b) Connect VCs with relevant counterparts and (c) Are driven to succeed as much as VCs are.  After all, if they don't generate returns, they go out of business. I have found that some FoF Managers are thought leaders - they keep a close watch on the technology frontiers, they see a lot of funds / strategies / fancy IRR data and challenge every assumptions.

They hold VCs to a higher standard.  These are the "Super LPs of choice" you want on your side !