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Savvy investors understand that venture capital is an asset class driven by power laws—especially in early-stage deals. For this reason, many VCs aim to invest in a wide variety of deals. But with many deals having significant investment minimums, getting the appropriate level of diversification can be difficult for investors who are capital-constrained.
That’s where funds of funds come in. With the same amount of capital that might have only allowed an investor to invest in a few deals, that same investor can gain exposure to a much higher number of deals by investing in a venture capital fund that invests in other funds.
Venture capital funds of funds can thus present a very attractive proposition for investors. Consequently, whether to use a fund of funds investment strategy is also a consideration for general partners (GPs). But while there are clear benefits for both GPs and investors, there are important considerations to know before jumping in.
Also known as a multi-manager investment, funds of funds are simply funds that invest in other funds. These are not necessarily venture capital related—they can be hedge funds, private equity, real estate, or mutual funds.
For the purposes of this article, we’ll be focusing on VC funds of funds. However, not all funds of funds that invest in venture capital funds are “pure” VC funds of funds. It’s possible for a single fund of funds to have a portfolio of funds spanning venture capital, private equity, and hedge funds.
In terms of their investment mandate, funds of funds can be either categorized as “fettered” or “unfettered”. Fettered funds of funds are only allowed to invest in funds that have the same management company as the fund of funds. For example, a fettered fund of funds by Fidelity would only be able to invest in other Fidelity funds. On the other hand, unfettered funds of funds can invest in a wider variety of funds.
Because of the smaller fund sizes in venture capital, most VC fund of funds are unfettered. A few notable examples of fund of funds in VC are Sapphire Ventures, SVB Capital, and Northgate.
For limited partners (LPs), investing in VC fund of funds can provide:
The above factors that attract LPs to fund of funds also make them an appealing investment strategy for GPs. GPs who decide to use this strategy may have an easier time raising capital—especially if they’re targeting smaller non-institutional investors as LPs.
Most VC fund of funds are limited partnerships.
This means they have both GPs and LPs. The LPs are charged a management fee while the GPs can earn carried interest on fund returns once the LPs have been paid back the full amount of their initial invested capital.
This also means investors in funds of funds must bear two layers of fees—first from the portfolio fund and second from the fund of funds. Returns are thus reported on a “net-net” basis (meaning they’re net of both layers of fees). And while funds of funds fees used to be opaque, the SEC now requires funds of funds disclose all their fees in a line item called “Acquired Fund Fees and Expenses.”
However, because of the double-layer fee structure, funds of funds usually have a lot more variation in their charged fees. For instance, most VC funds follow the “2-and-20” structure (2% management fee and 20% carried interest). Investors might be unwilling to pay an additional “2-and-20” on top of that, meaning the VC fund of funds might have to lower its fees to attract investors.
Venture funds of funds typically invest in other funds—whether as a primary investor when the fund is raising capital, or as a secondary investor by buying out other LPs’ stakes. But there are situations where they invest directly in portfolio companies as well (usually alongside other venture capital funds). This is called a co-investment.
When co-investing in a startup, the fund of funds has the assurance that the company has already been “vetted” by one or more VC funds—which helps de-risk the investment. On top of that, the fund of funds avoids needing to pay additional fees to the fund. Many VC fund of funds reserve a portion of their capital for such co-investment opportunities.
While following a fund of funds strategy has clear benefits, GPs—as the potential fund of funds manager—should be aware of its drawbacks. Investors considering venture fund of funds may be concerned about:
For many investors, VC funds of funds are viable vehicles for gaining exposure to venture capital investing. The AngelList Access Fund, for instance, provides investors exposure to both startups and other venture capital funds—with historical returns that have outperformed the top quartile of other VC funds.
Similarly, GPs could more easily raise capital by following a fund of funds strategy if they can justify the additional fees.