Fund of Funds in Venture Capital
Can someone explain to me how fund of funds in venture capital works and what the benefits are? I understand that VC's invest in other managers to gain exposure to more companies but what are the terms? Would a fund of funds own a stake in each of the companies that the manager has invested in? Are there fees involved?
Hi John-Ryan1, whoops, looks like nobody chimed in here.... maybe one of these discussions below is relevant:
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Yes to fees and general advantages of management and diversification to LPs
I maybe totally wrong about this but doesn't venture capital follow the power law? If so, why would venture FOFs want to diversify? Doesn't this reduce their returns?
Venture capitalists don't invest in other managers. They themselves are managers.
A guy who decides he wants to run a fund sets up a fund structure (this is always a Limited Partnership) and raises $100m from friends, family, and big institutional investors.
(For US funds, the registration is almost always done in Delaware. For off-shore, it varies based on where the investors are; usually Cayman Islands, sometimes Mauritius or Guernsey or Gibraltar or Seychelles.)
He makes an entity that will on paper control how that fund is invested. That entity is known as the General Partner. Any individuals who have a say in the management of that entity (and thus the fund) are known as General Partners.
All of the above is true for whatever the fund strategy is: public equity, public credit, private equity, private credit, venture capital, growth equity ... doesn't matter. The one exception would be real assets (e.g. real estate, timber, oil and gas ... which I don't know a ton about) where instead of a Limited Partnership they may use a different vehicle structure like a trust or MLP.
It's also true regardless of whether it's a fund or a fund-of-funds.
A fund takes its money to invest in businesses, while a fund-of-funds specializes in picking other GPs to invest in.
A private equity fund does this by seeking either control (>50%) or non-control (FoF has strong relationships to the best VC managers who say no to new investors. Why would someone say no? Because they may be at their 'hard cap' for their strategy.
Illustratively, a VC fund may only accommodate $500m. They do ten $10m Series A deals per year, and based on their track record across the past two decades, they know they have a 75% success rate where those companies need a Series B and that they'll write a $25m check then, and that of those, only 50% will make it to a Series C and they'll write a $50m check there.
That means that their capital deployment model tells them they need $425m, and a general rule of thumb is to have 15% buffer in case you see a higher number of good deals than you expected or that your companies are crushing it and are raising bigger rounds and you want to be able to maintain the same ownership level.
[ (10 * $10m) + (7 * $25m) + (3 * $50m) = $100 + $175 + $150 = $425 ]
$425 * 0.15 = $75 for your buffer
$425 + $75 = $500 total fund size
Say you've been around for two decades and you were an investor in great companies like eBay, blogger, eBags, OpenTable, Yelp, Zulily, Dropbox, Twitter, Blue Apron, Mint, Lyft, and Zenefits, in addition to two dozen others that died along the way and returned no money.
Your track record is superb. You are a top-decile (that means top 10%) manager. Everyone wants to invest in your fund. Your last fund's hard cap was $400, your current fund's hard cap is $500, and you think your next one will be $650 when you launch it in two years.
You hate the headache of meeting new people, enduring all their diligence requests, and managing the process of getting them onboarded as a Limited Partner if they choose to commit. So, rationally, each time you get ready to raise a new fund, you call your existing investors to see if they're interested in a larger commitment to your fund next time around.
You betcha. Golly, there's space for each of them to size up by 10% on the new fund? Jesus, would you by any chance be willing to let them size up 50%? You've done such a good job managing their capital for the past twenty years, they want you to take as much from them as you can handle.
With a sigh of relief you smile knowing you never have to go through the six months of diligence a new investor would ask you to endure.
Well, if one of your original investors is a FoF, every time you come back to market to raise a new fund (and you let him increase his commitment to you by 10-20%), he knows he can raise a 10-20% bigger fund from his own Limited Partners. As you grow, he grows.
If a FoF is in really good managers (like Accel, Sequioa, Benchmark, First Round, Lightspeed, Flybridge, etc.), they are going to get a lot of interest from big institutional investors who want exposure to those funds but couldn't get in on their own as a new investor.
This is a great segue to the second point: diversification.
If you're an allocator at a massive behemoth of a pension fund ($50b, $100b) or a sovereign wealth fund (hello, $300b), you have a scale issue. There are very, very few venture funds that can accommodate a $100m check.
The quick rule of thumb is that no GP or LP wants a commitment to the fund to be larger than 20% of the total fund, so that would mean that at the very minimum the total fund size would have to be $500m. Realistically, people set 10% as the limit (unless they're only on Fund I or Fund II and still getting set up), so that means the fund needs to be $1b.
There are less than a dozen firms who raise $1b "VC" funds, and those guys are all the massive multi-stage shops that do both early stage and growth equity out of the same vehicle. That's Norwest, Sequioa, Accel, General Atlantic, etc.
So, if you're on a team managing $100b, you have limited time, you need to find ways to write $250m+ checks. Doing all the diligence on a fund takes the same amount of time on a $100m fund as it does on a $1b fund.
How on earth do you find a way to get exposure to VC as an asset class while maintaining your minimum check size? Ah, the FoF. You write them a $500m check and they spend three years figuring out how to divide it into $25-50m checks among the managers they have good relationships with and have diligenced.
So, in summary, the FoF allows bigger institutions who have either no ability or no visibility to get into good managers to actually get into those managers while also not violating their size requirements.
In exchange, the investors in the FoF demand a lower fee level than they would pay to a normal fund manager. It makes complete sense, no one wants to pay two layers of fees. If you are Temasek, you don't want to pay some FoF 2-and-20 on top of the 2-and-20 that the ten underlying funds in the FoF portfolio are charging. That would be massively dilutive to returns.
Instead, you demand 0.5-and-10 or 1-and-5 or something.
This, incidentally, is why a lot of GPs don't love fund-of-funds. They're notorious for pressing very hard for fee concessions (where you as the manager agree to 1.5-and-15 instead of your normal 2-and-20 with them).
The FoF is charging high fees, relatively speaking in terms of FoF to its own Limited Partners, so to keep absolute returns as high as possible, it wants you the fund GP to charge it lower fees so the overall fee expense to the Limited Partners in the FoF is the same.
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The fund-of-funds business is really under pressure today. On the public market side, the recent history of hedge fund under-performance has led a lot of LPs to withdraw capital. On the private market side, so many funds have gotten so large that they can accommodate the bigger LPs' check sizes directly.
The FoF guys that are succeeding today are those who have accepted some compression on their fee structure and who have maintained pristine relationships with great underlying managers who continue to grant them allocations.
I hope this is helpful.
Sorry for bumping this after a long time. Just thought I could help a bit. I have seen a CVC open a FoF team, to get exposure and access to startups through other funds before investing with the CVC for the relevant ones.
first job Venture Capital fund of fund (Originally Posted: 03/15/2016)
I am in a target undergraduate business program. I've been offered an analyst position at a very solid venture fund of funds (also does late stage direct investments). The firm/people seem great, and its in a good location, but I'm worried that this is a limiting move coming right out of school. At a top target, I stand a good chance of getting a job in investment banking or consulting, as most of my peers are currently doing. I was not that interested in the traditional route, as the work seems boring, the hours are long, and the competition for your next job seemingly never ends. I am attracted to this as an opportunity to go directly into an interesting industry (VC), and to gain a different skill set from my peers. However I don't know exactly where I want to be down the line, and I am concerned that this is too niche of an industry/opportunity to give me options for the future.
I know that's vague, but I would love some insight from people more experienced in the PE/VC industry. Could this be a good, alternative, move right out of college, or am I limiting my future career options? As recruiting will continue for the traditional routes of IB, Asset Management, or management consulting, should I make more of an effort to pursue those opportunities instead?
VC/PE FoF Direct investment (Originally Posted: 11/06/2013)
I know FoF get a bad wrap, but I figured I'd throw this question out anyway.
I had an informational interview with a VC FoF last week with ~2-5 bn AUM in the midatlantic area. About 20% of the funds holdings are direct investments alongside the funds they invest in. After talking to a few analysts I got the impression that they didn't do any of the direct investment DD on their own, but rather just relied on what the fund managers supplied them, and would occasionally rebalance their holdings based on performance. Is this typical in the FoF world? It seems like the analysts don't get any real exposure to deal flow, but rather spend their days disaggregation and recombining powerpoints to eventually pitch to partners.
I have read through a bunch of the FoF threads on this site, but can anyone speak to this? It sounds like the experience isn't very worthwhile unless you want that as a career. That being said, the people there seemed to enjoy it--I just can't tell if it is something I would be into.
As always, thanks for the input.
Very common, which is why it gets a bad rap. FoF analysts/associates aren't running models at the same level as PE/VC they are partnering with or doing the DD. They also tend to be passive, meaning the most you will see is board meeting participation. They are simply just a capital provider to get the deal done or get a better piece of the action with a fund they invest in.
bump
Disadvantages of working at a VC FoF straight out of undergrad? (Originally Posted: 07/17/2013)
Would you be able to move to traditional PE, VC, large FoF, or IB after this? Or does it limit you?
It would likely be hard to transfer to PE or VC direct investing from this role. If there was some co-investment that would help you some, but it would still be challenging. You could later get a MBA and get into IB at the associate level.
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