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:

If we're lucky, the following users may have something to say: Camondo umax17 @FitzroyHills"

Hope that helps.

I'm an AI bot trained on the most helpful WSO content across 17+ years.
 
John-Ryan1:
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?

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?

 
Best Response

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.

///

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.

I am permanently behind on PMs, it's not personal.
 

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.

 

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.

 

Numquam aut nemo unde occaecati earum. Eaque esse nesciunt est totam quia. Voluptatum et assumenda nesciunt at voluptatem molestiae. Qui dolor ratione hic alias ullam qui. Iste architecto aut aperiam. Ut ea omnis aut iste sit.

Career Advancement Opportunities

March 2024 Investment Banking

  • Jefferies & Company 02 99.4%
  • Goldman Sachs 19 98.8%
  • Harris Williams & Co. (++) 98.3%
  • Lazard Freres 02 97.7%
  • JPMorgan Chase 03 97.1%

Overall Employee Satisfaction

March 2024 Investment Banking

  • Harris Williams & Co. 18 99.4%
  • JPMorgan Chase 10 98.8%
  • Lazard Freres 05 98.3%
  • Morgan Stanley 07 97.7%
  • William Blair 03 97.1%

Professional Growth Opportunities

March 2024 Investment Banking

  • Lazard Freres 01 99.4%
  • Jefferies & Company 02 98.8%
  • Goldman Sachs 17 98.3%
  • Moelis & Company 07 97.7%
  • JPMorgan Chase 05 97.1%

Total Avg Compensation

March 2024 Investment Banking

  • Director/MD (5) $648
  • Vice President (19) $385
  • Associates (86) $261
  • 3rd+ Year Analyst (13) $181
  • Intern/Summer Associate (33) $170
  • 2nd Year Analyst (66) $168
  • 1st Year Analyst (202) $159
  • Intern/Summer Analyst (144) $101
notes
16 IB Interviews Notes

“... there’s no excuse to not take advantage of the resources out there available to you. Best value for your $ are the...”

Leaderboard

1
redever's picture
redever
99.2
2
Secyh62's picture
Secyh62
99.0
3
Betsy Massar's picture
Betsy Massar
99.0
4
BankonBanking's picture
BankonBanking
99.0
5
kanon's picture
kanon
98.9
6
CompBanker's picture
CompBanker
98.9
7
dosk17's picture
dosk17
98.9
8
DrApeman's picture
DrApeman
98.9
9
GameTheory's picture
GameTheory
98.9
10
bolo up's picture
bolo up
98.8
success
From 10 rejections to 1 dream investment banking internship

“... I believe it was the single biggest reason why I ended up with an offer...”