Fund of funds: why to invest and, more importantly, why not
In stark contrast to the private equity and venture capital business, fund investment business is not that sexy. In fact, I often wonder how I ended up here. At dinner parties, whenever I am asked to explain what I do, and I tell them that I invest into private equity and venture capital funds, I can see them glancing over my shoulder to find another person to talk to. And I get it. It seems abstract and boring at first. But I do believe it can be very interesting from a strategic, analytical and even philosophical point of view. For that and mostly other reasons, it seemed a good idea to explain some more about fund investments. Below the first piece on fund of funds. Our bread and butter at Welt and Marktlink Capital.
What’s in a name: fund of funds, umbrella funds or multi manager funds
What is a fund of fund? Whereas private equity and venture capital funds invest directly into companies, often referred to by a fancy name as ‘assets’, fund of funds invest into a blend of private equity and venture capital funds, often referred to by a fancy name as ‘managers’. Fund of funds are therefore also often referred to as umbrella funds (i.e., many funds under one umbrella) or multi manager funds (i.e., one fund with multi underlying managers). If you would compare it to stock market investing, it’s similar to holding a relatively portfolio of individual stocks, compared to stock picking (investing in one company or fund) or buying an index (investing in all companies or funds).
Needless to say, this alters the risk-return profile considerably of the investment. Whereas investing in a single company can be considered ‘high risk’ and investing in a single fund ‘medium risk’, investing in a fund of fund can bring the risk profile further down. This is also logical, given that the number of portfolio companies increases significantly from a single asset, to a fund (on average 10–20 assets) to a fund of fund (on average 250+ assets). Because of the risk limiting nature (and other factors such as access and diversification), fund of funds have become popular in higher risk asset classes such as private equity and venture capital. In a study conducted by Cambridge Associates on the performance of different asset classes between 2006 and 2021, private equity and venture capital ranked both as the highest performing asset classes (both in terms of median and top quartile performance) and as the most risky ones (where risk is defined as the dispersion between the best and the worst performance).
Because predicting future performance of a fund is a tricky thing (I will write a separate article on the art and science of it), people tend to invest either in multiple funds or in a fund of fund. This statistically dramatically reduces the risks. Lets take venture capital as an example. If you would have invested randomly into one fund between 1991–2005* (i.e., monkey taking a marble out a jar of 3077 marbles) this would have led to you losing money in 23.6% of cases. Depending on your risk appetite, you may think this is low or high. What is more interesting however, is that investing in 9 funds historically however, reduces the chance of you losing money to less than 1%. So, by spreading your bets over 9 funds, you reduce the risk of losing your money by over 25x.
And its not just about limiting downside (i.e., risk), but also about increasing upside (i.e, return). Again taking Venture Capital as an example, startups returns follow a power law distribution (meaning that a small number of investments will generate the majority of returns) and venture funds follow a derivate function of this power law distribution. This means that by selecting more funds you actually increase the chance of selecting an outlier fund, that may return the whole fund of fund (these funds are also sometimes referred to as dragons). When you look at portfolio distributions of venture capital fund of funds, you can see that the median performance therefore improves by adding funds to the portfolio. Although counterintuituve, the significance of this shouldnt be underestimated.
Fund of funds: the solution to all your problems
So, say you have some money. And you want to have access to the private equity and venture capital market because you have read pioneering portfolio management and you want to invest like the top 1%. Then why don’t go out there yourself and find some funds to invest in?
Firstly, because of adverse selection. What does this mean in practice in private markets? It means the funds you can distinguish as being high performing are not actually looking for your money. In fact, they are ‘oversubscribed’, meaning more people want to invest money than they are accepting into their funds.* And because returns are power law distributed, investing in the best funds is of critical importance to get good risk weighted returns. If you would draw up a matrix of what funds like about their LPs (fancy word for investors), it would have two axes: investment size and investment horizon. Based on that 2 x 2, you can distill a hierarchy of LPs. In the top right corner you can find the endowments and pension funds (i.e., lots of money, investing long term). As a retail investor however, you score left bottom quadrant (i.e., not so much money, investing short term). So if you don’t want to do $20m tickets per fund, and you want your investment back as soon as possible, the chances of you finding a good fund that wants to take your money, are relatively small.**
Secondly, it’s not only about selecting the best funds, but also about selecting the best team of funds. I don’t want to fire all my guns in this first article, but suffice it to say that (i) venture capital is actually quite a generic term for many different archetype of funds (primary vs secondary, early stage vs late stage, generalist vs specialist, local vs regional) (ii) venture capital funds therefore don’t behave the same way in the same circumstances (i.e., in statistical terms: are not perfectly correlated) and therefore (iii) its not just about selecting the best funds, but the best mix of funds is that is part of the secret sauce of a great fund of fund. You can compare it to selecting a football team where you have 10,000s of players to pick from and where you can even decide on the number of players you want to start. To give you an example of the relevance of this metaphor, we actually have a data scientist as part of our team who used to do player and team analysis for AZ Alkmaar (I know what you are thinking, is this the Dutch version of Moneyball? But think much smaller: small stadium, suburb of Amsterdam, mediocre hooligans).
Lastly, investing in multiple funds yourself is just an administrative, legal, fiscal and financial nightmare. My CFO/COO will kill me if he reads this, but it’s just the worst. Even if you find a perfect team of great funds that all want to take your money. For every fund investment there are legal documents to negotiate, KYC procedure to be finished, entities to be setup, fiscal blockers to be put in place, capital calls to be managed, reporting to be done, tax statements to be filed. If you are the type of person that makes to do lists for your weekends, keeps monthly family budgets in excel and reads the Harvard law review in family holidays, this is obviously no problem for you.
Because of the three reasons described above, fund of funds seem to be popular. Fund of funds are therefore also sometimes referred to as a way of making ‘cost-effective diversification’. And although fund of funds can be costly, as you pay fees to the fund and to the fund of fund, there popularity is not unwarranted. Taking Pitchbook data from 1996 to 2022, and looking just at median performance, you can see that fund of funds have actually outperformed direct VC funds by about 2 percentage points. The outperformance of VC fund of funds is also the conclusion from a research paper investigating this topic, that was published in 2018 and is quoted below.
’’Moreover, strategies for investing in direct funds may be constrained by limits on fund access or manager selection skills. We show that FoFs in venture capital often outperform direct investing handicapped by these limitations — which are likely to be particularly relevant to investors without a long track record of investing in successful VC funds. Therefore, the evidence suggests that VC FoF managers are more likely, through fund selection or access, to overcome their additional layer of fees” — Harris, Jenkinson, Kaplan, Stucke (Journal of financial economics, 2018)
So fund of funds are great, I get it! — but what’s the catch?
There always is a catch, in fact there are many reasons not to even consider investing in a fund of fund in the first place. Let me list a couple of examples that may be relevant.
· Wealthy: · if you can write $20m+ tickets per fund, you may want to consider building your own fund portfolio. You can do this making a selection of top tier private equity, growth equity and venture capital funds either yourself or with a 3rd party. Returns may be higher, unless you find a fund of fund that has additional benefits next to access, selection and hassle management***
· Liquidity: Remember, the money you will invest in a fund of fund will be locked for at least 6–7 years (average time until good funds reach 1x DPI). If you expect that you may need the money you are investing in that time frame; then you should probably not invest. In life, bad things happen****, and there are ways of dealing with liquidity when problems do arise, but if you already know you need the money in that time frame, then don’t invest.
· Stressed: markets have gone up and down in the past and and will likely keep doing that in the future. It’s true that private markets are less volatile than public markets (not in the least because book valuations are more patient than market valuations). However, returns may be lower than expected or liquidity may take longer to realize. If you don’t like the uncertainty of that, you should just invest money into an index tracker and get a very sweet 7–8% per year in the long term but can also be a rocky ride short term.
· Optimistic: I believe you shouldn’t expect to make 10x or 30% net IRR on a fund of fund. Remember, you are not investing in a startup or a single fund but in a portfolio of funds where some funds will do 30% net IRR and some underlying companies will do 10x. You should be aiming to get significant alpha (>5pp above market returns) with a significantly lower risk profile. As a smart investor once told me, concentration is how you get rich, diversification is how you stay rich.
So, it’s not for everyone. But if you do decide to invest into a fund of fund, realize that (similar to venture capital and private equity funds) there is a huge spread in performance. I won’t tell you what I believe a good fund of fund looks like, but I can give some pointers to red flags that I see when it comes to investing in a fund of fund.
· Expensive: many fund of funds are just too expensive, and therefore not worth it. As a rule of thumb, anything above 10% carried interest and 1% management fee per annum should be deemed too expensive. Even if it gets you into top funds. The math won’t work and you will get below average returns.
· Distinctive: mediocre fund of funds will offer you a selection of funds that you either have direct access to yourself (without additional costs), or can distinguish yourself as being good (between the 10.000s of funds that exist). If what the fund of fund offers looks too easy, it probably is too easy.
· Bullish: private market returns take a long time to realize, this is true for private equity, but especially for venture capital. Fund of funds that offer you investment horizons of less than 10 years have either found a magic exit window, or are selling secondaries at horrible discounts.
· Obscure: if it’s a good fund of fund, there will be investors that want to serve as a reference (i.e., other people who invest in the fund that you can ask questions). They should have annual general meetings that you can visit and documentation you can look into. You should be able to do your research.
That’s it for now on fund of funds. Why you should invest. And more importantly: why not. If you have questions or feedback, please reach out.
To infinity and beyond.
*The best funds in history have gotten so rich, the money they invest is actually mostly from partners and previous partners of the firm (also listen: Benchmark Part II, The Dinner)
** Almost needless to say is that exceptions do exist to this rule. For example, some emerging funds, that have experienced a lot of trouble raising capital, have been able to produce stellar returns.
*** Although fund of funds are an additional cost layer, they can under circumstances actually be more cost efficient than investing directly. As an institutional investor writing bigger tickets, fund of funds sometimes get size discount on management fees and carried interest. They are also typically better at structuring investments in a fiscal intelligent way. And, lastly, they sometimes have co-investments as part of their fund of fund strategy, that they can often source free of fees.
**** I briefly studied art history in university where art brokers like Sothebys and Christies would say that people would sell old master paintings in case of the 3 D’s: death, debt and divorce.
