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Fund of Funds: Granting Investors Smart Access to the Early-Stage VC Game

By: Daniel Balmisse, Managing Partner, Cathay InnoSquare

Investing in Venture Capital funds was historically considered a risky move — resulting in most Limited Partners (LPs), being drawn to the “safe,” well-known, oversubscribed funds. But for newer LPs, these are hard to get into, ultimately barring them from the early-stage game.

Today, things have changed. With the globalization of tech, there are more startups than ever before — resulting in more big exits and better returns. According to KPMG, globally, VC-backed startups attracted more than $157B across 7,687 deals, producing over $300B in exits in Q2 of 2021 — while VC funds are on track to break fundraising records with $200B by the end of the year. This highlights growing investor demand, along with institutional investors’ favorable perception of the current economy, fueling significant momentum for the market.

Similarly, VC has evolved. The range of funds that can deliver top performances has significantly increased, making the VC game an attractive investment for LPs looking to diversify assets or gain exposure to the innovation field. But with already over 3000 venture firms (and counting), choosing the right early-stage fund manager across geographies can be incredibly challenging and time-consuming.

Enter venture capital’s fund of funds — specifically designed to identify and invest in “feeder funds” or early-stage funds that fuel some of the best investment opportunities to larger, top tier VCs. We launched Cathay InnoSquare, our fund of funds, to invest in the next-generation of entrepreneurial venture firms across the US, Europe and Asia. Below, we’ll share why we believe now is the time to break into the global, early-stage VC game.

I. The “Cambrian Digital Explosion” ushers in a new era of tech investment.

In the early days, successful fund managers invested in areas like semiconductors, hardware, networking or software. These early tech companies built the infrastructure for all the digital services and applications we know today. With technology and digital infrastructure becoming more advanced, and widely accessible, the cost of launching a startup has dramatically reduced.

We’ve now entered into what one might call the “Cambrian Digital Explosion”. As the Cambrian Era saw the rapid diversification of life forms, startups today are constantly emerging to satisfy the unlimited need to make things better, easier and more efficient as the entire economy goes digital. These new startups are seizing the opportunity of having an almost immediate global playing field, accelerated pace of development and scale — leading to higher market potential, startup valuations and creating more billion-dollar companies (or Unicorns).

For example, Europe has seen phenomenal growth in the last three years with Pitchbook reporting the number of Unicorns tripling and the aggregate value increasing sixfold to €253B through Q2 2021 — that’s double the €107B recorded in 2020. As “software eats the world,” the floodgates have been opened for a greater number of startups to succeed along with the venture funds who back them.

II. The democratization of venture capital knowledge.

The democratization of VC industry knowledge is another key factor contributing to the wider success of funds today. The key ingredients, from investing to portfolio construction and management as well as fund management, were previously only mastered by few and are now widely accessible. This is due to various trends that have taken hold over the last decade:

As a global venture capital firm, counting many leading corporations as strategic partners and investors in our funds, we believe sharing knowledge across geographies and sectors is key to the broader success of our ecosystem. And the VC industry is no different — it gets stronger thanks to the diverse perspectives and insights gathered from all corners of the world.

III. The VC playing field has gone global.

Initially dominated by pioneering clusters from Silicon Valley, Route 128 or Silicon Alley, vibrant startup hubs can now be found across the globe. We’ve seen innovation centers expand to European cities such as London, Berlin, Paris and Stockholm to Chinese municipalities like Beijing, Shanghai and Shenzhen.

We’re seeing emerging markets come of age as well such as Southeast Asia, Africa and Latin America. Increasing Internet and mobile penetration, highly-skilled students, and urgent social and economic needs in these parts of the world have led to the creation of startups leapfrogging incumbents. These new digitally-native players are reinventing industries from the ground up from commerce, financial services, mobility and supply chain — tailoring and evolving innovation to meet specific regional needs.

This has resulted in a growing number of local, early-stage VC firms looking to fuel economic development and the creation of the region’s next billion-dollar startups. According to Singapore’s Cento Ventures, Southeast Asia saw a record number of 393 venture-backed investments in the first half of this year. Big companies are now being built everywhere and will only accelerate with digital transformation from the lasting impacts of the COVID-19 crisis.

IV. The maturation of the VC ecosystem breeds more early-stage, specialists.

A fourth element is the maturation of the VC ecosystem, which now has a broad spectrum of specialist funds across the financing chain from seed to early-stage, early-growth and growth funds. With a wider variety of specialized funds, startups are now working with different types of investors at every stage of their lifecycle, further increasing the pool of capital.

This has led to the bifurcation of the VC industry. On one side, you have a limited number of larger, integrated, full-service, global VC firms primarily consisting of well-established, larger funds investing in early to growth-stage companies that require more capital to scale. On the other hand, there is now a greater number of entrepreneurial VC firms that are small, agile and highly ingrained in the operating environment. This group represents a whole new generation focusing on selective seed and early-stage deals, and in some cases specialize on specific sectors.

These next-generation early-stage fund managers have demonstrated a clear ability to outperform the market. They also “feed” top-tier, established VCs with quality deals downstream.

V. More Exit Paths

Lastly, there are now greater exit possibilities for startups, increasing the appetite for early-stage VC. Traditional paths, either through IPOs or M&As, used to limit exit prospects for investors given the restricted set of potential buyers (in the tech sector) and the cyclical nature of the public markets.

Today, digital transformation has not only diversified the type of potential acquirers (beyond corporate tech) but has significantly grown the option pool with the growing trend of startups acquiring startups. In fact, per Mind the Bridge and Crunchbase’s “Startup M&A 2017 Report,” the global startup M&A market saw the highest year-on-year increase in deal volume with +42% since 2011. At the same time, the maturation of the VC ecosystem, with more growth capital or direct secondary funds, now offers earlier exit opportunities through secondary sales.

Thanks to increasing valuations and companies staying private for longer, startups are now attracting crossover funds, private equity and hedge funds. Recently, SPACs have also jumped into the fray. These new players are adding to the diversification of exit routes for the initial backers of startups. Thanks to these evolutions, time to liquidity can be greatly shortened for early-stage funds.

Parting thoughts — early-stage venture beyond the capital.

Venture capital continues to expand and transform itself. It has grown from an almost niche activity with a limited number of generalist players and a narrow exit market, to a global industry with many highly specialized, sophisticated firms supporting the entire startup lifecycle with numerous viable exit possibilities.

As a consequence, competition is fierce and differentiation is key. Venture Capital is no longer only about funding. It’s about bringing smart capital and strategic value to startups at each stage of their development. The venture industry is slowly becoming more like the service industry — constantly reinventing itself to identify and win over startups with customized support to reach their goals.

At the same time, investing in early-stage funds and companies has become a must for diversifying investor assets. Nevertheless, picking the right players across regions and gaining early exposure to future Unicorns in “feeder funds”, will require, more than ever, sound experience and a deep understanding of the dynamics at stake.

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Cathay Innovation

A global venture capital platform investing in startups positively impacting the world through technology. #VentureCapital #Global #Startups #Digital #Impact