When Fund-of-Funds for Venture Work
By Wiley Becker
Fund-of-funds have fallen out of favor in recent years due to strategic and structural issues. Historically, fund-of-funds have focused too much on diversification, to the detriment of their performance. With too much diversification, many have mimicked the average of their asset class of focus and, in venture capital, the average has struggled to justify the illiquidity over the last ten years.[i] Further, fund-of-funds charge an additional layer of management fees on top of those charged by their portfolio funds. While these fees are gratuitous when performance merely achieves the asset class index, they are easily offset with outperformance of just 1% annualized above the index (analysis to follow). Fund-of-funds also remain prudent for particular asset classes, including venture capital, and for particular investors, including those with either too low or too high a level of assets under management to diversify appropriately.
The venture capital asset class is characterized by one of the highest dispersion of returns among funds. Since 1980, the standard deviation in Net IRRs has been 40% from the mean.[ii] This figure is skewed dramatically by several funds achieving extraordinary performance (see Exhibit B). With over 400 venture funds raising capital or expected to be raising capital over the next three years, it requires experience, insight, and dedication to determine which of these funds will outperform. While this expertise can certainly be built in-house by institutional investors, it takes time to build relationships with general partners and requires staff dedicated to studying the ever-changing asset class on a daily basis. Considering that venture is often only 5% of an institution’s portfolio, it may not always make sense to hire internal investment professionals devoted solely to venture capital.
Access, as it has historically been portrayed, is no longer an issue in the venture capital asset class. Billion-dollar funds are raised annually by many of the old-line names and often accept new investors. However, access to the next generation of elite firms is very limited. Firms like Foundry Group, which was founded in only 2007, limit their fund sizes as part of their strategy and are vastly oversubscribed for new funds after they have proven their performance. These firms raise smaller funds in the $200MM range, have flat organizational structures where the partners work intimately with each portfolio company, are focused solely on sectors in which they have personal experience, and may or may not be based in Silicon Valley. Oftentimes these firms are started by partners or principals at other firms that spin-out to create their own firms. Accordingly, access requires long-term, personal relationships with this next generation, knowledge of new funds coming to the market (currently over 50), and insight in order to determine whether to make a commitment before performance has been proven.
Considering the high dispersion of returns in the venture asset class, investing in just one fund is risky and imprudent. However, the historical approach to diversification, by which institutions and fund-of-funds invested in over 30 primarily large funds, results in a reversion to the mean of the asset class, which has not been particularly attractive for venture capital over the last ten years. The following exhibit demonstrates the statistical ranges of performance for portfolios of various numbers of venture capital funds.
Exhibit A [iii]
Depending on an institution’s risk tolerance, a portfolio of only 10-15 funds should limit the downside risk while allowing the potential for outperformance and proper diversification among sector, stage, and geographic focus. Considering the average minimum LP commitment for funds between $100-250MM is $5MM,[iv] an investor would need to have a venture allocation of $50-75MM when fully called. Assuming a venture allocation of 5%, an investor would then need to have $1-1.5B in assets under management to diversify adequately. Institutional investors below this size may then require a fund-of-funds to achieve diversification with a smaller aggregate commitment.
Commitments to larger venture capital funds are also more likely to constrain returns to the average of the asset class. The simple scatter plot that follows charts fund performance by fund size and demonstrates that smaller funds more often outperform the venture index by a greater degree.
As expected, smaller funds in the venture asset class have a higher dispersion of returns than larger funds. Consequently, they have the ability to ether outperform (or underperform) the average more dramatically. This is a rich, but riskier segment of the venture capital market where there is the opportunity for significant outperformance with the appropriate insight, due diligence, and diversification. Unfortunately, for larger investors who are often not able to own more than 20% of a portfolio fund, a $20MM commitment to a $100MM fund is not an efficient use of time. Say for a $20B institution, staff would spend the same amount of time (or more considering the intricacies of the small fund segment of the venture asset class) to invest just 0.1% of the portfolio as they would on a $200MM commitment to another fund for 1% of the portfolio. Thus, in order to access this fertile region of the venture market, larger institutions may require fund-of-funds as well.
Fees are the largest point of contention when it comes to fund-of-funds. The typical fee structure is a 1% annual management fee and 5% carried interest on profits. First, these fees must be weighed against the alternative of building an internal venture capital staff. A team of two experienced investment professionals will cost on average approximately $400,000 annually.[vi] Therefore, an investor committing $40MM or below to a venture capital fund-of-funds would be paying the same or less in annual management fees than had they hired internally. However, that investor would also be benefitting from outsourcing to a specialized firm with an established track record and greater professional depth.
Secondly, if an experienced venture capital fund-of-funds is able to achieve an annualized return greater than 1% of that which an investor would have returned itself, all of its fees including carry are offset. The following tables calculate the gross performance a fund-of-funds would have to achieve in order to provide various net returns to LPs after a standard 1% annual management fee on committed capital and 5% carried interest on all fund profits.
For instance, a fund-of-funds would have to achieve a 20.71% Gross IRR and 2.16x Gross Investment Multiple on its portfolio of funds in order to provide investors a Net IRR of 20% and Net Investment Multiple of 2.0x after all fees. Consequently, if a fund-of-funds can provide more than a 1% annualized Net IRR gain to that which an LP can expect of itself, then the investment in that fund-of-funds is worthwhile.
While fund-of-funds are not appropriate for all asset classes or all investors, they remain a valuable part of the venture capital ecosystem. The venture markets require full time and attention, long-term relationships, and prudent diversification. Although fund-of-funds charge for this service, the fees are reasonable when compared to the alternatives and when justified by outperformance.
[i] Cambridge Associates LLC, 10-Year US Venture Capital Index 4.41% Annualized Net Return as of 03/31/12
[ii] Analysis of 772 venture capital funds investing North America, vintage years 1980-2008, greater than $50MM in size as of 09/30/11
[iii] Analysis of 581 venture capital funds investing North America, vintage years 1998-2008, greater than $50MM in size as of 09/30/11, analysis based on the Central Limit Theorem
[iv] 2011 Preqin Private Equity Fund Terms Advisor
[v] Analysis of 772 venture capital funds investing North America, vintage years 1980-2008, greater than $50MM in size as of 09/30/11, 46% standard deviation of Net IRRs for funds $250MM and below, 27% standard deviation of Net IRRs for funds greater than $250MM
[vi] 2011 Preqin Private Equity Compensation and Employment Review