In the dynamic world of venture capital, the concept of a “fund of venture capital funds” (FoVCF) is gaining significant traction. But what exactly is a FoVCF, and why should investors consider it as a part of their investment strategy? This blog delves into the intricacies of FoVCFs, offering valuable insights into their benefits, risks, and strategies for maximizing returns. Whether you’re an experienced investor or just starting, understanding FoVCFs can open new avenues for portfolio diversification and financial growth.
What is a Fund of Venture Capital Funds?
A Fund of Venture Capital Funds (FoVCF) is an investment vehicle that pools capital to invest in multiple venture capital (VC) funds. Rather than investing directly in startups, FoVCFs allocate their capital across various VC funds, thereby diversifying the risk associated with individual startups and sectors. This structure provides investors with access to a broader range of investment opportunities, managed by professional VC fund managers.
Key Components of FoVCFs
- Diversification: By investing in multiple VC funds, FoVCFs spread risk across different industries, geographies, and stages of startup growth.
- Professional Management: Investors benefit from the expertise of seasoned VC managers who make investment decisions based on thorough market analysis and due diligence.
- Accessibility: FoVCFs provide access to top-tier VC funds that might otherwise be inaccessible to individual investors due to high minimum investment requirements.
Frequently Asked Questions About Fund of Venture Capital Funds
1. Why Invest in a Fund of Venture Capital Funds?
Investing in a FoVCF offers several advantages, including diversification, access to professional management, and reduced volatility compared to direct investments in startups. By pooling resources, FoVCFs can invest in a wider array of opportunities, spreading risk and potentially increasing returns.
2. What Are the Risks Involved?
While FoVCFs offer diversification, they are not without risks. The performance of a FoVCF is dependent on the success of the underlying VC funds. Market volatility, economic downturns, and poor fund management can all impact returns. Additionally, the layered fee structure—where investors pay fees to both the FoVCF managers and the underlying VC fund managers—can eat into profits.
3. How Does a Fund of Venture Capital Funds Differ from Direct VC Investment?
Direct VC investment involves committing capital to a single startup or a few startups, which can result in higher returns but also higher risk. In contrast, FoVCFs invest in a portfolio of VC funds, offering a diversified approach that mitigates individual startup risk. This diversification is particularly appealing to investors seeking exposure to the VC asset class without the volatility of direct investments.
4. What Should Investors Consider Before Investing in a FoVCF?
Investors should evaluate the track record of the FoVCF managers, the fee structure, and the fund’s investment strategy. It’s crucial to understand the sectors and stages the underlying VC funds focus on, as these factors will influence the risk and return profile of the FoVCF. Additionally, investors should consider their own risk tolerance and investment horizon.
Benefits of Investing in Fund of Venture Capital Funds
- Broader Exposure: FoVCFs provide exposure to a wide range of sectors and geographic regions, allowing investors to participate in diverse markets.
- Reduced Risk: The pooled investment approach reduces the impact of any single fund’s poor performance, leading to potentially more stable returns.
- Expertise and Network: FoVCFs often have access to elite VC funds managed by experienced investors, providing a higher likelihood of successful investment outcomes.
- Scalability: Investors can achieve greater portfolio scalability and optimization by spreading investments across multiple funds, increasing the chance of participating in high-growth startups.
The Risk Profile and Popularity of Fund of Venture Capital Funds
Investing in a single company often involves a high-risk profile due to the concentration on one asset, making the outcome heavily dependent on that company’s success or failure. On the other hand, investing in a single venture capital fund diversifies this risk across multiple companies, typically ranging from 10 to 20 portfolio companies, thus categorising it as a medium-risk investment. However, the diversification extends even further when investing in a fund of venture capital funds (FoVCF), which can encompass over 250 assets on average. This substantial increase in the number of portfolio companies significantly lowers the overall risk profile, as the performance of the investment is less likely to be adversely impacted by the failure of any single company.
The Risk-Limiting Nature of FoVCFs
Combined with benefits such as increased access to a variety of sectors and enhanced diversification has made FoVCFs particularly appealing in higher-risk asset classes like private equity and venture capital. According to a study conducted by Cambridge Associates, which analyzed the performance of various asset classes from 2006 to 2021, private equity and venture capital emerged as the highest-performing asset classes. These sectors not only offered exceptional median and top-quartile returns but also exhibited the most considerable risk, defined by the wide dispersion between the best and worst-performing investments.
This combination of high potential returns and high risk underscores the attractiveness of FoVCFs for investors seeking to maximize their returns while mitigating risk. The ability to spread investments across a vast array of companies and funds provides a more stable investment profile, reducing the likelihood of significant losses and smoothing out the performance volatility inherent in individual investments. Thus, FoVCFs serve as a strategic option for investors looking to balance their portfolios with exposure to high-growth sectors while managing risk effectively.
’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)
Conclusion
A Fund of Venture Capital Funds represents a compelling investment option for those looking to diversify their portfolio and gain access to the venture capital market. While FoVCFs come with their own set of risks and fees, the benefits of professional management, reduced volatility, and broad market exposure make them an attractive choice for many investors. As with any investment, due diligence and a clear understanding of one’s financial goals are key to making informed decisions.
Amit Khanna, 7startup Founder
Amit is an investor and advisor with two decades of experience and an MBA. He supports entrepreneurs with fundraising & go-to-market expansion in Saudi Arabia. His strategy is built on two pillars: deep investment acumen and a vast operational network. Reach out to us today and see if we’re a fit!
