Venture Capital and Fund of Funds
A look at venture capital performance and variance over two decades
Venture capital (VC) is an exciting asset class focused on investing in future leaders, companies, and technologies. And yet, many investors tend to shy away from VC, hesitant to take on the perceived risk associated with investing in new companies — especially during early-stage funding rounds, when little is known about the company’s trajectory and exit potential.
The high uncertainty of the underlying investments leads to high variance in returns of venture capital funds. Most investors therefore look to create a diversified portfolio of venture capital funds — and ideally want to invest only in top quartile or top decile funds. However, it can be very difficult to access these top-performing funds, much less build a diversified portfolio of them. Thus, many investors instead choose to allocate to venture capital fund of funds (FoF).
A fund of funds invests into a selection of underlying funds, offering investors immediate diversification. Experienced fund managers can help investors smartly allocate to venture capital through their expertise across sectors and geographies, as well as through their network and relationships. Usually investing in a FoF will grant access to 2-3 years of vintages, which further diversifies the portfolio. By partnering with the right FoF manager, investors can benefit from the frequent higher returns of venture capital with the advantage of strategic diversification.
A long history
Much has changed since the early days of venture capital, whose beginnings date back to just after WWII. Venture capital used to be narrowly focused on finding that one rising star, with a long-term strategy of investing in emerging, private companies. These days, sophisticated investors mitigate the risks of early-stage funding by prioritising diversification. The asset class is also now more widely accessible, and top performance isn’t limited to veterans. New players often achieve impressive returns.
The venture capital landscape itself has also shifted. Investment firms today pour resources and efforts into creating supportive environments for entrepreneurs and fledgling companies (e.g., accelerators). Deal sizes are growing as the industry matures. It’s much easier now to judge a sound investment opportunity due to the wider availability of data and analytical tools: thirty years ago, the capital loss ratio was greater than 50%. Today, it’s around 20% .
But despite the evolution of venture capital, many investors consider it a risky investment. By developing a better understanding of the asset class and selecting a trusted strategic partner, investors can more confidently allocate funds to venture capital with the potential of high returns.
Real and perceived risk in venture capital
One misleading perception is around the inherent risk of venture capital. A common heuristic for a VC fund is to expect that out of any ten investments, most will fail, a few will return the principal, and one will be a home run delivering the returns of the fund. For many, these odds sound risky. After all, a significant portion of venture capital funds fail to deliver on return targets. So why invest?
Venture capital funds tend to either deliver very lacklustre returns or knock it out of the park. In other words, there’s a wide spread and variability of returns from fund to fund. Thus, when investing in VC, accessing funds in the top decile becomes very important. The best performing funds (i.e., those in the top decile) are often specialised, and built on years of investing experience. As there is such a wide dispersion of returns among funds, investors need to put together a portfolio of multiple top-performing funds, in order to reduce the variability of returns of their combined venture capital portfolio.
Investing beyond the hubs
For a long time, venture capital has been associated with specific geographical areas. Most visibly, the industry seems centred around Silicon Valley. But investment opportunities can come from anywhere, and it’s prudent to adopt a global approach . Cities around the world are brimming with entrepreneurial talent, and each location boasts its own key strengths. In particular, today’s globally-minded investors are keeping a sharp eye on China’s growth as a technology leader, and India’s untapped power as a highly-populated market.
Stages of VC investing and historical performance
Venture capital funds are generally focused either on early-stage or seed-stage investing – or on later scale-up or growth stage investing.
Early-stage venture capital investments
In the pre-seed and seed rounds, entrepreneurs typically approach friends and family, accelerators, or high net-worth individuals for capital. Following these rounds is the early-stage investment. In the early-stage funding rounds (typically Series A and B), young companies have a much higher risk profile. With no financial track record, little to no advancement on research and development, and unproven product/market fit, the company may offer very little evidence regarding its chances of future success.
Early-stage investors assess the opportunity by taking a hard look at the management team, and analysing the growth of the relevant sector(s), the current competition, and the nascent technology. To accelerate the company’s growth, investors may also provide mentorship to the management team as part of their overall investment strategy.
Historically, early-stage funds have outperformed late-stage funds. Early-stage funds with vintage years between 1981-2015 achieved an internal rate of return (IRR) of 19.7%, with late-stage funds at a much lower 11.6% . As early stages inherently hold more risk than late stages, there’s more variance (larger standard deviation) among the returns.
Loss rates for early-stage investments hover around 65% (recall our earlier heuristic) . However, early-stage investments have generally outperformed the public market. The table below shows the average performance of early and late-stage funds based on 1,970 US venture capital funds created between 1981 and 2020 .
Late-stage venture capital investments
Late-stage VC investments typically refer to Round C and later funding rounds. As more companies are staying private for longer, opportunities for late-stage venture capital are expanding . Late-stage investments are for more mature companies, meaning they likely already have a robust operating model, an established product/market fit, and clearer path to profitability. Often, these companies are looking to raise capital in order to lay the groundwork for eventual expansion. The investments often have larger dollar amounts than they do in the early stages, a loss rate of less than 30%, and an IRR target of 20% . Similar to their earlier counterparts, late-stage venture capital investments have also historically outperformed public markets.
Variance in Venture Capital
One of the key characteristics of venture capital is its wide variance in performance, which is typically broken down by quartiles. Investors should aim to invest in top quartile — or ideally, top decile — funds .
The graph above illustrates the importance of choosing managers with a history of selecting top-performing funds and a strong, strategic vision. An example concerning a separate group of funds further emphasises the dispersion: In a group of 779 US VC funds, removing the top 5% of funds drops the combined IRR from 10.2% to 7.8% .
Fund access and selection
It’s often said that 20% of the companies drive 80% of the returns in the industry. To increase the likelihood of selecting a top-performing fund, investors can partner with fund managers with a strong track record in generating high returns. Without investing in at least one top performer, generally through diversification or skilled fund selection, investors are likely to be left unsatisfied with venture capital’s performance. However, access to top decile VC funds is highly competitive — and thus difficult for most investors — and many investors therefore turn to specialised venture capital fund-of-funds for their venture capital exposure.
Investing in venture capital through fund of funds
An introduction to fund of funds
As the name suggests, a fund of funds (FoF) is an investment fund that invests into other underlying funds as opposed to investing directly into companies or securities.
A FoF invests in a group of underlying funds, providing investors with diversified exposure across the underlying funds. Each underlying fund typically follows a certain strategy, such as investing in specific geographies, industries, stages, or a combination of these and other factors. The investment time of an underlying fund is typically 3-5 years.
FoFs began as an investment strategy in the 1970s , but truly gained significance a couple decades later. They’re an attractive option due to their inherent diversification, but are sometimes criticised for adding an additional level of fees. However, the best fund of funds offer several key benefits including access, diversification, expertise, and efficiency, and can often compete with direct fund investments on returns.
Opening up access to funds
Direct investing in venture capital funds often requires tickets of $5 million US dollars or more. Even if this may be an appropriate investment for some investors (or Limited Partners, LPs), they would have to make multiple investments to provide the diversification they want in the venture capital space. A FoF not only offers greater diversification through a single investment, benefitting those with limited capital, but goes one step further, leveraging legacy access to gain exposure to top funds, which new investors would otherwise be restricted from accessing.
By its nature, a FoF has diversity built-in. Higher diversification means reduced volatility, eliminating much of the downside of venture capital investments. For comparison, while a regular venture fund might encompass 30 companies, a venture capital FoF will have exposure across several hundred companies .
Tapping into expertise
Assessing a venture fund investment opportunity really means assessing the fund manager. At the time of investment, the underlying investments are not known (hence why funds are often referred to as a “blind pool”). It follows that an investor should invest with trusted managers who have thoughtful strategies, excellent networks in the target segment, and strong track records of picking great companies.
Having this insight requires extensive background knowledge of the managers — a level of insight that can often take years to build. By investing into a FoF, you immediately access the FoF manager’s knowledge and networks, increasing the chance of thoughtful investments into underlying funds.
Increasing investing efficiency
Portfolio diversification often means long hours taken up by due diligence, and stretching already-limited bandwidth for investment discussions and deliberations. The structure of a FoF provides investors with the upside of diversification without straining limited capacity. Especially in the venture capital space, where innovation and new technologies form the core of many companies, the learning curve can be steep and staying up to speed is a daunting task. To efficiently select diverse funds with a high potential for success, FoF investors must depend on their fund-of-fund manager, and choose a skilled partner accordingly.
When looking at performance, it’s important to separate out FoF into asset classes. In the case of venture capital, FoF performance is similar to the performance of portfolios of direct fund investments , thanks to its ease of access and high level of diversification. Additionally, venture capital fund-of-funds in the top quartile have a history of continued success: both top quartile performers in large and small funds between 1979 and 2010 had a 42% and 45% chance, respectively, of repeating their top-ranked performance .
Fund-of-funds and Co-investments
In a co-investment, an LP invests directly into a particular company within a fund alongside the fund itself. In the case of a co-investment with a fund-of-fund, the FoF invests directly into an underlying portfolio company — of one of the funds the FoF has invested in.
By their very nature, FoFs focus primarily on investing into funds, and thus don’t ordinarily invest directly into companies. However, co-investments with underlying funds can often provide attractive opportunities. Many fund-of-funds, especially in the venture capital space, reserve a portion of their capital for co-investment opportunities.
Management fees for co-investments are often different from the main fund-of-funds, though participating in the main fund-of-funds can sometimes be a prerequisite for accessing the co-investment opportunities. This requirement is slowly changing, however, with the development of pure co-investment funds with FoFs .
It’s important to note that co-investing is not always an option for all investors involved in the main fund-of-funds. It’s sometimes a separate agreement at the discretion of the General Partner, and typically an option extended to key strategic partners. “Strategic” may mean that the LP has a particular background or previous relationship with various aspects of the company, such as its geography or industry.
In the case of venture capital fund-of-funds, co-investment opportunities can be especially attractive for investors. This is because these opportunities have already been vetted by a trusted underlying fund manager, and have often been significantly de-risked by the time of the co-investment.
Venture capital investors invest in nascent companies that have the potential to become global leaders. But not all companies succeed, leading to significant variability among venture capital fund returns.
To mitigate the variability and achieve a risk-balanced return, most investors seek to diversify their venture capital exposure across a range of venture capital funds. However, with performance varying wildly from fund to fund and manager to manager, it’s key to invest in top-performing funds and managers. This isn’t always easy, as the best performing funds are often difficult to access. Further, building a portfolio of the best performing funds is even harder. Investors need strong networks to even gain access to the right managers, as well as extensive knowledge and experience to ensure they’re partnering with the best ones.
This is where venture capital fund-of-funds really shines, leveraging long relationships with key managers along with extensive data and experience to select the best managers and funds. In one stroke, a good venture capital fund-of-funds offers investors a complete and comprehensive venture capital programme with best-in-class funds, and exposure to interesting co-investment opportunities in some of the most exciting upcoming companies.
 Cambridge Associates. "Venture Capital Positively Disrupts Intergenerational Investing." (2020)
 Schroder Adveq. "The opportunity in early stage venture capital." (2019)
 Cambridge Associates. "Global Venture by Strategy," as of Dec. 31, 2015, inclusive of all available vintage years dating from 1981-2015. Early stage data represents 1,278 funds and late stage data represents 214 funds. Past performance is not a guarantee of future results (Accessed via Invesco)
 Industry Ventures. "The Venture Capital Risk and Return Matrix." (2020)
 Cambridge Associates. "US Venture Capital Index and Selected Benchmark Statistics". (2020)
 Invesco. “The case for venture capital.” (2020)
 Industry Ventures. “The Venture Capital Risk and Return Matrix.” (2017)
 Cambridge Associates. "US Venture Capital Index and Selected Benchmark Statistics". (2020)
 Cambridge Associates, Frank Russell Company, Thomson Reuters Datastream, Global Financial Data, Inc., TVPI Advisors’ analysis. Returns are net to LPs in USD and are through December 31, 2016 for US-focused Venture Capital funds of vintage years 2001 to 2014. Funds ranked by IRR, vintage years based on first cash flow. Relative performance calculated using Direct Alpha Methodology. (Accessed via ILPA and TVPI Advisors)
 Probitas Partners. “Funds of funds: a brief history.” (2015)
 Schroder Adveq. “The opportunity in early stage venture capital.” (2019)
 “Financial Intermediation in Private Equity: How Well do Fund of Funds Perform?” by Robert S. Harris, Tim Jenkinson, Steven N. Kaplan, and Ruediger Stucke (2017). Accessed via Canterbury Consulting.
 “The Persistence of PE Performance,” by Adams Street Partners (2017). Accessed via Canterbury Consulting.
 Eureka Hedge. “Emerging Trends in Co-Investing Alongside Funds in Asia.” Eureka Hedge (2018)
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