The Case for Fund of Funds in Venture Capital
Aug 23, 2021
Venture capital is an exciting asset class for investors seeking higher returns, but evaluating untested companies at the beginning of their lifecycle and picking winners at an early stage entails significant risk. It’s a tricky proposition, as most companies either fail outright or do not live up to their (perceived) potential. As a result, investors may fail to achieve their return targets, or in the worst case, lose their entire investment. For investors looking at venture capital as an asset class, an alternative mitigates venture capital investment risk through greater diversification: a venture capital fund of funds (VCFOF).
Range, risk diversification, and easier access
Unlike individual venture capital funds, which invest in a single fund that puts all its resources to work to find the next ample opportunity while entailing a high probability of failure, VCFOF invests in a range of venture capital funds. VCFOF uses these underlying funds to provide investors with immediate risk diversification across several opportunities, which offers a greater likelihood of success and thus some protection from the significant risks of a lone bet going bad.
Furthermore, a VCFOF usually offers access to two or three “vintage years” – the years that represent the first influx of investment funding in the underlying company – providing investors with a better range of investment options at the bottom of the typical 10-year cycle for venture capital investments. Therefore, it effectively presents investors with more early-stage opportunities, thus increasing the multiple returns by the end of the investment cycle.
Investors can also access venture capital investments with smaller amounts through a VCFOF than they can do with a traditional venture capital investment. Due to their nature and regulations, venture capital funds require a significant minimum investment – typically several hundred thousand dollars for individual investors and several million dollars for institutional investors, such as pension funds. However, a VCFOF provides access to venture capital for much lower amounts to individual investors, with the opportunity for the same level of returns. Access to VCFOF is available for as little as a few thousand dollars, making it much more feasible for individuals looking to tap the potential of this asset class.
The power of the Power-Law
VCFOF has another powerful feature: the power law. According to the power law, individual outliers drive overall fund returns. As evidence of this, only 5% of all venture capital funds have a return multiple of more than 3x, with just 2% of funds accounting for 95% of all venture capital returns. Therefore, the law implies that the best funds do not need to have more big winners – they need to have more prominent big winners to be successful and achieve the return objectives. In other words, more investments increase the odds of finding an outlier that makes a fund – a fund maker. And this is borne out by data: out of more than 4,000 venture capital financing rounds each year, the top 100 generate 70% to 100% of the profits.
In addition, the fund of funds performs relatively well, considering the risks, due to the total value to paid-in (TVPI) capital ratio. A look at several representative examples (see chart) shows that although the top 10% of fund of funds and the top 25% of venture capital funds recorded a TVPI ratio of less than 2, the ratio for the Multiple I fund came in at almost 3, nearly 50% better than the other asset classes. This means it has a greater value with an equivalent amount of paid-in capital and thus provides investors with a better return opportunity, despite the inherent risks of the investment.
The benefits of VCFOF
A VCFOF presents an opportunity to invest in venture capital for retail investors seeking higher returns, an asset class typically reserved for large institutional investors. Where else can they find a venture capital investment with significant diversification, less risk, and lower entry costs? VCFOF allows investors to concentrate their resources in a single investment while still taking advantage of an asset class that focuses on innovative companies with significant upside while they may be untested. All it takes is picking the one big winner – VCFOF makes this even more likely.
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*Disclaimer: The above article is for educational purposes only and does neither constitute investment advice nor should it be considered to be an invitation or recommendation to buy securities or any other investment products. Please consult your financial advisor about the risks and opportunities prior to making investment decisions. By clicking on that link you confirm that you are a resident of Switzerland and a Qualified Investor according to the new Swiss legislation on collective investment schemes (CISA and CISO).
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