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If you want to invest in some high-risk, high-reward startups but have no idea which will be the next Unicorn and which will be sent to the glue factory, that’s where funds of funds (FoF) might just come in to save the day!
These fund of funds are pretty special – they give limited partners (that’s LPs for short) access to a variety of top-notch VC funds. Plus, by spreading the love around, they can bring in better returns. And hey, they’re not just about making money – they’re also seen as key players in helping the VC ecosystem mature.
In this article, we’re going to give you a bird’s-eye view of what FoFs are all about and what you should keep an eye on as an LP or a potential fund manager. Oh, and of course, this wouldn’t be a Skytrain article if we didn’t focus on Germany, so there’s plenty of info there, too.
To help us put this together we consulted experienced FoF investor and founder of Multiple Capital, Ertan Can
Over the last 10 years, Ertan has been deeply involved in the European venture Fund of Funds scene. Starting at a family office in 2013 and building the first pan-European micro VC FoF. In 2018, he went on to found Multiple Capital, a FoF focussed on micro VCs (€5-50M). Now, he’s going on to start his third fund.
So, yeah, with 10 years of experience investing in almost 50 funds, with over 1,200 portfolio companies, it’s safe to say he knows his onions.
So what exactly is a Fund of Funds and how do they work?
Well, the answer’s really in the name. Just like a regular VC fund, you have Limited Partners (LPs) as investors, but instead of investing the fund’s capital directly into startups, you put that money into other VC funds.
Of course, there are FoFs that invest in pretty much any kind of asset class (private equity, real estate, hedge funds, stocks, etc.) but as we’re all about venture capital around here, that’s what we’ll focus on.
What are the benefits for LPs investing in FoF over regular VC funds?
Basically, a FoF makes every asset class accessible. So, if you think of stocks, you can buy just one stock of any company in the world. That’s why I have this opinion – it’s democratic. You can head over to the stock exchange, form an opinion, and buy a single stock of Google or Silicon Valley Bank, for instance. But when it comes to venture capital, it’s a different story altogether. You can’t just buy one single stock like that. You need to be an angel investor, exchange ideas with the founder, and basically have your ears to the ground all the time to even stand a chance of investing in the right startup. And even if you could call up your broker and buy a share, it would be almost impossible to get information about the most promising startups in far-off lands like Finland, Romania or the Baltics.
So, venture capital is one of the few classes of investments left where FoFs make a lot of sense. Because venture capital is high-risk, if you only invest in two or five companies, the risk of failure is pretty high. That’s where Fund of Funds come in handy, because they allow you to invest in a broad allocation of venture capital, and therefore, diversify your risk.
In Ertan’s fund, for instance, they invest in 30 funds, which invest in 30 companies each, resulting in almost 1,000 companies in their portfolio. Plus, they have experts who select the best fund managers for them. It’s like having a secret sauce that helps you pick the best of the best.
On top of that, each fund manager has their own area of expertise, like crypto, blockchain, or synthetic biology. It’s like having a specialist for every vertical and geography, and let’s be real, no one can be an expert in everything. Even Sequoia, one of the biggest players in venture capital, can’t do it all.
Sure, you pay for that privilege, but it’s clear why investing in FoFs makes a lot of sense for investors who want to take a chance on startups without putting all their eggs in one basket.
So, what kind of due diligence do FoFs carry out when choosing fund managers to work with?
When it comes to due diligence, the fund’s not about to go all Sherlock Holmes on a new fund manager’s portfolio. They’ll look for a few key things, like the fund size, the investment focus, and the manager’s experience in that focus area.
If a manager is new to a certain asset class, like climate tech, for example, and suddenly decides to start a climate tech fund just because it’s trendy, they’ll probably turn them down.
But of course, there are exceptions to every rule. For instance, with emerging asset classes like blockchain or Web 3, there may not be a lot of long-term experience to go on. In that case, if a manager can demonstrate unique knowledge or insights into the market, they might land the deal. But those cases are few and far between.
Overall, the goal of fund of funds is to identify the best-performing fund managers with the most promising investment portfolios to maximize diversification and mitigate risk.
Some advice to emerging fund managers
For an emerging manager, the most important thing is to find your niche and be one of the best in that niche, whether it’s geographically or vertically. For example, don’t pitch a small fund just because you heard that some fund of funds only invest in small funds. The most important thing is to be one of the best in your niche.
You also need to understand your commitment to the VC industry and be aware that raising a fund means committing to the next 15 to 20 years. This is not a job you can leave after a few years without creating conflict. If you’re successful in raising your fund, you commit the next 15 years to that one single fund.
So, find your niche, commit to the VC industry, and be aware of the time commitment involved.
And for Investors thinking about becoming an LP in a Fund of Funds
If you’re considering investing in a fund of funds, you’ll want to make sure you do your due diligence first. It’s not just about blindly throwing your money at the first opportunity that comes your way. You’ll want to look into the fund’s investment strategy, performance history, and management team.
Does the fund have a clear focus and well-defined investment criteria?
Have they consistently delivered returns to their investors?
Who are the fund managers and what kind of experience and expertise do they bring to the table?
These are all important questions to ask before committing your hard-earned cash. And don’t forget to do your research on the fund’s fees and expenses, too. After all, you want to make sure you’re getting the most bang for your buck, right?
So take your time, do your homework, and choose wisely. Your future self will thank you for it.
What are the typical fees associated with investing in Fund of Funds and how is that different from other investment vehicles?
In a normal VC fund you can expect 2% management fee and 20% carry. A fund of funds will charge half of that, so 1% management fee and 10% carry. But it adds up, because investing in a fund of funds means you’ve got two layers of fees to consider: the fees for the FoF and the fees that come when they invest capital into the VC funds.
But let’s put it into context.
For a very modest investment of €250,000, that capital will be deployed into 1000 via 30 different VC funds through the FoF. That’s the equivalent of investing €8,000 into each fund or €250 into each startup in the portfolio and, outside of crowdfundling platforms, that’s otherwise impossible in VC.
Even if you have a €1M check. That’s €30K per fund and €1K per portfolio company, again impossible to get that kind of diversity through regular angel investing or as an LP in a VC fund.
And now think about the fees associated with that. If you deploy €1M into a FoF, you’re looking at €10K per year management fees and you just couldn’t get the same kind of expertise and diversification for that amount of money. When you run the numbers, you would have to be investing more than €10M before it would be possible to do the job of a FoF in-house.
Let’s take it up a notch and say you’re a high-net worth family who want to deploy €50-100M across a variety of VC funds. That’s really when the “make or buy” decision comes into play. Through a FoF, you’d be paying €500K – €1M in fees. That’s a hefty chunk of change. You could hire two or three in-house experts and they’d be your employees but, chances are, they still wouldn’t do the same level of work as someone who’s incentivised to earn carry over the long term. Plus, employees change jobs. They stay with you for two, three years then move on to a bigger institution for a higher salary and take all the knowledge and experience they’ve built up managing your investments with them.
In the long run, committing your capital to a FoF could still make financial sense even for very high checks.
One last thing to watch out for is whether a fund charges management fees based on committed capital or Net Asst Value (NAV). If it’s based on committed capital, for your €1M investment, you’ll continue to pay €10K per year. When fees are charges based on NAV, the amount you pay as the Limited Partner will increase as the value of the investment increases. So, if your portfolio doubles in value, so will your fees.
OK, so let’s get into the German side of things as we promised…
How does the Fund of Funds market in Germany (and the rest of Europe) compare with the United States?
The first difference is pretty a pretty big one.
Up until around 10 years ago (when Ertan founded Multiple Capital), there weren’t really any FoFs investing in venture capital. Even today, there isn’t really a venture FoF “market” in Germany or Europe in general for that matter.
More recently we’ve seen a bunch of these funds popping up all over the continent and more and more people are realizing the potential of FoFs. But a lot of these funds are still in the process of raising capital. It’s one thing to have a great idea, but can you find investors who actually want to put their money into it? And can you actually invest that money wisely? A lot of these new fund of funds haven’t even made their first investments yet, so we’re very much still at the beginning in Germany and Europe.
Note: European VC news site Sifted published decent overview of ‘All the VC fund of funds you need to know in Europe’, here.
One of the biggest differences between Germany/Europe and the US is the activities of government FoFs and how they’re putting pressure on the private fund of funds ecosystem.
In Germany, there’s the KFW Bank and in Europe, there’s the European Investment Funds, and pretty much every country seems to have their own government funds acting as a fund of funds.
Initially, these government funds were supposed to fuel the Venture ecosystem and then make themselves obsolete, allowing private funds and LPs to swoop in and pick up where they left off. But, over the last 20 years or so they’ve become more and more powerful. The government funds are now the biggest LPs in Europe giving fund managers up to 50%, sometimes more, of the raised capital.
Though using government funds to fuel venture capital is a bad thing – especially as it was intended to kick-start a non-existant VC ecosystem – but they ended up competing with private investors, which can actually damage an emerging FoF manager’s ability to get off the ground.
One of the big reasons for that is the fees. In a government subsidized FoF, there aren’t any. So if you’re an insurance company in Germany and you have the option to invest in multiple fund of funds, you can either invest in a private FoF and pay fees, or you can invest in a government-managed fund without fees. Of course, most of them choose the no-fee product because who doesn’t like a free lunch, right? And that’s how the government funds are hurting the private fund of funds ecosystem.
In the US, which is the most mature market in venture, you don’t see the government acting as a fund of funds and offering private products without fees to investors. Just doesn’t happen.
Because here’s the thing: if you want to build an ecosystem in venture, fund of funds are part of the ecosystem. You can’t replace one part of the ecosystem with the government forever. It’s just not possible. And if you do that, it’s very unhealthy for the ecosystem because you’re deleting one of the parts. In a healthy ecosystem, you have startups that are private, funds that are private, and fund of funds that are private.
And believe me, it’s not just a short-term thing. It could hurt the private fund of funds ecosystem in Europe for the next 10 years or even longer. Taxpayers’ money is used to offer products without fees, which disrupts the private market because there’s no way they can operate without fees. It’s just not a level playing field.
So, the real answer is for the government to back private fund of funds instead of becoming competitors. A good example is the government subsidized Kfw Bank FoF in Germany. The government put around €400M into that private vehicle that could have been spread over 10 private FoFs, 40 million each, to really back the ecosystem. But, they decided to put everything in one government vehicle.
Note: Ertan told us his team at Multiple Capital are currently working on an article to shed more light on this topic. Follow him on LinkedIn or Twitter to hear about that when it’s published.
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