What is a Fund of Funds?

Savvy investors understand that venture capital is an asset class driven by power laws—especially in early-stage deals. For this reason, many VCs aim to invest in a wide variety of deals. But with many deals having significant investment minimums, getting the appropriate level of diversification can be difficult for investors who are capital-constrained.

That’s where funds of funds come in. With the same amount of capital that might have only allowed an investor to invest in a few deals, that same investor can gain exposure to a much higher number of deals by investing in a venture capital fund that invests in other funds.

Venture capital funds of funds can thus present a very attractive proposition for investors. Consequently, whether to use a fund of funds investment strategy is also a consideration for general partners (GPs). But while there are clear benefits for both GPs and investors, there are important considerations to know before jumping in.

What is a Fund of Funds?

Also known as a multi-manager investment, funds of funds are simply funds that invest in other funds. These are not necessarily venture capital related—they can be hedge funds, private equity, real estate, or mutual funds.

For the purposes of this article, we’ll be focusing on VC funds of funds. However, not all funds of funds that invest in venture capital funds are “pure” VC funds of funds. It’s possible for a single fund of funds to have a portfolio of funds spanning venture capital, private equity, and hedge funds.

In terms of their investment mandate, funds of funds can be either categorized as “fettered” or “unfettered”. Fettered funds of funds are only allowed to invest in funds that have the same management company as the fund of funds. For example, a fettered fund of funds by Fidelity would only be able to invest in other Fidelity funds. On the other hand, unfettered funds of funds can invest in a wider variety of funds.

Because of the smaller fund sizes in venture capital, most VC fund of funds are unfettered. A few notable examples of fund of funds in VC are Sapphire Ventures, SVB Capital, and Northgate.

Benefits of Venture Funds of Funds

For limited partners (LPs), investing in VC fund of funds can provide:

• Easy diversification. Funds of funds make diversification easy by providing exposure to multiple VC funds with a single investment—reducing the capital requirements for diversification. A fund of funds will typically also have several years of vintages in its portfolio, which boosts diversification even further.
• More balanced returns. Pitchbook data shows that standard deviation in the IRRs for funds of funds are significantly lower compared to traditional venture capital funds. Of course, there are outliers—funds of funds showed a much higher standard deviation in 2020 compared to venture capital funds. But the data indicates that the general rule holds.
• Access to exclusive VC funds. Certain funds don’t offer access to non-institutional investors. This can be due to high investment minimums or even “exclusive” funds that carefully vet their LPs. In such cases, the only way for non-institutional investors to get access to those funds may be through a fund of funds.
• An extra layer of professional management expertise. Investors benefit from two layers of professional management expertise—one at the fund of funds level and other at the underlying venture funds’ level. This can help provide greater reassurance in an asset class generally perceived as highly risky.

The above factors that attract LPs to fund of funds also make them an appealing investment strategy for GPs. GPs who decide to use this strategy may have an easier time raising capital—especially if they’re targeting smaller non-institutional investors as LPs.

VC Fund of Funds Structure and Fees

Most VC fund of funds are limited partnerships.

This means they have both GPs and LPs. The LPs are charged a management fee while the GPs can earn carried interest on fund returns once the LPs have been paid back the full amount of their initial invested capital.

This also means investors in funds of funds must bear two layers of fees—first from the portfolio fund and second from the fund of funds. Returns are thus reported on a “net-net” basis (meaning they’re net of both layers of fees). And while funds of funds fees used to be opaque, the SEC now requires funds of funds disclose all their fees in a line item called “Acquired Fund Fees and Expenses.”

However, because of the double-layer fee structure, funds of funds usually have a lot more variation in their charged fees. For instance, most VC funds follow the “2-and-20” structure (2% management fee and 20% carried interest). Investors might be unwilling to pay an additional “2-and-20” on top of that, meaning the VC fund of funds might have to lower its fees to attract investors.

Co-Investments in Venture Capital Funds of Funds

Venture funds of funds typically invest in other funds—whether as a primary investor when the fund is raising capital, or as a secondary investor by buying out other LPs’ stakes. But there are situations where they invest directly in portfolio companies as well (usually alongside other venture capital funds). This is called a co-investment.

When co-investing in a startup, the fund of funds has the assurance that the company has already been “vetted” by one or more VC funds—which helps de-risk the investment. On top of that, the fund of funds avoids needing to pay additional fees to the fund. Many VC fund of funds reserve a portion of their capital for such co-investment opportunities.

VC Fund of Funds Considerations

While following a fund of funds strategy has clear benefits, GPs—as the potential fund of funds manager—should be aware of its drawbacks. Investors considering venture fund of funds may be concerned about:

• Whether the additional fees are worth it. As mentioned, investing in a fund of funds carries an additional fee layer—which can substantially affect returns. GPs must be able to justify this, whether it’s through providing access to exclusive funds or the prospect of returns.
• Potential overlap reducing diversification. If the portfolio funds hold the same startups in their respective portfolios, diversification levels are reduced.
• Fund manager skill. In most instances, LPs in a fund of funds are investing in a “blind pool” where they have no idea what the underlying funds are. GPs must show they have the skill necessary to evaluate and identify outstanding venture capital funds to attract investors.

Final Word on Funds of Funds

For many investors, VC funds of funds are viable vehicles for gaining exposure to venture capital investing. The AngelList Access Fund, for instance, provides investors exposure to both startups and other venture capital funds—with historical returns that have outperformed the top quartile of other VC funds.

Similarly, GPs could more easily raise capital by following a fund of funds strategy if they can justify the additional fees.