Most people picture venture capital as a firm choosing a startup and writing a check. There is another layer above that, though. Fund of funds investing doesn’t put money straight into most companies. It invests in other funds, and sometimes in companies too. It’s a bit like a person who doesn’t pick stocks but picks the people who pick stocks. This explainer covers how the model works, why it exists and what to watch for.
The basic structure
Picture the three layers of fund of funds investing. At the top are the people and institutions with money: pension funds, university endowments, foundations, family offices and wealthy individuals. In the middle sits the fund of funds, which pools their money. At the bottom are the underlying funds, such as venture capital firms, which put that money into startups.
The investors at the top are called limited partners. The managers of the underlying funds are called general partners. A fund of funds is itself a limited partner in those funds, and it has its own investors above it.
The result is that one check from an investor can end up spread across many managers and, indirectly, across hundreds of companies.
Why investors choose fund of funds investing
There are several reasons an investor might add this extra layer.
- Access. The best-known venture firms often have limited space and prefer investors they already know. A fund of funds with long relationships may be able to get in where a newcomer cannot.
- Diversification. Spreading money across many managers, strategies and years reduces dependence on any single one.
- Expertise. Judging a venture manager is a specialized skill. Smaller investors may not have the staff to do the research.
- Lower minimums. Some vehicles let investors take part with smaller amounts than a direct commitment would require.
- Time. Picking and monitoring many funds is a full-time job, and some investors prefer to hand it off.
The appeal of fund of funds investing is delegation. You accept less control in exchange for breadth and expert selection.
The cost of the extra layer
Nothing is free. A standard venture fund charges its investors a management fee and a share of profits. A fund of funds adds its own fees on top, so money passes through two sets of charges before it reaches the investor.
That double layer is the main criticism of fund of funds investing. For it to make sense, the manager’s selection skill and access must be worth more than the added cost. If the fund of funds picks managers who would have been available to the investor anyway, or if it does no better than an average choice, the extra fees simply reduce the return.
Fund of funds investing also tends to be slow. Venture funds often run for a decade or more, and the money is locked up for much of that time. Adding a layer doesn’t speed things up, and it can make it harder to see what is happening underneath.
How performance is judged
Measuring fund of funds investing is not simple. Returns arrive late, because the underlying companies take years to grow or be sold. Early on, reported values are estimates, and they can move a lot as startups raise new rounds or fail.
Investors tend to look at both what has been paid back and what is still held at estimated value. A fund might look strong on paper long before real money returns. A careful reader looks at the share of value that has actually been distributed, not just the unrealized gains.
Another key question is how the fund of funds compares with alternatives. Could the investor have reached similar managers directly? Did the selection add value after all the fees?
What a fund of funds does for startups
Founders rarely deal with a fund of funds directly, but its influence is real. By supplying capital to venture firms, particularly new or specialized ones, these investors help keep the pipeline of startup money flowing.
Some are created with a public purpose, such as supporting new managers, encouraging investment in a certain region or backing underrepresented founders. In those cases, the aim is to grow the ecosystem, not only to earn returns. Backing a first-time venture manager can lead to a wave of early-stage funding in a place that had little.
For a startup, the practical effect is more choice. A wider group of venture investors usually means more places to pitch and more variety in the types of companies that get funded.
Some questions worth asking
Whether you are an investor or just curious, a few questions help when you look at any fund of funds investing offer.
- How does it choose managers, and what does it offer that others can’t?
- What is the full fee picture, including both layers?
- How concentrated is the portfolio? Ten funds with similar strategies are less diversified than they appear.
- How much of the reported value has actually been returned in cash?
- How long is the money locked up, and are there any options for early exit?
Transparency matters. A fund that is vague about fees or portfolio makeup deserves extra caution.
Is it right for you?
For large institutions, fund of funds investing can be a sensible way to build a venture portfolio without hiring a big team. For smaller investors, it can be a path into an asset class that is otherwise hard to enter, as long as the costs are understood.
For everyone else, the lesson is simpler. Behind a headline about a startup raising money, there may be several layers of capital stacked on top of one another. Knowing how those layers work makes the whole system a little less mysterious.
For a neutral background reference, the Wikipedia article on Fund of funds is a useful place to start.
Related reading: How Fund Structure Shapes What Venture Firms Back and What a Fifth Fund Tells You About a Venture Firm.
