fund of funds - Cup of Zhou

We’ve had a number of family offices (FOs) ask Sam and I for advice recently on investing in venture. And Sam shared a post recently on exactly that, which I highly recommend reading if you’re considering investing in a fund-of-funds. This post is more of an elaboration, a continuation on his.

Some of which have had experience investing in startups. Others in venture funds. And many still, absolutely no venture exposure in their portfolio. And a fraction of them want to.

Some have reached the conclusion that it makes sense to invest in funds-of-funds (FoF), which we’re a big proponent of. That said, not all fund-of-funds are created equal.

Yes, different FoFs will pitch different value-adds to GPs. And yes, different FoFs will pitch different strategies — anchor versus co-invest versus secondaries versus asset class diversification versus lower fees. And yes, different FoFs will tell you they have access to different pools of GP talent.

But your motivations for investing in venture as an asset class are often different as a family office.

Some FOs want to invest in venture passively and use FoF exposure to give them comprehensive exposure to VC. Kind of the set-it-and-forget-it mentality. As long as the asset appreciates 10-15% per year. Here, families look for institutional processes. Do the FoF GPs know how to run a fundraising process? Is reporting and communication clear and timely? Do all interactions have a feel of polish? How many managers do these GPs see per year? Are they in embedded networks?

Some FOs want to eventually directly invest in startups, but want to use FoFs to have co-invest exposure, as well as learn how to underwrite deals. In fact, I talked to two family offices last week. One of which invested in a FoF who invested in Sequoia because they wanted access to Anthropic. Another because they wanted to invest via an SPV into a hot AI infrastructure deal. Here, they’re looking for thoughtful and elaborate memos. AI-written memos only go so far. They want to ask questions. Here, FOs are unlikely to move fast. In fact, they’re looking to spend time to get conviction on a deal. Webinars, meets and greets with founders, regular internal content pieces about why a space/vertical or a company in the underlying portfolio is exciting is paramount before an SPV gets put in front of them. Assuming they’re not looking for the same ol’ pre-IPO, blue chip names, they not only need to trust the FoF’s taste, but also the underlying GP’s taste and why the space is exciting. Returns from the FoF matter less than their individual returns from investing in the SPVs or direct vehicles.

Other FOs want to invest in venture funds due to a portfolio approach rather than being a stock picker, but hesitate at the risk-reward profile of unproven managers, so will only invest in Fund III+ (maybe Fund IV and onwards), and need FoFs to do the diligence/relationship-building for them. Yes, this is also true for a lot of institutional capital in general. It’s for that reason, that they typically say, “It takes us 3-7 years to get to know a manager.” The number of years itself is arbitrary. Depending on where on the totem pole an individual sits (for institutions), they’re motivations for punting the conversation till later varies from “Is this deal going to get me promoted/fired?” to “I just don’t have the time in the immediate future to spend disproportionate time on one deal that’s asking for the smallest ever check size I can write in the smallest asset class I allocate to.”

Similar to the above archetype who likes co-invests, but with an added layer of dinners, happy hours, and invitations to events where they get to meet different portfolio GPs helps them build conviction. The frequency of these don’t have to be as often as with founders, just because knowledge and insight atrophy faster than relationships with people. Individual returns from best-performing GPs matter more than the overall FoF returns. Batting average matters less than magnitude of the home runs.

Others still want to build their own fund-of-funds program, but don’t know how to and want to see how the best operate before pursuing it themselves. They would like regular calls with the FoF GPs, frequent texts back and forth and the liberty to ask rookie questions. For many FOs, we usually tell them it’s hard to expect these unless you’re an early commit to a brand new FoF, or you are at least a 5% check of the overall FoF size. Our general recommendation is that as a family office, you also commit to investing in the next vintage as well, so the GPs of the fund-of-funds have a reason to continue to the conversation with you. Simply, because, well… oftentimes, GPs whether a FoF or venture fund could be short-sighted in their ways of thinking. That also means if you have $5M to invest in a fund-of-funds, it generally makes sense to split that check up to invest $1-2M in the first vintage of a $30-50M FoF and double down in the second vintage if you are able to get what you want out of the relationship.

Returns also don’t matter as much, but these FOs will want to have at least seen what quality GPs look like. Ideally through the portfolio of the FoF, but if not that, at least through events and interactions made by the FoF.

There are those who want to put capital towards impact initiatives and fund-of-funds with an ESG/DEI mandate is one way they can bring impact with capital. FOs with these intentions are quite explicit, but to add on to what already is, regular reports and communication to know their dollars are being put to good use is really what they’re looking for. Returns matter a little less.

And yes, finally, there are those who care about fees. For most families that we work with, the fees don’t seem to be the primary concern. But having chatted with a number of families out there, it is a concern that exists for some, not all. That said, it is a low-hanging excuse to pass on a fund-of-funds. 🙂

Photo by Y M on Unsplash

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The views expressed on this blogpost are for informational purposes only. None of the views expressed herein constitute legal, investment, business, or tax advice. Any allusions or references to funds or companies are for illustrative purposes only, and should not be relied upon as investment recommendations. Consult a professional investment advisor prior to making any investment decisions.

Danny Meyer wrote in his book, Setting the Table, that as Union Square Hospitality Group, which has always stayed rent-free in my my mind, they prioritize the following in the order of:

The team
The customers
The community
The suppliers
The investors

And I’ve always thought that was an interesting stack ranking of the stakeholders in the business. Which oddly enough, until recently, I hadn’t thought about it for the fund business. A friend asked me a simple question the other day: “If a GP wants my time versus an LP wants my time, and I only have time for one phone call in the moment, who would I prioritize?”

Now before I answer that question, a few things:

The suppliers and the investors in a venture fund are effectively the same thing. Your LPs.
You can probably argue that service providers sit somewhere in this totem pole, but if we’re getting into the details of who a GP is collaborating or spending time with, we can also include parents, spouse/family, friends, and so on.
So, for the sake of this thought experiment, there are four primary stakeholders: team, customers, community, and investors.

Because I’m spending a lot of time with fund-of-funds these days, let’s also take this from the perspective of a FoF GP. (Although you can draw many analogies between a venture GP and a FoF GP). You have the team, your GPs, the community, and, your LPs.

Under the assumption that the FoF is designed as a financial vehicle than a strategic vehicle, I believe the ranking is:

team > GPs > LPs > community

GPs are a higher priority than LPs since without the GPs the LPs don’t make their money back. The GPs must outperform to deliver value to the LPs. How much help the best GPs need is debatable. But if your GPs ask for a service at the same time an LP does, then my belief the priority goes to the GPs.

Now, the more debatable point is that I believe the team should be prioritized over the GPs. Now this is also assuming that you have a team, and you’re not a solo enterprise (or a small, small partnership) yourself. Ideally, the team’s lifetime value (LTV) outlasts a GP’s LTV. I’d much rather be in business with the right team much longer than I imagine a FoF will be involved with a GP who usually graduates from the portfolio once they become obvious. Yes, there are edge cases, but I’m not here to debate the edge cases. The team’s value spans across fund vehicles. The GPs’ are only within the vehicle we invest in. As such, empowering your team members should be paramount. Set them up for success. Set them up to run their own initiatives and eventually lead the firm. But hire slowly, and fire quickly.

And lastly, your LPs are more important than the community. I am a believer in a rising tide raises all ships (after all, it’s why I’m writing blogposts like this), but I know not everyone believes in that. In fact, I’ve actually gotten in fervent debates with very successful investors who believe insight and information is proprietary. If you can’t serve your LPs well, no matter how great of a brand you have, no matter how much content you produce for the ecosystem, no matter how many speaking engagements, dinners, happy hours, and so on you host, you have a leaky bucket. Arguably a sinking enterprise. Your job as a business owner to create enduring and growing value for your shareholders. Your job as a charity or a foundation is to support the community first and foremost. That said, it doesn’t mean you throw the community out of the window.

In fact, the primary takeaway from all of this is that you always need to start from the lowest rung of the ladder. And that’s the community. To borrow Brian Chesky’s 11-Star Experience framework, at the base of this hierarchy, you need to already deliver a 6-out-of-5-star experience. You need to already go above and beyond for them. If everyone else is hosting happy hours already, you’re doing dinners where every diner gets a handwritten card from you about why they should be at the table. If everyone else has a Whatsapp community where they’re just adding people to a like-minded group, your community should have chapter leads that champion different topics and niche communities and be incentivized to host.

Only after that, do you deliver a 7-out-of-5-star experience for your LPs. 8-out-of-5-star experience for your investments (GPs or founders). and 9-out-of-5-stars for your team.

This is slightly different, though still similarly true, for fund-of-funds than with venture funds, but people often forget that venture is a financial services business. They get the finance part, but they forget the services part. Venture capital as a whole is an asset class, although arguable more than just one asset class. But emerging managers, via a fund-of-funds, is an access class. Implied in access, is providing access to people. Your LPs. Your GPs. Innovation. Insight.

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Tag: fund of funds

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