Venture Capital: Why ‘fees on fees’ can be good for investors
8 July 2021: For some private equity investors looking to allocate capital to the Venture Capital (VC) asset class, funds of funds are a no go. They traditionally have the reputation of being expensive, due to the double layer of management fees – fees they pay to their underlying Venture Capital fund managers (usually around 2% of commitments), and fees they charge to their own LPs (ranging from 0.5% to 1%). They also charge a second layer of carried interest.
It is easy to understand this reasoning. VC funds’ performance follows a J-curve early in their life, with fees dragging down performance while underlying assets are still held at cost. This means a negative return for LPs in the first years. Add more fees for the fund of fund manager, the J-curve becomes even deeper and longer: until recently, it was not uncommon for it to last for four or five years.
This understanding, however, is now largely out of date. Funds of funds have changed drastically over the past decade and most of them implement an investment strategy to mitigate – or quite often, simply remove – the J-curve. While they used to only make commitments to underlying fund managers, they now add secondaries and co-investments into the mix. Secondaries are LP positions typically bought at a discount to net asset value (NAV), meaning they provide an immediate fair value uplift. When acquired early in the life of the fund, this uplift has a significantly positive impact on the whole performance. Co-investments are made to later stage, high growth companies, and therefore tend to be more profitable and be exited relatively quickly. Also, funds of funds generally do not pay any fees on co-investments, reducing the average cost on their LPs’ committed capital.
Furthermore, when investing towards the end of the fundraising period, investors will likely buy into an existing portfolio which is already in positive territory. The final upside is also greater than what it used to be: while 1.8x was considered as decent for a fund of funds in the old world, they now frequently return 2.5-3x on invested capital.
These days, with those two strategies included, high quality funds of funds can show a negative return for just a few quarters – or none at all, for some of them. Their overall J-curve can even be shorter than the VC funds they have committed to! This is backed by Cambridge Associates’ data, which indicates that the median performance of US venture capital funds of funds has consistently outperformed the median three-year rolling benchmarks for direct US venture capital funds.
This is also exactly what we are seeing in our portfolio, three years after the launch of British Business Investments’ Managed Funds programme. This £500m programme is designed to address the patient capital funding gap in the UK. By targeting a commercial rate of return, our primary objective is to demonstrate the attractiveness of long-term, late-stage venture and growth capital for institutional investors. We typically make commitments of £50m to £100m to venture and growth funds of funds and have invested nearly £400m so far, to four different managers. Our net TVPI has always remained above 1x, and we currently see a significant acceleration in performance.
J-curve mitigation is not the only rationale to invest in funds of funds. Those who are not long-time institutional venture investors, are not usually able to access top VC funds. These funds are repeatedly oversubscribed and without an existing relationship with the managers, it is very difficult to get an allocation and build a high quality, balanced portfolio. This is where funds of funds, with decades of venture experience and connections all over the world, can grant access to top quartile VC funds. They may cost more in management fees, but those will largely be offset by the additional performance of such best-in-class VC funds, that will mitigate the high dispersion of returns from the Venture Capital asset class.
Fund of funds also have the advantage of providing a diversified portfolio with minimal efforts and costs. They typically give investment exposure to 10 – 20 VCs and 5 – 20 co-investments, significantly reducing the time and resources needed to build such a portfolio. In addition to a team sourcing and completing fund investments, an investor also needs experienced, connected, senior people able to find and evaluate venture secondaries and co-investments. For smaller investors, such as a family office or a mid-sized wealth manager, the ask will be too significant. For large institutional investors, Venture Capital as an asset class probably represents a tiny part of their existing assets. Will it be worth recruiting and deploying a team to look after this asset class? Funds of funds can be the answer to deploy a large amount of capital in a relatively short time frame. For the pensions industry, particularly, there are indications that more flexibility will be introduced to allow them to invest in more innovate ventures like funds of funds.
In conclusion, if investors have the experience, access, time and resources to build their own diversified venture capital portfolio, they will save fees by doing it themselves. If one or more of those is missing, their risk / reward ratio will increase dramatically, and a fund of funds may address this issue. For others with more limited experience in venture capital, funds of funds may be a very good place to start in order to put some capital at work rapidly while learning about the asset class.
Vianney de Leudeville is Director of Managed Funds at British Business Investments. Having joined in 2018, he came from the British Business Bank Strategy team, where he spent nearly two years working on British Business Investments-related projects.
Read more about the Managed Funds programme.