Digging in the gold rush: The investor case for fund of funds
Paco Navas
Technology companies are the biggest investment opportunity out there. Thanks to the low barriers to entry and leaps forward in cloud and API capability, it’s never been easier to build – and scale – massive tech businesses. They drive unparalleled returns for those investors who can identify and access them early. But many can’t. Venture Capital is more an art than a science, and doesn’t yield reliable results – even to those that know where to look for the most promising businesses. Offering better access, lower risk and stronger returns, funds of funds are – as far as we’re concerned – the smart way for investors to reap the benefits of the tech boom. Here’s why.
Technology is the biggest investment opportunity
To understand the changing shape of the investment market, consider the identity of the world’s largest companies. Fifteen years ago, with the global financial crisis on the horizon, just one technology company – Microsoft – ranked among the ten biggest public companies by market capitalisation. Today, it is one of seven on the same list, all of which were once backed by venture capital (VC) investors.
Technology is taking over, with relatively young companies displacing some of the most established names in capitalism from its top table. Technology is transforming the world’s biggest industries – from financial services to healthcare, transport and education, unlocking improvements in productivity and driving rapid growth. And the revolution is gathering pace. It’s never been easier – or more profitable – to start a technology business. The ubiquity of cloud computing has removed many of the old barriers to entry, so much so that the costs of starting a software business have plummeted by up to 90% in recent years. And once built, they’re extremely scalable, with no COGS and potentially infinite distribution.
Alongside the rise of technology has come another power shift: from public to private markets. While the number of listed companies in the US was cut in half between 1996 and 2016, private markets have boomed. Between 2010 and 2017, the number of venture capital deals increased by 73% and capital invested accelerated by 231%.
In this environment, technology companies have been staying private for longer and raising larger and larger sums from venture capital investors to fuel their growth. On average, technology companies were 7.5 years-old at IPO in the 1990s, compared to almost 11 years-old during the last decade. The consequence is that much more growth is happening – and consequently much a larger slice of investor returns is being yielded – before companies become available to public markets investors. Amazon and Netflix were valued at a few hundred million dollars when they went public in 1997 and 2002 respectively. By contrast, Uber was valued at over $75bn when it listed in 2019, and Airbnb in excess of $100bn at its IPO last year. As a result, the advantage increasingly lies with those who are able to invest early and take stakes in private companies – which, in the technology sector, typically means venture capital funds.
VC investment in technology is volatile
Against this backdrop, it’s easy for investors to reach the conclusion that they need more exposure to private markets. Deciding how best to achieve this is harder. The first step is to recognise the distinctive features and specific challenges of investing in these asset classes. In the case of VC, the risk-reward calculations are dramatically different from public markets investing. The returns can be impressive – but they are also extremely inconsistent. According to one study, in an average group of 10 VC investments, seven will not return the capital invested in them, two will return enough to make up those losses, and the final one will be the primary driver of the fund’s returns.
Those seeking to allocate capital to VC therefore need to select fund managers they believe can find the 1 in 10 ‘home run’, and compensate for the inevitable failures that come with investing into such early-stage companies. That’s a skill: in early-stage companies, the usual metrics by which you would assess the success of a business, like cashflow, profit margin, market position and so on don’t exist. So intuitively, it makes sense to back those with proven success. That’s a hypothesis the evidence appears to back up: unlike public market managers, the performance of VC managers from one fund to the next is very highly correlated. In other words, if you back a VC manager that has succeeded once, they have a very good chance of doing so again the next time, and the time after that.
The art of picking the founders, companies and market opportunities that amount to an early-stage winner is something that the best managers seem to be good at repeating, as their skill and experience grows. But unfortunately, capital allocation in this space is not as simple as picking those with a track record of picking winners. Because the evidence also suggests that the most successful investors can be the ones just starting out – the so-called ‘emerging managers’ raising their first or second fund. Of VC funds raised between 2007-16, 52% of the top 10 annual performers were run by emerging managers.
That underlines the complexity of allocating capital in VC, a job that requires an understanding of the particular risk dynamics of the asset class, and the ability to pick managers who offer a combination of the best returns and the most persistent. These needs bring to the fore one particular investment strategy: the fund of funds.
Funds of funds offer improved access and odds
Through a fund of funds, investors gain access to a spread of different managers across the spectrum from established to emerging, including those who specialise investing into particular sectors or geographies. In an asset class that is defined by concentration of risk, it allows them to benefit from a degree of diversification – an appropriate allocation to emerging managers who hold the potential for the highest returns, and those with a proven track record who offer a greater (though, of course, never guaranteed) promise of consistency.
Those who invest in a fund of funds are backing a manager who will scrutinise the risks and benefits of each VC fund manager as carefully as they in turn do the companies into which they invest. At the highest level, fund of funds managers analyse all the previous investments of each GP, what they’ve raised and how they’ve performed. Then they look at changing risk profiles. If a VC has changed its investment thesis, or switched from backing seed to later-stage companies, for example, those investments might be less reliable. And then they scrutinise portfolio companies themselves to understand and sense-check the broader rationale of the fund. By doing so, the fund of funds approach adds additional layers of due diligence into the process of determining where capital will finally be invested. Plus, it provides a seat at the table with established managers who might not otherwise be accessible.
As institutions increase their allocations to private markets, they will understandably be seeking a high level of diversification and risk management to smooth what can be a bumpy ride of investing in early-stage companies, which offer huge potential alongside significant risk. There is no one perfect model of investing in these asset classes, but the fund of fund strategy is designed to maximise opportunities while limiting concentration of risk. In the business of finding that elusive handful of companies that can supercharge returns, diversification is common sense: why have only one talented manager digging for gold on your behalf when you could have several, all looking in different places? At its best, this approach doesn’t just limit risk – it also broadens opportunity for those taking their first steps into the rewarding world of private markets.