When investors allocate to a fund of funds, they are not just securing access to a range of portfolio managers in a key asset class, in our case venture capital (VC). They also benefit from a fund manager dedicated to the process of selection – ensuring that LPs are invested in managers with the best returns potential and the greatest risk mitigation.

The need for selection has perhaps never been greater, as the number of VC funds grows and grows across the spectrum. The number of VC funds has multiplied by more than 6x since 2008 in the US alone, including double the number of corporations now running their own funds.

This trend reflects a growing volume of capital and broadening opportunity set. It also puts a premium on the ability to sort between many different funds and select those with the best prospects of delivering top quartile returns consistently, regardless of whether they are well-known or newly established. Not every fund can be a winner. Not all who start well will achieve return persistence. No long-term track record amounts to a future guarantee.

The purpose of a fund of funds is to tell the difference: picking future success stories and filtering out emerging risk factors.

The selection process

No selection process is completely scientific or failure-proof, but our approach at Balboa is designed to be as rigorous as possible, looking at numerous factors in parallel to assess funds and select those that offer the greatest promise of sustained outperformance.

The first factor is deal sourcing. In an increasingly competitive landscape where the volume of available capital puts founders in the driving seat, how do fund managers attract companies and secure deals? For some established funds this will be about brand recognition and the network they can offer. By contrast, emerging managers might be deep sector specialists who have been successful founders themselves, and can add value through relevant experience. Whatever the case, we are looking for managers who not only find good companies to invest in, but are an attractive proposition to founders who often have a choice of which capital to take on. We are searching for managers who will enable us to co-invest in the kind of companies that will drive up a portfolio’s value significantly.

When assessing managers, it’s not just knowledge and focus that matter. We also want to know about their background and career history: their personal track record as well as their past investment performance. If they are a former founder, how many businesses did they run and how successfully? If an established manager, how long have they been with their current fund and how likely are they to stay for the long-term? There is nothing worse than backing a fund only to see a key decision maker depart months later. Another important question is how much of their own capital managers have invested in their funds. You want a chef who is eager to eat their own cooking.

Unsurprisingly, we also look very closely at track records. A majority of VC funds have outperformed the S&P 500 over the last 10 years, but the dispersal between the most and least successful has historically been significant. A recent study of VC funds, which analyses current returns of funds with vintages over a 20-year time span, found that those in the top quartile provided a 4.5x return on capital and outperformed the public market by 2.6x, whereas the bottom quartile was capital destructive and did worse than the stock market.

Fund quality also affects return persistence: the ability to maintain performance over time and across multiple funds. The same research found that VCs with a previous top quartile fund retained that position in 45% of cases (rising to 69% for above median performance). By contrast, little more than 1 in 10 of funds moved from the bottom to top quartile (or in reverse) between funds.

Performance assessment begins with rates of return and capital distribution to investors, but loss ratio (proportion of deals that ultimately lose money) is also key. Some, even many, VC investments are always bound to be failures, but if a fund’s returns are too reliant on one or two outsized winners, that gives us cause to worry about the sustainability of future performance.

Size of successive funds is also important: is the next one bigger than the last, suggesting growing momentum and investor satisfaction? And we want to know about a fund’s attitude to ESG: not just the principles and benchmarks on which investments are made, but how funds encourage and support their portfolio companies to be socially and environmentally responsible.

We also look at a fund’s underlying portfolio companies. This is not about analysing each in detail, but to get an understanding of the process and preferences that led to that investment. What kind of founders have they backed and why? What does it suggest about how they may invest in emerging trends and sectors? The best portfolios are those with high quality companies that we would be pleased to back as a secondary investor, and which are indicative of an investment approach which gives us confidence as a primary investor in new funds.

Finally, much like the funds themselves, we spend a lot of time on referencing. Conversations with a fund’s LPs, portfolio companies and competitors all help to paint a picture that the metrics alone cannot. They give us a rounded perspective on what a fund’s partners are like to work with, their approach to making investments and their ability to attract the best founders.

Few from many

Alongside all these selection criteria comes a raft of due diligence, looking at everything from where a fund is domiciled for tax purposes to the way they run their investment committee (the decision-making body), the quality of their LPs and the kind of funds they have co-invested alongside.

All of which adds up to a detailed and lengthy selection process, one which is designed to increase as far as possible the probability of future success.

Even so, there are no guarantees in investing, and VC is no exception. The most carefully chosen fund in the world can still stumble for all sorts of reasons – bad decisions, changes in personnel, shifts in a particular industry or volatility in the market as a whole.

But what we can say with confidence is that no manager is ever admitted to the fund of funds lightly. Our search focuses on three geographies: the US, with its unrivalled density of start-ups and venture funding; Europe, home to four of the five fastest-growing VC hubs since 2016; and Israel, which has the highest rate of VC funding per capita.

We are choosing from a pool that comprises over 8,300 funds in the US, 4,300 in Europe and several hundred in Israel. For all the funds we consider, only 10% go forward for detailed assessment, and around 1% to the final decision stage.

Our job is to distil the VC universe until we are left only with those funds that can claim the clearest track records, deal sourcing capability and quality of personnel. And our promise is that every single fund we select is there for a reason.