Fund of funds: origins, evolution and deep dive with Michael Kim | E1890

05 Feb 2024 (9 months ago)

Changes to the "Angel" Podcast

The podcast "Angel" is rebranding to "Liquidity" as the host's focus has shifted from angel investing to managing a fund and discussing the broader venture capital space.

Limited partners (LPs) are investors in venture capital firms, including family offices, sovereign wealth funds, university endowments, pension funds, and high net worth individuals.
Fund of funds is a pooled investment vehicle that invests in other funds, providing access to a diversified portfolio of venture capital funds for large investors or those lacking the resources to directly invest in multiple small funds.
Fund of funds charge management fees, but they argue that the value they provide in terms of access, filtering, and education offsets these fees.
Some venture capital firms allocate a portion of their funds to invest in fund of funds as a way to gain exposure to new and emerging fund managers.

In the late 1990s, software companies required significant investment in hardware and software licenses, making it more expensive to start a company.
The emergence of Amazon Web Services and open-source software significantly reduced the cost of starting a software company, leading to the rise of seed funds.
As multi-stage venture firms grew larger, they began to focus on larger investments, creating an opportunity for seed funds to fill the gap and invest in smaller startups.
Seed rounds have become increasingly appealing to limited partners (LPs) due to the high returns generated by successful seed investors such as Chris Sacca, whose first fund had a DPI of 204x.
LPs are also realizing that commitments to larger platform firms may not provide sufficient exposure to early-stage ventures, leading them to allocate funds specifically to seed-stage investments.

Some venture firms continue to raise larger funds despite the potential for decreased performance, while others have remained disciplined and stayed small.
Multi-stage firms like Benchmark and Union Square Ventures have remained small, while others like First Round Capital have grown their fund sizes significantly.
Larger funds can generate more management fees, which can be tempting for VCs and lead to a decrease in their hunger and sharpness.
The math behind carry shows that even with a 2x return on a larger fund, a GP can make more carry than with a 10x return on a smaller fund.
Institutional LPs, such as state pension funds, need to write large checks and often invest in larger, later-stage funds to meet their asset allocation requirements.
There is a demand for consistent, top-quartile funds that generate persistent returns, even if they are not the highest TVPI or DPI funds.
Asset allocation is important for institutional LPs, and they need to fill their venture allocation, which can be done by investing in larger, established firms.
Yale University has a unique approach to venture investing, with over 50% of its endowment in private funds, including 30% in venture, and has achieved phenomenal results.

Fund of funds provide access to early-stage and seed-stage exposure for investors who want to diversify their venture portfolios.
YC and Techstars were early-stage space combinators that tried to scale up significantly, but their returns have been average historically.
YC invests in hundreds of companies a year and owns a small percentage of each, which is a good starting point but ultimately an index of high-quality companies.
The power law applies, so most companies won't return capital or be 1X, but catching one or two outliers like Airbnb or Stripe can lead to phenomenal returns.
Institutional LPs invest in YC with the understanding that it's a high-quality index with the potential for outliers.
Maintaining quality is crucial when scaling up investments. If the quality starts dipping, it's better to stay at the current level rather than expanding.
YC keeps its acceptance rate to 1.25%, ensuring that they only invest in the top applicants.
Fund of funds provide exposure to a large number of companies, with Sana having 4,000 portfolio companies and 130 unicorns.

Seed funds have a higher probability of getting to 3-5X, while pre-seed funds have a higher probability of being 5-10X.
Balancing exposure to seed and pre-seed funds can lead to a 4X return, which is historically the average for Sana's funds.
Diligence is crucial, and Sana focuses on talking to founders to understand how fund managers have helped them post-investment.
Founders should also do their due diligence by talking to founders of other portfolio companies to assess the responsiveness and support provided by fund managers.