Funds-of-funds and Venture Capital
As the name suggests, a fund-of-funds (FoF) is an investment fund that invests into other underlying funds as opposed to investing directly into companies or securities. In order to gain a better understanding of whether Old Street Ventures is right for you, in this article we're going to take you through how FoFs work, the benefits they offer, and how they fit into the VC ecosystem from an investor's perspective.
An Introduction to FoFs
When you invest in a FoF like OSV your money gets allocated across a group of underlying funds, providing you with diversified exposure across a mix of strategies and startups. Each underlying fund typically follows a certain strategy, such as investing in specific geographies, industries, stages, or a combination of these and other factors. The investment time of an underlying fund is typically 3-5 years.
FoFs began as an investment strategy in the 1970s, but gained significance a couple decades later. They're an attractive option due to their inherent diversification, but are sometimes criticised by institutional investors for typically higher fees than investing directly with VC funds. However, the best FoFs offer several key benefits including access to top managers, diversifying away risks, expertise, and investment efficiency, and can often compete with VC funds themselves on returns. This means that it's quite common for professional investors who can afford to invest directly with VCs to opt to invest with FoFs like OSV instead.
Opening up Access
Direct investing in venture capital funds often requires having $5 million dollars or more to invest. Not many of us can afford that much, right? Even if this may be an appropriate investment for some investors or LPs, they would still have to make multiple investments to get the diversification benefits they need in the venture capital space. So building a truly risk-balanced portfolio is just too hard for most investors in this space! A FoF not only offers greater diversification through a single investment, benefitting those with limited capital, but goes one step further, leveraging the team's network and relationships to gain exposure to top funds, which new investors would otherwise be restricted from accessing.
Think of a FoF as a well-crafted basket of investments. More things in your basket, aka higher diversification, means reduced returns volatility, so if one startup doesn't do well, it won't hurt your whole investment. For comparison, while a regular venture fund might encompass 30 companies, a venture capital FoF may have exposure across several hundred companies! We're not necessarily saying that OSV will seek out quite that many, as with increased diversification you also eliminate much of the upside from outliers and unicorns. Instead, we aim to get our investors exposure to 100-200 companies, thereby mitigating downside risks but leaving room for the big winners to flourish.
Tapping into Expertise
When you invest in a venture fund, it's not about just the VC fund and its strategy; it's about the people who manage the fund. At the time of committing capital, you don't know what startups they will end up investing in. That's why it's essential to invest with managers who have a good track record, have relevant expertise, and have great networks in the business.
Having this insight requires extensive background knowledge of the managers — a level of insight that can often take years to build. By investing with OSV, you immediately access our knowledge and network, meaning your investment is placed with some of the top GPs in the world.
Increasing Investing Efficiency
Portfolio diversification often means long hours taken up by due diligence, and stretching already-limited bandwidth for investment discussions and deliberations. This is the core problem with equity crowdfunding and angel investing - how do you find the time to review all those companies? OSV provides investors with the upside of diversification without straining your time, leaving more room to enjoy the finer things in life. Especially in the venture capital space, where innovation and new technologies form the core of many companies, the learning curve can be steep and staying up to speed is a daunting task - which is why at OSV we take the time to find the best GPs for you.
When we look at how well FoFs do, we can compare them to different types of investments. In the case of venture capital, FoF performance is similar to the performance of portfolios of direct fund investments, thanks to its ease of access, faster capital deployment and high level of diversification.
And guess what? A good FoF strategy (and that's what we're here to implement) often mitigates or eliminates the dreaded J-curve effect - where in the earlier life of a fund performance is dragged down due to fees and overheads, whilst startup investments are held at cost until the next round where typically valuations are reviewed up.
These days, high quality FoFs 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.
By investing across sectors, stages and vintages (ages of funds) in OSV's funds, and with the option of participating in secondaries and co-investments (more on this later!), we aim to accelerate returns back to our investors and smooth out any bumps along the way.
Venture capital investors invest in young companies that have the potential to become global leaders. But not all companies succeed, so venture capital returns can be unpredictable. To mitigate the downside risks whilst maintaining attractive returns, most investors seek to diversify their venture capital exposure across a range of funds. However, this is unaffordable for most and with performance varying wildly from fund to fund and manager to manager, it's key to invest in top-performing funds and managers. This isn't always easy, as the best performing funds are often difficult to access. Further, building a portfolio of the best performing funds is even harder. Investors need strong networks to even gain access to the right managers, as well as extensive knowledge and experience to ensure they're partnering with the best ones.
This is where venture capital fund-of-funds like OSV really shine, leveraging relationships with key managers along with extensive data and experience to select the best managers and funds, all while reducing the minimum investment threshold. We said we want to keep it straight forward, that's why we do the heavy lifting so we can offer our investors (you!) a complete and comprehensive venture capital investment opportunity with top-tier funds.