The Business of Venture Capital, 3rd Edition

9LPs of Choice: Fund of Funds

Some large, really large institutional investors (like pension funds and endowments) invest in venture capital funds using an indirect investment approach. They pick an intermediary — a fund of funds (FoF) — as opposed to investing in venture funds directly. Now the obvious question is, why do smart, institutional investors bother adding a middleman — yet another layer in this mix? After all, they could bypass this step and invest in funds directly.

ADVANTAGES OF A FUND OF FUNDS

The fund of funds (FoF) model was established to meet the asset allocation and diversification demands of larger financial institutions. OK, let's try that in plain English — large, multibillion-dollar institutional investors have to sprinkle money in different buckets. Each bucket is an asset class and has risk associated with it and offers a different financial return. As we saw earlier, there are many buckets such as stocks, bonds, and real estate — even bitcoins. Venture is one such bucket. It's a smallish bucket when you compare it with other buckets like hedge funds, but it's getting bigger.

The venture bucket competes with a lot of other buckets for attention. As a result of risk-reward trade offs, not all buckets are equal. VC is the riskiest of them all — indeed, we often brag that 9 out of 10 companies in any fund's portfolio will fail. That's 90 percent of your LP capital squandered away. Not too long ago, eager investors put $1.5 million in a social media ...