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

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

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) and Fund of Funds

  • 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.

Evolution of Seed Funds

  • 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.

Fund Size and Performance

  • 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 and Early-Stage Exposure

  • 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 and Pre-Seed Funds

  • 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.

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