Source: Pitchbook (Written by Leah Hodgson)

The late-stage venture market is a perilous place to be at the moment, particularly for those itching to offload assets in the public markets.

For that reason, many VCs dedicated to backing the most mature of startups are glancing behind them to see what the earlier stages have to offer. The advantages of this strategy seem obvious—today’s early-stage companies could mature in a more forgiving exit environment—particularly for those worried about late-stage valuation trends.

Most investors who focus on more mature companies have simply begun making direct investments in younger companies. But there’s another way.

Andreessen Horowitz is preparing to launch a fund-of-funds, Business Insider reported. While the details of its plans—such as size and whether it will be raising external capital—are unknown, the FoF vehicle reportedly has the express purpose of giving the firm a stronger foothold in the early-stage market.

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Several high-profile VCs have used FoFs to access early-stage dealflow over the years, including Bain Capital and Insight Partners. Even the once-mighty hedge fund Tiger Global started taking stakes in venture investors to give it visibility into the seed-stage market—although the firm has recently been seeking to sell some of its portfolio.

Still, the strategy hasn’t been particularly popular in recent years as the accessibility of direct VC investments has increased. In 2022 the venture world saw its lowest count of these vehicles in a decade, and only three have closed so far this year, according to PitchBook data.

But with the possibility of a trendsetter like a16z adopting an early-stage FoF strategy, I wonder whether now might be the right time for a resurgence.

Seed banks

There are a few reasons why fund-of-funds could gain traction now that the market has become more challenging.

FoFs inherently provide diversification by investing in multiple underlying funds across different sectors, stages or geographies, which can be appealing to investors looking to spread risk and reduce the impact of potential losses. Instead of making 10 investments in startups, make two fund commitments instead and have access to twice as many companies. The investor increases the potential to capture high-growth companies and reduces the risk of any individual investment.

It’s true that investors can diversify on a smaller scale by doing direct investments, but it’s important to note that late-stage investing requires a different skill set compared with early-stage bets. Many may be hesitant to leave their comfort zone and take on a new strategy given the more difficult times they are facing. In which case, investing in a fund rather than trying to build up early-stage startups without prior experience may be more beneficial.

The universe of VC-focused FoFs is small, but the strategy has a strong track record. Over the past decade, vehicles that invested in VC outperformed FoFs across all other private market strategies, according to PitchBook data.

A VC fund-of-funds can also reduce the operational burden for investors compared to making direct investments in individual startups. Try as they may, even the largest investor can’t do everything at once. Having the underlying VC fund manager handle the due diligence, monitoring and selection processes frees up time for the investor to focus on other critical aspects of their investment strategy or business.

Fee fears

Using a FoF can have benefits beyond returns for late-stage VCs. By backing a fund, the LP has insight into the portfolio’s performance, which wouldn’t be as accessible to outsiders. A late-stage investor who has committed to the underlying fund can use that knowledge to make direct investments into the best-performing companies and thereby increase deal flow for its core business. This is particularly beneficial when there’s increased competition for the best assets.

The downside is that the late-stage investor doesn’t have direct control or influence over the investment decisions made by the underlying funds. This lack of control might limit the ability to shape the portfolio according to specific preferences or strategic goals.

The main drawback, however, is fees. Investors in these vehicles must convince their LPs that the opportunity warrants two layers of fees.

The fees reduce net returns, and the effect is worsened by the longer-term nature of early-stage investments. In an environment where VCs and LPs alike are counting pennies, the double-fee structure is a hard sell, particularly when direct investments are an option.

With the fundraising climate being what it is at the moment for VCs, FoFs are unlikely to become widespread across the venture market—even with the stamp of approval from a big-name VC. But as competition intensifies for the best assets in the early stages, we may see more than in years past.

Related read: PitchBook’s 2022 Global Fund Performance Report

Source: https://pitchbook.com/news/articles/fund-of-funds-early-stage-dealflow