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Venture Capital Funds of Funds |
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Venture capital fund investments are among the highest returning fund investments.
Venture capital fund investments have a low correlation to traditional asset classes.
Exposure to the venture capital asset class can increase return, reduce volatility adddiversification and improve the overall risk/return profile of a portfolio.
Initial Background An investor can get exposure to the venture capital asset class by investing directly into a single venture capital fund. But there are four problems to this approach: 1) Wide dispersion of returns problem - Venture capital funds have a wide dispersion of returns with very high returns in the top quartile of the return unviverse. Also venture capital returns are not as systematically correlated as say public equity funds. So it is difficult to pick the correct fund. 2) High initial investment problem - The initial investment in a venture capital fund is very high. Therefore some investors without enough capital would not be able to participate at all. Investors who did have enough capital to purchase interests in say one or two funds would not have adequate diversification, unless the one or two funds represented only a smaller part of their overall portfolio. 3) Access problem - The best managers of venture capital funds have long track records of exceptional and consistent returns. This puts the best managers in a strong bargaining position in how they choose their investors. Proof of this strong bargaining position is the fact that new fund offerings from managers are often oversubscribed and offers go to those investors who have subscribed in the past. 4) Monitoring problem - The venture capital fund universe is very large and also not as transparent as the mutual fund universe. Therefore it is quite costly to excercise due diligence of potential venture capital fund investments. Solutions to the Venture Capital Investing Problem Several solutions are available to solve some of the problems of venture capital fund investing. 1) Non-discretionary management - It is possible for an investor to use an outside firm in a consulting type arrangement in order to help choose individual venture capital fund investments. In the non-discretionary type of arrangement the investor retains control over final investment decisions. 2) Discretionary management - It is possible for an investor to use an outside firm in a consulting type arrangement in order to help choose and also implement venture capital investments. In the discretionary type of arrangement the investor hands over all control over investment decisions to the outside firm. 3) Venture captial funds of funds - It is possible to pool capital with other investors to create a fund that would use the pooled capital to invest in multiple venture capital funds. An outside firm would provide this outsourced administrative function. Solutions 1) Non-discretionary management, and 2) Discretionary management are basically outsourcing the due diligence function. So they solve problem 4) Monitoring problem. But problems 1) Wide dispersion of returns problem, 2) High intial investment problem and 3) Best manager bargaining problem, are still not solved. Solution 3), Venture capital funds of funds, solves problems 1), 2), 3), and 4). Assuming the venture capital fund of funds firm has good relationships with the venture capital funds managers, monitoring expertise, and a reasonable fee arrangement, the venture capital funds of funds solution is the best solution for venture capital investing for most firms. |
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