The Innovator’s Dilemma for Fund-of-Funds
In Revere’s first content piece on why venture capital is broken, we talked about “access”...namely throwing out the old definition: trying to get something that you can’t have, and we started a dialogue around understanding something that is inherently hard to understand.
We also noted a plethora of investment firms and consultants that serve purely as access gateways to name-brand and oversubscribed funds, offering little in the way of transparency into underlying positions and opportunities to build direct relationships. Oh, and many of these structures they proffer come with two layers of fees for this "access" and have a steep J-curve to boot.
We unpack the dilemma of and limitations around fund-of-funds that focus on venture capital, and preview a few solutions through Revere’s productization and thematic basket approach.
HOW WE GOT HERE
Venture capital fund-of-funds (“FoFs”) have been around for at least the last 20-30 years. They were a result of the reality that the best venture capital funds raised modest sized funds and only a select number of LPs had access and allocation. These same LPs were the early pioneers of the venture capital FoF model.
This brings us to the time-honored concept of the S-curve of innovation, made famous in The Innovator’s Dilemma, the classic treatise from the late Clayton Christensen, who was deemed by The Economist as the foremost management thinker of our time. The S-curve elegantly maps out the life cycle and usefulness of technology and innovation and is set out below:
In the early 2000s or so FoFs were at the forefront of investment innovation, grabbing the attention of various investors that adhered to the principles of endowment-like passive asset allocation models. Many of these investors were looking for technology investments but not getting exposure and returns in traditional buyout funds or public markets, so they turned to FoFs that provide access to the best venture capital funds...and were willing to pay whatever the cost of admission. These FoFs would settle on their straightforward niche and value proposition -- reselling their access.
BUT THE S-CURVE KICKS IN...
Soon thereafter, given the S-curve, FoFs were maturing and approaching a plateau, nearing the end of their value proposition. While FoFs delayed S-curve effects by innovating (somewhat) and building out co-investment, secondaries and even region specific funds, these were only iterative points of expansion. Largely driven by the type and profile of investors that they were servicing (large institutions, endowments, pensions, etc.), FoFs were locked in and couldn’t truly move into innovative models.
Revere co-founder Eric Woo is well-versed on the FoF model, having worked for nearly 8 years in the industry. When he first started in 2009, some FoFs dabbled in seed and emerging VCs, but didn’t seriously commit to these strategies, eventually burying these commitments within their main funds. For most FoFs, even socializing a standalone emerging manager fund-of-funds was deemed too risky because it might alienate their established (and largely satisfied) LP base, and posed tremendous fundraising and strategic risk.
This “gap” led to new entrants coming in and focusing on these niche strategies. With early difficulties trying to educate potential LPs, these new entrants endured very long fundraising cycles. But through perseverance, being early to the new category and shifts within venture capital itself, these new entrants carved out their market share, eventually forcing the more traditionally-thinking incumbents to establish their own emerging manager programs.
CHOKED BY CONSTRAINTS
By the mid 2010s, traditional FoFs grew long in the tooth and are generally in decline because the windows of opportunity to innovate are long gone. The structural model itself is choked by certain critical constraints (old and new), including:
- Core LPs stuck in their ways. Most FoFs have a relatively concentrated LP base that wants to “buy” venture capital a certain way. These LPs are even slower moving and most don’t even have the word “innovation” in their vocabulary. Thus, they hold FoFs hostage, making it even harder for them to do new things.
- LP’s direct access to name brand funds. The FoF model itself relies on the good ol’ “access” story, putting nice logos of name-brand, oversubscribed funds in their marketing materials. However, many of these name-brand funds have gone on to raise significantly larger funds and expanded into opportunity funds, thereby making it easier for FoF LPs to get direct access themselves, without the need for a FoF to provide access.
- FoFs are a beta product with alpha product fees. Without the “access” storyline, FoF have to rely on “alpha generation” through manager selection. Cambridge Associates research has shown that there is a wider distribution of venture capital returns over the last 10-15 years, meaning generating consistent alpha is getting that much harder. Without the ability to generate alpha consistently, FoFs become a beta strategy, which makes their extra fees and carried interest harder to justify.
- Investors are impatient. Many new investors entering venture capital do not abide by traditional longer-term asset allocation principles and place an emphasis on liquidity. As such, the extra fee drag and steep J-curve of FoFs are simply not palatable for many investors, especially given the regression of FoFs returns. Furthermore, with illiquidity in venture capital only getting worse as companies stay private longer, FoFs and their LPs cannot justify this (worsening) illiquidity premium.
WHERE DO WE GO FROM HERE?
For any FoF insider and their institutional investor LPs, these are existential issues with no simple answers. These issues are further complicated by the fact that many of these insiders are at the tail end of their careers, often with precious little talent to succeed them. We don’t meet many experienced tech investors or successful founders with exits under their belts looking to start a traditional fund-of-funds or joining the established FoF brands.
Revere believes that a new dawn is at hand, and innovative new products will replace the incumbent FoF approach. To disrupt the old way, Revere is utilizing an arsenal of tools that include:
- Use of technology to increase transparency of holdings. FoFs are notoriously opaque, so the use of technology by companies like Revere bring increased visibility and transparency to underlying asset holdings of the products they build. This enables operational efficiency and resonance with a newer generation of LPs that are tech literate and need to know the individuals and causes that they are backing.
- Product orientation to specific segments of the LP stack. With Revere’s call that venture capital has become a bona fide asset class (read it again here), more types of LPs are entering the fray and the vast majority of them want to buy venture capital in a different way. While addressing specific segments initially revolves around smaller pools of capital, this makes it easier to find early product-market fit. Traditional FoFs simply cannot justify the resources nor do they have the right people to actually pivot.
- Marketing and building a brand that stands for something. Historically, FoFs was a reflection of the people running the firms and their sets of relationships, personalities, and client service acumen, all of which make for an antiquated experience and is a relic of the past. The new disruptors will instead lead with their brand -- like any consumer product/service -- which will be synonymous with quality, capability and strength. The members of these new organizations will fold into this brand, not the other way around.
- Innovation through iteration. Mr. Christensen is also known for stating that innovation is refined through iteration/failure and bred from unique perspectives. Because these disruptors are not from traditional asset management backgrounds, they will be able to iterate, build and scale their businesses much faster and efficiently. While they may pivot and fail early and often (again, a necessity according to Mr. Christensen), this process will serve as an advantage, whereas any engineered failure at a traditional FoF would mean a death spiral.
CALL TO ACTION
So what does this mean for observers on the sideline looking to invest in venture capital? Revere unequivocally believes that it is the ideal time to do the work, because you will see the incumbent-disruptor movie play out before your eyes. Certain underlying “cinematic” themes are very much worth noting:
- While the crash and burn of existing models will be slow (but somewhat entertaining), finding the right approach is a bit more complicated. A modern asset allocator MUST study the new models and should not “settle” for something that everyone is slowly moving away from.
- With more innovation, particularly around what Revere is calling the productization phase of venture capital, fees will come down, transparency will improve and there will be increased awareness of how to measure the quality of fund managers and their portfolios --all tailwinds for justifying venture capital as a permanent part of any asset allocation strategy.
- As productization moves forward, Revere is pioneering new models that give investors the “trinity of asset allocation”: customization, risk mitigation and lower fees. Revere’s approach focuses on the thematic basket, which enables investors to actually select what they want to invest in (customization) and spread their bets across different investments (risk mitigation), without a dual layer of fees (it’s all about the fees!). This did not exist in venture capital...until now.
- Beyond this trinity, Revere's approach enables the investor to get closer to the underlying startups, their innovative technologies and the emerging managers that back them. This bodes well for sophisticated investors who can take advantage of the information asymmetry and strategic relationships built through the new models that Revere are building to further deploy capital into those winners and truly engage in innovation investing.
If you’re reading this, that means you’re looking for something better and looking to participate in the Golden Age of returns in venture capital. This involves a new, better way...
Revere lights the way.