The fund-of-funds model has a new role to play in the venture ecosystem as the amount of capital allotted to such funds has declined over the years. And as its role changes, I couldn’t help but wonder if this new version is helping diverse and emerging fund managers.
Forget, for a moment, the pros and cons of the model itself — my colleague Rebecca has already covered that. Think instead of the actual premise of a fund of funds (FoF): Investors and LPs back such funds as a way to enter a market, sometimes to get into early-stage deals, as they can use the funds’ broad base to spread risk. So if an investor is already adjusting for risk, why not back diverse and emerging fund managers who are doing the same thing as any other manager: placing bets and hoping for high returns?
If the problem is that diverse fund managers are riskier, for whatever reason, then the FoF model should give an added layer of protection should everything go astray. Typically, FOFs do good diligence, meaning the level of diligence will be lower for the LPs looking to invest in the funds backed by the FoFs. This might be a plus for some investors.
An easy way to see how a prospective fund is doing is to simply ask them: schedule a call to connect. Or ask a friend what they’ve heard about so-and-so. Literally, just go out there and get them. A lot of diverse fund managers fit into the emerging fund manager bucket, and they are not going to turn down an established investor.
After all, it’s a tough market out there, as Sara Zulkosky, managing partner at Recast Capital, a U.S.-based fund of funds, points out.
“We’ve seen firsthand that it can take diverse-led venture firms over twice as long to raise their funds. Many emerging managers, raising more modest fund sizes, are raising from high-net-worth individuals, family offices and other institutions via modest check sizes,” she told TechCrunch+. “FoFs, specifically those focused on emerging managers, can oftentimes write more substantial checks and help to accelerate a fund.”
Zulkosky and her co-founder Courtney McCrea decided to start Recast to solve a problem: Emerging managers perform well, but LPs find it difficult to access them directly because they can’t write checks small enough or find the time to expand into another market.
“We saw an opportunity for an institutional-grade intermediary to help LPs gain diversified exposure to diverse and emerging managers in venture,” she said.
In a way, the FoF model is perfect: Emerging managers are looking for more capital, and investors are looking for diversification and exposure. Fabrice do Rego, the founder of Brussels-based The Blueprint VC, said that the FoF structure could help more firms like his to grow throughout Central Europe and attract more money to help back diverse founders.
Chloe Dagnell, an associate at FoF, Isomer Capital, noted that FoFs could lower the risk barrier for international LPs to enter a market because they provide diversification while also enhancing the coverage that LPs desire. “In Europe, this is particularly important,” she told TechCrunch+. “The fragmented nature of the geography means it is nearly impossible for one manager to cover the whole market.”
Emerging managers are also often seen as too small or riskier to invest in, which leads to hesitation on the part of LPs, as larger LPs might not be able to cut them a check or have time to do proper research.
Allocation through an FoF would give larger LPs access to an emerging manager and their market, rather than simply not investing at all, randomly picking a firm, or solely backing later-stage funds, Dagnell added.
“FoFs are typically long-term investors in the space, and they can follow on an emerging VC’s next vintages and be a true partner as the firm grows,” she said. She said her firm has helped teams create new VC firms, assisted with policy and legal setup, and introduced managers to LPs.
Zulkosky’s Recast does something similar, offering additional support not only to the emerging managers in whom it invests but also to the broader community, such as through its Enablement and Accelerate Program to support more people of color, as well as women and nonbinary individuals within venture.
This avenue for building relationships is another reason why FoFs are good for emerging fund managers. “Many LPs leverage fund-of-funds as a means of market intelligence, allowing them to watch the underlying manager’s performance over time and then try to invest directly alongside their fund-of-fund relationships,” she continued. “This can be valuable to build a durable LP base over time.”
“FoFs are essential interlocutors for fund managers, especially for emerging managers, because beyond providing them with financing, they provide market sentiment,” do Rego said.
FoFs can also serve as a signal to other LPs and investors about the validity of an investor or a market, according to Adriana Embus-Figueroa, an investor at U.S.-based Include Ventures. She said that the substantial due diligence of FoFs allows “limited partners to fund the often-overlooked fund manager who’s doing great work.”
Embus-Figueroa’s point has merit. Many diverse fund managers are also experts in backing their own communities and can provide investors access to potentially lucrative and overlooked markets.
A good example of this would be Black hair care, a multi-billion-dollar industry. Founders from France, the U.K., and the U.S. have told me that investors simply do not understand the Black hair care market and are not convinced it’s big enough to be worthy of an investment.
The added protections that an FoF offers could help investors in situations like these, as these funds back managers who have already found success in an industry.
A drawback of the fund-of-funds structure is there’s always a commercial agenda, and there are too many good fund managers to back. Embus-Figueroa noted that the structure of an FoF means that allocators pay double fees for both the FoF fund and the underlying fund. In turn, that means FoFs have to be extremely selective about the funds they will back.
On the other hand, she pointed out, an advantage is that FoFs may often serve as the first institutional check to allow for a diverse emerging manager to begin their fundraising season. “I think there should be more FoFs to provide liquidity to underserved markets. And there should be more creative funding as well, whether providing LP capital or providing general partner recoverable grants to help reduce a lot of the early costs for emerging managers.”
As with most debates regarding diversity within venture, the argument always boils down to who is willing to take the risk. Uncertainty will always be there, but until investors cease equating underrepresented communities with “exposure to peril,” the opportunities allocated will remain lopsided. If risk and money are the game, this is perhaps an exciting ball park to bet on.
Do Rego feels that the FoF model could help create more diverse-led LPs who are looking to dip their toes in new markets and back emerging managers. He believes more diverse LPs will lead to more diverse VCs, who in turn will back more diverse founding teams.
“It should be a virtuous circle,” he said.