Do Emerging Manager Fund of Fund make sense for LPs?
It's a polarizing topic within the GP/LP world, so let's take an analytical view
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Are Fund of Funds (FoFs) worth the fees when investing in emerging managers?
Limited Partners (LPs) have long debated this question, with strong opinions on both sides. Some LPs, such as endowments and pensions, use them to save time and resources, achieve diversification, and gain access to high-quality promising managers —- Given the maturation of Emerging Managers, there are now plenty of quality emerging FoFs in the market now.
For other investors the conversation often focuses on the fee structure. "Another layer of fees? How can that possibly make sense?"
While this concern is valid, it overlooks the broader goal: maximizing net returns while minimizing the time commitment.
Of course, many LPs prefer to invest directly as they enjoy building relationships with fund managers and it certainly increases their chances for co-investments (buyer beware here). However, this paper primarily focuses on an economic analysis.
Since we are focusing on smaller-cap/emerging manager (EM) funds (though much of this analysis is also still relevant for established manager FoFs), let’s start with return data. Pitchbook data for 2010-2020 small-cap funds (sub-$250MM) indicates:
Top decile managers deliver 38.4% returns
Top quartile achieves 24.2%
Median performance sits at 12.8%
Bottom decile drags at -4.2%
That's a staggering 42.6 percentage point spread between top and bottom decile. In emerging manager investing, selecting the right managers isn't just about upside – it's about avoiding significant underperformance that can drag down an entire portfolio.
Having spent 25+ years in venture and the last 17 years working with funds, successfully identifying, accessing, and building a portfolio of complementary funds is absolutely a full-time job if consistent outperformance is to be expected. This requires deep networks, sophisticated due diligence processes, and, most importantly, the ability to construct a portfolio that mitigates extreme return dispersion.
Comparing Investment Approaches to invest in Emerging VC
Let's analyze a hypothetical $5 million allocation to emerging venture managers. For an LP, there are three primary approaches to building an emerging manager portfolio every year (6-10 investments for diversification):
The DIY Approach (Do It Yourself, Not Hiring professionals)
Time and cost analysis: 400-500 hours minimum
300 initial GP meetings (150-300 hours)
Deep diligence on 20 funds (100 hours minimum)
Portfolio monitoring - AGMs, meetings with GPs (50+ hours annually)
Opportunity cost: $60,000-$75,000 in year one (assuming $150/hour per hour of time spent; my guess is most people that can deploy $5MM would value their time higher than this)
Challenges: Limited time to truly canvas the market, diligence/investment capabilities may not be institutional grade, and access limitations may lead to suboptimal investments.
Hiring an In-House Investment Professional
Annual cost: $200,000+
Salary, benefits, and overhead
Additional costs for data services, travel, and due diligence
Challenges:
Management required
Risk of key person dependency if professional leaves
Potential lack of extensive network and access compared to established FoF managers (unless the individual is very experienced with a strong network)
“Hiring” a professional Fund of Funds manager (typical fees below)
1% management fee: $50,000 annually
5% carried interest on profits
Two-year deployment period
Note that beyond fee comparisons, FoFs led by experienced teams often offer structural advantages:
Established relationships with managers, leading to better sourcing through high quality warm referrals and access.
Institutional credibility, capital predictability, and check sizes that allow access to oversubscribed funds.
More robust diligence processes, including the ability to tap trusted networks for meaningful references.
As mentioned, even family offices hiring full-time investment professionals ($200K+/year all-in for a mid/senior level person) may struggle to match these institutional advantages. Only the largest family offices can replicate institutional benefits, which comes at a high cost.
Comparing Economic Outcomes
Let's analyze the three approaches over a 10-year period with an assumed gross return multiple of 2.75x on a $5 million investment:
DIY Approach:
Initial investment: $5,000,000
Gross return (2.75x): $13,750,000
Costs:
Time cost off sourcing/diligence:: $150,000 ($150/hour × 500 hours × 2 years)
Monitoring: $60,000 ($7,500 × 8 years)
Total: $210,000
Net return: $13,540,000 (2.71x)
Hiring In-House Professional:
Initial investment: $5,000,000
Gross return (2.75x): $13,750,000
Costs:
Deployment: $400,000 ($200,000 × 2 years)
Monitoring: $60,000 ($7,500 × 8 years)
Total: $460,000
Net return: $13,250,000 (2.69x)
Fund of Funds:
Initial investment: $5,000,000
Gross return (2.75x): $13,750,000
Costs:
Management fees: $500,000 (1% × $5M × 10 years)
Carried interest: $437,500 (5% × $8.75M gain)
Total: $937,500
Net return: $12,812,500 (2.56x)
Conclusion
While the DIY approach may deliver the highest net multiple, it assumes that the investor can execute institutionally with regard to manager selection and portfolio construction.
Given the 42.6 percentage point return dispersion between top and bottom decile managers, even small mistakes in manager selection could significantly impact returns. In the scenario above, even if the DIY or hiring a professional options provide for the exact same return as a professional FoF manager, the net delta in actual return is only 0.13x to 0.15x. In truth, highly qualified FoF GPs should theoretically outperform those approaches by a magnitude substantially higher than the 0.15x net difference.
The Bottom Line
For LPs where time, sourcing, and risk are important determinants, the FoF model can be the most efficient path to building a diversified, professional venture portfolio.
While direct relationships with GPs offer valuable learning experiences, the economic analysis generally favors the FoF approach for those focused on optimizing returns and resource allocation.
Investors can also take a hybrid approach of using FoF as an anchor for diversification and do a few one-off managers self directed to maintain agency and network w/o significant time and expense constraints.