Portfolio Construction VC x FoF

By āltitude x Pacenotes

Marc Penkala
8 min readJul 3, 2023
Marc Penkala (GP @ āltitude) x Jeroen van Doornik (GP @ Pacenotes).

When it comes to portfolio construction, venture capital funds and fund of funds are distinct investment vehicles with different strategies and objectives.

>> Understanding the main differences between these two types of funds is crucial for investors seeking to allocate their capital effectively. <<

Here, we (Jeroen and myself) will outline the key factors that set them apart in terms of differences and portfolio construction.

1. Investment Focus

Venture Capital Fund: A venture capital fund (VC) primarily focuses on making direct investments in early-stage or high-growth companies. It seeks to identify promising startups and provide them with capital, expertise, and network access to fuel their growth, although strategies may vary.

VCs typically invest in a relatively small number of individual companies, ranging anywhere between 15 to 50 startups on average, with the goal of achieving significant capital appreciation through successful exits, such as trade sales, initial public offerings (IPOs), secondaries, or acquisitions. Furthermore, most VCs aim to invest in startups with the potential to generate substantial returns.

Fund of Funds: In contrast, a fund of fund (FoF) invests in multiple venture capital funds and, depending on the strategy, selectively in direct co-investments (hybrid funds). The FoF pools capital from investors and distributes it across a portfolio of VC funds to diversify investment risks, similar to how a VC pools capital to build a balanced portfolio of startup investments. The risk appetite, or risk-reward, of the investors is typically one of the factors in deciding whether to focus on VC or FoFs.

Depending on the investment strategy and stage, the focus of a VC and a FoF can be quite similar, but typically the FoF has a greater focus on stage/focus/geo diversification. For VCs building their brand based on expertise and specialization, being focused and less diversified, for example in terms of geography, helps to gain access to great founders.

2. Risk and Diversification

Venture Capital Fund: VCs inherently carry a higher degree of risk due to their direct investment approach. By investing in individual companies, VCs are subject to the specific risks associated with each investment. However, they have the potential for substantial returns if their portfolio companies achieve success. VCs often target sectors with high growth potential but may face higher failure rates due to the early-stage nature of their investments.

Fund of Funds: FoFs mitigate risk by diversifying across multiple venture capital funds rather than individual companies. The FoF’s portfolio typically includes funds focused on various sectors, stages, and geographies, reducing exposure to any single investment. This diversification aims to provide a more stable and consistent return profile compared to a standalone venture capital fund. However, there is a risk of overdiversifying the portfolio, where the exceptional performance that VC as an asset class can provide may not be fully reflected in the FoF’s performance.

3. Investment Process and Focus

Venture Capital Fund: VCs employ a team of investment professionals who perform extensive due diligence on individual companies. They evaluate market potential, founding teams, technology, the competitive landscape, and other critical factors before making investment decisions. The entire process, from initial call to investment, may take anywhere between two weeks and six months, depending on multiple factors that are not always within the VC’s control. After investing, VC funds often take an active role in supporting their portfolio companies, providing guidance, mentorship, and strategic input to maximize their chances of success.

VCs usually have a fairly narrow focus on stages, industries, and geography, particularly for emerging fund managers and solo, micro, and nano VCs.

Fund of Funds: The objective of FoFs is to identify top-performing funds with a consistent track record of delivering returns and manage the portfolio allocation across these funds accordingly. Depending on the type of FoF, “institutional” FoFs mainly rely on their expertise in selecting and allocating capital to a portfolio of VC funds.

These FoFs may be somewhat removed from the process of negotiating term sheets, and their investment team evaluates and monitors the performance, track record, investment strategies, and risk management capabilities of various VC firms in the context of overall asset allocation. Other FoFs rely more on their experience, expertise, and knowledge of which VC or manager is skilled at access and picking winners, such as former VCs managing a FoF. One FoF approach is more top-down, while the other is bottoms-up.

4. Liquidity, Fees, and Returns:

Venture Capital Fund: VC investments typically have a long-term time horizon, often extending between five to ten years. The inherent illiquidity of these investments limits the ability of VCs to provide immediate liquidity to investors. Therefore, investors in venture capital funds must expect an extended holding period, as the potential for returns materializes upon exits or liquidity events within the portfolio companies.

VCs generally adopt a “2/20 Fee Structure,” which entails an annual management fee of 2% per annum, alongside a 20% carry on proceeds exceeding the hurdle, in addition to potential organizational expenses of up to 1% per annum. While the specific details may vary from one fund to another, fees and structures have a significant impact on the net proceeds for limited partners.

Potential returns from VCs can range anywhere between less than 1x (20%) and greater than 10x (1%), with top quartile performance starting at more than 3x, depending on the vintage of the venture capital fund. To justify an illiquid, high-risk investment in a VC fund, it must yield an internal rate of return (IRR) considerably higher than the equivalent in the private market, which currently fluctuates between 6% to 8% per annum.

Fund of Funds: FoFs usually have a longer investment horizon due to the investment periods of the underlying VC funds and the diversified nature of liquidity. If it’s a stage-mixed FoF, there could be liquidity events earlier than in a typical seed fund but later than in a typical growth or opportunity fund.

Historical data shows strong performance of FoFs despite fees, and the best FoFs are able to compete with direct fund investments in terms of returns. The global average for FoFs is 1.8x. FoFs focus on top-decile and quartile VCs, which may result in higher performance. Management fees range from 0.5% to more than 1%, plus carry, depending on the type of FoF and the passive or active approach.

Simplified Cashflow Overview VC / FoF.

5. Portfolio Construction Strategies:

Venture Capital Fund: VC portfolio construction strategies play a crucial role in maximizing returns and managing risks in the dynamic and high-risk startup ecosystem.

Monte Carlo simulations are a valuable tool in VC portfolio construction as they allow fund managers to model various possible outcomes and assess the probabilities associated with different investment scenarios. By simulating multiple iterations of potential investment outcomes, investors can gain insights into the range of potential returns and the likelihood of success. This approach helps optimize the allocation of capital across different investments and manage risk exposure effectively.

Furthermore, the power law is a prominent phenomenon observed in venture capital, suggesting that a small number of investments generate a significant proportion of the overall returns. This implies that a few high-performing companies have the potential to deliver outsized returns and drive the success of a VC portfolio. Understanding and leveraging the power law can guide investors in focusing on identifying and supporting companies with the potential for exceptional growth and value creation.

When it comes to portfolio size, there is no one-size-fits-all approach as it depends on various factors, including the investor’s risk appetite, available capital, and investment strategy. While a larger portfolio may provide more diversification, it can be challenging to actively monitor and manage a vast number of investments effectively. Striking a balance between diversification and manageable oversight is crucial.

Regarding follow-on strategy, it is often beneficial for VCs to allocate additional funding to portfolio companies that show promising growth and progress. Follow-on investments allow investors to increase their ownership stakes and support companies on their growth trajectory. However, the decision to make follow-on investments should be based on rigorous analysis, including the assessment of the company’s performance, market dynamics, and the availability of capital.

Ultimately, construction follows strategy. There are two main strategies for VC portfolio construction: the “entry only” strategy and the “back the proven winner” strategy — with a gray zone in between. VC fund portfolios may range between 20 and 60 companies, with “entry only” funds highly optimizing for maximum ownership and a large portfolio, while “back the proven winner” funds pursue a mid to large portfolio ranging between 20 and 40 companies and focus on the right follow-ons with the highest terminal value, keeping around +/-50% dry powder to focus on outliers.

>> In conclusion, constructing a VC portfolio involves employing strategies such as Monte Carlo simulation to optimize risk and return expectations, recognizing the implications of the power law, and tailoring portfolio size and follow-on strategies to align with the investor’s objectives and risk appetite. <<

Fund of Funds: There are roughly three strategies driving FoF portfolio construction: deal flow, alpha, and index.

Many VC firms have created their own FoFs in recent years, typically to generate additional deal flow (along with network, insights, and other perks). With this strategy, the portfolio usually consists of only earlier-stage funds active in the same or adjacent markets and geographies. Risk mitigation is not as important, and creating the right coverage becomes critical. FoF sizes are often determined by a percentage of the main flagship funds.

With the ‘Alpha’ strategy, there are several portfolio strategies to create alpha. The two main strategies involve building a high-conviction portfolio of more established top quartile and top decile funds with approximately 10 portfolio funds or focusing on a larger portfolio of 20–30 small (seed) funds (<50m), which usually includes emerging managers.

>> Data indicates a strong correlation between the size of the portfolio and its performance. With the first strategy, the maximum number of portfolio funds to execute this strategy falls in the range of 12 to 15. With the second strategy, the data is clear that ‘small is beautiful’ in terms of fund size. <<

The portfolio of a FoF executing an index strategy can consist of more than 15 top quartile funds. While this provides great diversification, the performance is more likely to align with the average. Some LPs seeking venture exposure, depending on their asset allocation and expectations, consider this strategy not sufficiently differentiated compared to other asset classes.

āltitude āltitude VC is a pan-European pre-seed/seed fund investing in accelerating the digital transformation of SMEs (B2SMEs).

Pacenotes is a hybrid fund investing in top tier funds and co-investing in the winners of their portfolio to generate strong risk-adjusted returns. Pacenotes’ focus is on top-tier tech funds in Europe, Israel and the US.



Marc Penkala

Venture Capitalist @ āltitude | creating better access, earlier.