Investing Billions - E70: How VC Fund of Funds Work with Alex Edelson

Episode Date: June 6, 2024

Alex Edelson, Founder of Slipstream Investors, sits down with David Weisburd to discuss the benefits and tradeoffs of investing in venture capital fund of funds. They also touch on Slipstream’s investment thesis, portfolio construction, and due diligence process. The 10X Capital Podcast is part of the Turpentine podcast network. Learn more: turpentine.co -- X / Twitter: @asedelson (Alex Edelson) @dweisburd (David Weisburd) -- LinkedIn: Alex Edelson: https://www.linkedin.com/in/alex-edelson-604767b/ David Weisburd: https://www.linkedin.com/in/dweisburd/  -- LINKS:  Slipstream Investors: https://www.slipstreaminvestors.com/  -- NEWSLETTER: By popular demand, we’ve launched the 10X Capital Podcast newsletter, which offers this week’s venture capital and limited partner news in digestible news bites delivered straight to your email. To subscribe please visit: http://10xcapital.beehiiv.com/  -- Questions or topics you want us to discuss on The 10X Capital Podcast? Email us at [e-mail] -- TIMESTAMPS:  (0:00) Episode preview (2:16) Discussion on portfolio diversification  (4:41) Benefits & trade-offs in fund to funds strategy versus single fund investing (7:13) Ideal number of funds for diversification in venture capital (8:46) Life cycle of a diligence process when vetting a manager (12:05) Assessing a fund manager (13:05) Importance of founder references (14:09) Essentials in a fund data room (16:17) Value of transparency with GPs (18:25) Gaining access to oversubscribed funds (19:22) Closing remarks

So I have a million dollars to invest in venture. Why would I invest into a single fund versus why would I invest into a fund of funds? What's the trade-off? It's a great question. Like, if you feel like you're seeing enough funds so that you can identify a great fund and you believe you can pick a great fund and you can get access to that fund, then I would say you should do that. Like, better to be more concentrated in a great fund. But there are reasons why people invest in fund of funds. For example, some people are not doing this full time. They don't have time to meet hundreds or thousands of funds. They may know some, but it's hard to know like which are the great ones if you're not meeting a lot of them and

spending a lot of time on venture. And in many of them, but not all of them, it can be hard to get an allocation in the best funds. And so one reason to invest in a fund to funds is if you want exposure to venture and you either don't have the time to try to get it, you don't know how to get it, or you can't get access to the funds you want to invest in, then a fund of funds is a great way to get exposure to hopefully top core town, top decile venture firms. Let me play devil's advocate. So for more ideas on how to raise venture capital in this market, make sure to subscribe below. Well, Alex, we chatted a few months ago is one of our most more popular episodes and I had to get you on as the first guest to come on for a second time. So welcome

to part two. Welcome to 10xGuyable podcast. Thanks. Thanks for having me on. I'm excited to be here. Some of the feedback from the episodes, a lot of people wanted to know what exactly you did specifically. So tell me about Slipstream. Tell me about your fund. So we invest in pre-season seed funds, typically a hundred million and smaller. They're managers' first three or four funds. So these are emerging managers. Our portfolio construction is we put roughly 90% of the fund into what we think of as core investments. So that's like 10 to 15 core investments. Each is about 6% to 12% of our fund.

We can use up to 10% of the fund for scout checks. So where a scout check would be a fund, usually a little earlier in its evolution, for one reason or another, not able to make it a core check, but high conviction on it. And then can use up to 20% of the capital in the fund to co-invest in the breakout companies of the fund.

Other things that we think about when it comes to portfolio construction is at least 70% of the funds based in the US, up to 30% of the funds based outside of the U.S. It includes generalist funds and sector-focused funds. There's time diversification typically across at least three years of vintages. So you mentioned time diversification. So walk me through that.

Aren't you automatically time diversified? And how do you think about time diversification within your portfolio? Well, let's assume each fund is deploying over like a two to three year period, you have diversification across initial investments made across two to three years, but we're investing in funds that start investing at different time periods. And so in the current fund, we have exposure to a 2020 fund, we have exposure to a 21 fund, we have exposure all the way through to 20 funds in 24. It's very difficult to time venture. And so we want diversification across vintages. I try not to be too rigid in how I think about vintages because I would take a great fund manager

in a vintage year where the average returns are not great because a great fund manager still should do well. And so we want vintage year diversification, but our focus is on investing with the best managers. I had a look at the year by year data for Cambridge data. And even in the two worst years of the last 30 years, the top quartile was actually slightly up. I think it was 4%. And the top decile, I think was 11% for that year. So in the very worst of markets, the top quartile and the top decile still leads to positive returns. You mentioned you overcommit your fund. I know a lot of top fund of funds do

this. Tell me about that. We charge fees and the fund pays expenses, but we invest at least 100% of the capital committed to us. We invest at least 100% of that in underlying funds. Let's just say for round numbers, a $50 million fund, we plan to invest $50 million, even though $50 million day one are not investable because some of them go to fees and expenses. And the reason is because funds are calling capital over a long period of time. Some funds are returning capital

at the time that others are still calling it. And especially if you have vintage year diversification, some of your earlier funds could be generating returns and some of your later funds could still be making new investments. As we receive capital back from funds in the initial distributions that we receive, those get recycled to fund future capital calls from funds that we've invested in. And, you know, part of this is also that like funds don't always call 100% of committed capital. So like, let's say they're calling 90 to 95% of capital, we could

commit all of our 100% of our capital. But that doesn't mean 100% of our capital will all be called. So let's talk the implicit trade off in a fund to fund strategy versus investing into a single fund. Talk to me about the trade offs. So yeah, I guess like, let's take this to the extremes. The most concentration is is go invest in one company. You have the highest upside and the lowest, and you have a very low downside. Okay. So you have a lower upside if you're investing in a fund and a higher downside. And if you're investing in a fund of funds, you have a lower upside and a higher floor.

So, but then you're like, hey, well, what are the chances of getting good returns here? The way I think about this is like any given venture fund, if you just look at the data, pick a random one, not likely to generate returns like most LPs are thrilled about. But a venture fund of funds has a higher chance of generating returns I think LPs would be happy with. So tell me, so I have a million dollars to invest in venture why would i invest into a single fund versus why would i invest into a fund of funds what's the trade-off yeah it's a great question like if you feel like you're seeing enough funds so that you can identify a great fund you're sort of calibrated if you know what great looks like and you believe you can pick great fund and you can get access to that fund

now say you should do that like better be more concentrated in a great fund but there are reasons why people invest in fund funds so for example some people are not doing this full-time they don't have time to meet hundreds or thousands of funds they may know some but it's hard to know like which are the great ones if you're not meeting a lot of them and spending a lot of time on venture it can be hard to get conviction on these funds. And in many of them, but not all of them, it can be hard to get an allocation in the best funds. And so one reason to invest in a fund of funds is if you want exposure to venture and you either don't have the time to try to get it, you don't know how to get it, or you can't get access to the funds you want to invest in,

then a fund of funds is a great way to get exposure to hopefully top quartile and top decile venture firms. Another is like folks who are just too big. Their check size is too big to get meaningful exposure to these small funds. It can be harder to get meaningful exposure to these funds. As a general matter, if you were to step back, how do you win in venture? You can try to invest in like very successful, established. Those are hard to get into.

High minimums, often oversubscribed, or you can get into like great small funds which like i said it's like a labor intensive time consuming exercise of investing in funds that like primarily have limited track records it's hard for folks to do let me play devil's advocate so let's say i had a chance to invest into a great top quartile emerging manager would i really want to put in all my money, all my venture money into that one manager? Or would it make sense to build out a portfolio either directly or through a fund to fund? Take me through that thought reasoning. This pushes on another reason to invest in a fund to funds that I didn't mention before. But the thinking on that is like, sure, you can get a bad vintage with a great fund. So easy for me to say, if you can put all your venture allocation

into one great, with one great fund manager, you should just do that. The reality is like that, yeah, there's some benefits that come from diversification. And so it's funny, one thing that we do is some of our LPs are investing in other venture funds and they're seeing good funds. They're getting to conviction.

They're getting access in some of the funds that they want to get in. And, but they're investing with funds. They're getting to conviction. They're getting access in some of the funds that they want to get in. But they're investing with us for strategic reasons. We're helping them find more funds. We're helping them diligence funds, partnering with them to help them build out their venture strategies. If your question was, well, then, Alex, why don't you just invest in the one fund that you think is best? Just put all of your capital into that fund. And my response would be, we're looking for a little more diversification than that.

So how many funds do you want to be in ideally? And do you look at that on a number of funds basis on underlying portfolio basis? How do you look at diversification? We want to be concentrated enough so that every investment we make can have a meaningful impact on our fund level returns, but not so concentrated that if, you know, one of these funds has a bad vintage that destroys our fund performance. And so we're putting 6% to 12% of our fund into each of our core investments. So that's 10 to 15 investments. That's designed to outperform if we're right. If we have some very high performers, we have enough concentration so that we should have enough exposure to them to generate great fund level returns.

And we should have enough diversification to weather some funds that don't perform to the level we're underwriting them. Talk to me about a life cycle of a diligence process when you go in and diligence a manager. The first part of that is like whether to do an initial call and like not use not a great use of folks time if it's very unlikely we'll invest. So if it's not a fit on portfolio construction or just not clear that there's an edge there, I probably won't do a first call. A successful first call for me is covering three things. One, I want to understand the GP. I want to know what makes them tick. I want to understand why are they hungry? Why are they doing this? Venture is hard. It takes a long time. I want to understand what's motivating them.

The second thing that I would want to cover is portfolio construction, how they're thinking about portfolio construction, chatting about that to make sure that it's a fit for what we're looking for. And the last thing that I want to understand is like, what's the edge? Like what's so unique? What's the competitive advantage here? Why are these folks likely to see the best founders and why will the best founders pick them? If I can cover those three things, that's a successful first call and it's enough to figure out whether I want to move forward or it's not a fit. The next step would be data room or a second call. Data room, second call.

Data room could be before or after a second call. Often along the way, also talking to like informal references. These are usually like mutual contacts. It's not cold outreach. It's not founders. Just to get a sense of like, are they serious? Are there obvious issues here? Is there like some very unique special element here?

And then after the second call, that is the earliest point in which I would consider doing references with people I don't know. That is not founder references at first. Usually founder references are towards the end, just to be respectful of founders' time and GP's relationships with founders. They're the most scarce, the founder references for the GPs. Their time is scarce and their relationships with the GPs are important. But if you're in the GP, like you don't want your founders having to do a ton of references for you to raise your funds. You'd want to let them do their work, support them and not be like asking them to take time away from building their companies to help you raise your fund in a perfect world. So I got to be respectful of that. And so that's the last step, the second to last step for me.

So we'll do I'll do references with downstream VCs. I'll do references with same-stage VCs and other mutual contacts and perhaps other folks they've worked with. And downstream VCs being that you want to see that whoever they feed into for the next round, there's a signal for the GP to those VCs? Yes. Let's say you're a fintech fund, and you're investing at the pre-seed or seed stage.

I want to go talk to the best seed seed and a stage funds and maybe B stage funds who've, you know, in a perfect world, like they've already invested in some of your companies, but at least like they know you, they've worked with you. They have a strong feeling about where you are in the ecosystem. Like maybe they'd say like, in our opinion, that's the best pre-seed fund in FinTech in this geography. And we think they have better picking and are finding great

founders and their founders love them. And they bring us great companies and we invest in their companies. That's the dream. It's for the best investors at the next stage to think that the investor that I'm looking at at this earlier stage is the best at this earlier stage. The last thing is founder references. Maybe one or two calls after you're done with references just to run through any outstanding issues. Like operational due diligence, legal, that's largely work I can do on my own. That doesn't take a lot of the GP's time. And that's the process. In an ideal world though, like this is happening before they're raising their next fund.

Like you're building a relationship with someone over years. And if that's happening, then when they actually go to fundraise, the process can move pretty quickly because you know a lot at that point. When you do your diligence, essentially, it's a checklist of sorts. What if you get a bunch of A answers and a C? Is that more attractive to you or do you want kind of A to A minuses across the board? How do you look about big pros and cons within a fund manager? We'll get right back to the interview. But first, to stay updated on all things emerging managers and limited partners, including the very latest data on venture returns and insights on how to raise

capital from limited partners, subscribe to our free newsletter at 10xcapitalpodcast.com. That's www.10xcapitalpodcast.com. It's hard to speak that generally. If I love everything, except for one thing, and it's an important thing, I probably won't do it. I probably wouldn't invest in that fund. What's some examples of that? Yeah, one comes to mind. So I was doing diligence on a fund. And let's just say they have like five winners in their track record or like emerging winners. Some are like real winners.

Some appear to be on the path to being meaningful to fund level returns. And I talk to one of those founders and I get a really negative reference. That would be really hard for me to overcome because your biggest winners, those folks are meeting younger founders earlier in their evolution, I should say. And those founders are going to these, let's say, best five founders in the sports world. And they're asking them for recommendations about funds they should talk to. And you'd want those to be advocates for the VCs. And that's one of the more important ways, at least what I've seen when it comes to VCs generating sustainable success is like, you have a community of founders who love you, who say good things about you, who send their best founder friends your way. And if that's

deteriorating early on, that's a big red flag for me. And it makes me wonder whether you will see the best deals. I was speaking to a mutual friend, Eric Sippel, and he mentioned that he doesn't mind, quote unquote, negative founder references from tier three, tier four founders, because his idea is that the GP should not be spending that much time with those founders. What are your views on that? Does every founder have to like you or just your breakout founders? I think the more they like you, the better. And I think being good to and supportive of the founders whose companies didn't work out is important. So tell me about the data room.

So what do you like to see? You mentioned some of the things that you like to see in the data room. What are some nice-to-haves? What are some neat-to-haves? Yeah, so things that are important to me, detailed schedule of investments is really helpful. Investments prior to starting the firm and at the firm. And it ideally has things like entry valuations, initial check size, initial ownership, current

valuation, current ownership, realized and unrealized gains, MOIC, IRRs, who's invested in the same stage as the GP, who's invested in the later stages. It's helpful, obviously, to know similar information about like following investments. It's great when people include things like how a company is trending, which are likely, which we think are fund returners. Really interesting to see when people are comfortable sharing things like how they're ranking companies or how they're thinking about the range of performance across the companies in their portfolio. Other things that are interesting and helpful to me, like prior investor updates are helpful. I want to understand the evolution of the firm and the evolution of the fund manager and how they're communicating and their style. Those are helpful. A fund model is helpful to see. Performance of their SPVs they've done. Some investment memos

to understand how they've thought about companies, their level of in-depth of their analysis, whether the things that they were thinking about at the time they made an investment is actually like they were right or they were right about the risks or they were right about the upside. I'm curious how like their investment decision matches up to like what actually happened. You know, materials from annual meetings, like recordings of those, decks, a reference list is helpful. Do you ever do on-list references or do you just skip them? It's a good question. My approach here is to be respectful of the GPs. So my preference is to just do my own thing and do it all off-list. But that doesn't always make sense for some GPs.

Some GPs have a strong preference. And I have to work with them. And I will make sure that my process is comfortable for them. I'll do at least some on-list references. But in a perfect world, I'm doing off-list references also. But yeah, the caveat is I need to be respectful of them and their relationships with folks. One other thing that I love to see is thought pieces, podcasts, talks, blogs, their work product is helpful to see. Would you ever invest into, let's say,

a fund too that you knew by fund four would be out of your box? There's something I think about. Sometimes I think, I could invest in this fund. I'm probably not going to do their next fund. They're getting close to the edge of my strike zone or they're on the edge of my strike zone. They're very likely to be out of it by their next fund. So when that happens, if I invest, it's on me early on to say that. Before I invest, I should tell them that and give them the opportunity to say, we'd rather work with someone else. That hasn't happened yet. But like, I want them to have that opportunity. So I would say that up front if I felt like that was likely. Why do you think institutional investors are reluctant to do that,

to invest into one vintage? Well, I think like the dream LP has a bunch of different components. But one of them would be like, I'll stay with you forever. They will always invest. And if a fund is oversubscribed, especially like wood, they should pick the LPs they think are most likely to stay with them. And so I think it's important from a GP's perspective to know that. And so if an LP is a long term LP and they have a reputation that I think that helps them get in great funds.

Also, if they're getting in great funds, shouldn't they be a long term LP like they should stay? Now, for me, I'm focused on smaller funds. And so you may get to a point where you are a great fund, but it's not. Now, for me, I'm focused on smaller funds. And so you may get to a point where you are a great fund, but it's not the right fit for us. Other folks might say, we never want to let them go. And it's part of our pitch with our LPs. It's part of our strategy is that we want to invest in the best with the best funds. We want to stay with them for a long time because we think they're the best. So I shouldn't speak for others, but I think that's what some folks are thinking. What's your biggest pet peeve when you work with GPs?

Let me come at that from like the opposite side of the question. Like I really value when people are honest and transparent about their strategy and their plans and what concerns them and where they think they're strong, where they think they could improve. And I'm very transparent and open. It's really energizing and refreshing and makes me trust. It helps build trust with folks when they are that way. And so I suppose the opposite is when it feels like people are not being that way. And sometimes it feels like folks are saying what they think you want to hear, or it's a little salesy and you have to do a little more work to figure out like, well, what's actually the truth

here. Tell me about some of your wins. Some of them are just like folks who I built a relationship with over a long period of time. And it was almost about a friendship first. And we were finding ways to help each other or we were just staying close and we enjoyed building the relationship and spending time and talking about venture and talking about their fund or talking about slipstream and how it's doing. And over time, there's some funds, there's one in particular where it was like, it was like really oversubscribed funds. I didn't really even start the relationship thinking like I'm gunning to get an allocation. Like I just kind of assumed like, no, I'm looking for the next funds that are,

that generate this level of interest. Like it's okay if we don't get into the funds that already have that level of interest because we want to find them before then and stick with them for a few funds. But we've been able to get into some of those funds. And they've been very hard to access. And great LPs were missing out. And it was a product of just building relationships with folks and building trust and trying to be helpful and enjoying the personal relationship that we were building. And over time, when there's an opportunity to invest, I didn't really even think it was

possible. I feel really fortunate to get into those funds. Well, Alex, I want to thank you again for jumping on the second podcast. I truly enjoyed it and I look forward to seeing you soon. Thanks again. Thanks for having me.