Listed VC Fund of Funds: Limited Liquidity and Higher Volatility

In today’s late-cycle environment, many investors have increased their allocation to strategies that are less correlated to the public markets and that have the potential to enhance returns. As a result, appetite for Alternative Asset Classes has significantly increased in recent years boosting AUMs from $6.5tr in 2013 to $8.8tr in 2017 (Preqin). Additionally, allocation is expected to increase further, as ~28% of investors are planning to increase their exposure to Alternative Assets in the next 12 months and only ~16% plan to decrease it (Preqin Investor Survey).

Within Alternatives, Private Equity -PE- represents the largest share of the market with $457bn raised in 2018. A significant part of the PE fundraising comes from increasing popularity of Venture Capital -VC- globally (~22% of Global PE AUM is in VC). Venture Capital provides exposure to the rapidly developing technology and innovation sector and has delivered the highest top quartile returns of any other PE strategy for funds with vintages between 2007 and 2013 (Preqin).

Recent returns, however, are not the only reason for the increase in allocation to VC. It is also driven by the inherently lower correlation of private vehicles to the public markets and undeniable potential of technology companies around the world. This is especially the case in Europe, where high quality deal flow has enabled European VCs to capitalize on a still large funding gap and to outperform US in the last 5 years (Cambridge Associates).

Investments into Venture Capital are not all simple and come with two constraints: High Return Dispersion and Limited Liquidity (Secondary market only).  High return dispersion is one of the key characteristics of VC and is linked to the manager’s ability to produce extraordinary returns whilst taking on a significant degree of risk. Nevertheless, this may be managed by construction of a well-diversified (in terms of Vintage, Vertical and Geography) and professionally selected portfolio. Limited Liquidity, however, is a problem native to any private instrument and is considered a fair trade off in exchange for higher returns, lower day-to-day volatility and absence of external factors affecting the stock price.

As building a diversified VC portfolio is complex, costly, and requires professional selection to manage return dispersion, many investors chose to gain exposure to VC through Funds of VC Funds. Such funds typically deploy the capital within 3-5 years and invest in adequate amount of funds to ensure that exposure to a single geography, vertical or vintage is limited. The liquidity issue is also solved partially, due to the fact that it is easier to sell a complete portfolio on the secondary market than it is a single fund. Nevertheless, the liquidity still remains limited and presents a concern especially for retail investors (for institutional is not that bad).

To counteract this limitation some alternative asset managers in the Fund of Funds industry have proposed a solution – a listed Fund of Funds. A listed Fund of Funds differs from a traditional FoF in two main ways: 1) net Asset Value of the underlying portfolio is no longer the only determinant of the value of the fund and 2) the Investment period is typically shortened to avoid losses due to time-value of money as capital calls can not be made on the rolling basis.

Listed Funds of Funds are traded on alternative stock exchanges and are marked to market daily by market participants. As such, the price of shares of the FoF is no longer reliant simply on the Net Asset Value, but rather incorporates the sentiment of market participants. Thus, this exposes the investor to higher volatility and even correlation to the public market. This is especially apparent during the time of economic downturns when investors turn away from perceived risky products and set their sights on quality and safer (defensive) assets. Furthermore, the effect of the market sentiment on the share price of a listed FoF is not limited to economic downturns. To illustrate this, it is interesting to consider how the share price of a theoretical FoF, which has invested (or even co-invested) in a company like WeWork, would react when the valuation of the company decreases overnight by a factor of 5x.

Lastly it is important to understand the mechanics that allow a publicly traded Fund of Funds to produce liquidity. Those Funds are typically listed on alternative exchanges which have far lower liquidity than the large exchanges such as LSE or NYSE. The shares of the Fund of Fund would be sold like any other second-line stocks, typically at a discount, making it difficult, if not impossible to get out without incurring losses. This is best illustrated with a quote from a manager at LGT: “Listed vehicles do offer liquidity to their investors, but we’re not talking about a daily 10% turnover rate […] It’s best to think of the liquidity of these vehicles in terms of weeks or months. If you have a larger position in the fund then, obviously, it will take a longer time to sell your shares, three months maybe. Waiting three months to sell and doing so at a significant discount to NAV may leave investors no better off than if they had committed to unlisted Private Equity and were forced to sell through the traditional secondary market. But that level of liquidity is still significantly higher than the typical ten to 15-year lock-up in traditional Private Equity structures.” To emphasize this message, it is interesting to consider a case of a listed FoF in Spain, BBVA CAPITAL PRIVADO F.C.R., which throughout its ~12-year lifetime has had a share turnover of 43%, or less than 4% per year. A share turnover is calculated as the number of shares traded over a period divided by the total number of shares. For comparison, Telefónica had a share turnover over the last 12 months of 115%.

To sum up, it is fair to say that emergence of Fund of Funds for VC in Europe is an important step in the right direction to attract more long-term financial investors or even retail investors into the asset class. (See “Participation of Institutional Investors in European Venture Capital) Nevertheless, it is important for investor to understand the benefits and constraints of each model. Privately held funds of funds are able to safeguard an investor from significant shifts in market sentiment, reducing volatility and correlation with the public markets at the cost of reduced liquidity. Meanwhile, publicly listed Funds of Funds are able to provide investors with theoretically higher liquidity but at the cost of significant increase in correlation and volatility of the asset.

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