Igor Sill, managing director of the tech-focused private equity firm Geneva Venture Group, discusses how tech investors can garner higher overall returns coupled with lower investment risk through funds of funds. Views are the author's own but this website is grateful for permission to publish them. As always, responses are welcome.

The global venture capital industry is undergoing major changes as Wall Street embraces dozens of new initial public offerings of venture-backed companies. Hopeful investors are again flocking to this alternative asset class as these venture capital investments continue to deliver positive returns at a better rate than public market indexes such as NASDAQ, FTSE or S&P. The venture-backed technology sector led on NASDAQ trading volume with 44 companies going public last year.

As pensions, endowments, family offices, foundations and institutional investors increase their venture allocations, they are also applying closer scrutiny of reported venture fund performance. These investors are recognizing greater opportunities to generate excess returns but are resource-constrained on due diligence, accurate performance comparisons and audit reviews. Many seek advice from independent accounting firms and law firms to decipher reported returns. And many delegate the oversight function to specific fund advisory organizations. A recent study by Casey & Quirk projects that outsourced investment assets in the US alone have grown to $510 billion as of this year.

Making the right selection

These investors are rightfully concerned with fulfilling their fiduciary duties by selecting specific venture funds and fund managers with proven market segment expertise. Understanding which market sectors are most likely to outperform, coupled with identifying capable fund managers to exploit those opportunities, are critical components of the investor’s decision making process. The goal remains to seize the benefits of higher overall returns coupled with lower investment risk.

Further complicating the process is the venture industry’s notorious lack of transparency relative to its funds’ actual performance. A venture fund series financing in one invested company may report a value considerably different than the same series investment by a co-investing venture firm.

Since reporting of venture equity returns is a relatively unregulated process, some firms tend to self-report questionable quarterly performance to public databases and publications so as to attract further investment capital. Researching public data results from sources such as CalPERS, Red Herring Limited, Preqin and other venture rankings tends to provide a more accurate picture of actual returns. The top tier performing venture capital firms achieve internal rates of return in excess of 30 per cent.

Why investors seek specialized venture funds of funds

Given that there are over 3,500 venture capital funds competing for the most promising start-ups, a focused fund of funds is a more efficient and risk-adjusted means to construct a balanced portfolio. The rationale behind this approach is simple: there are only 26 venture funds which have historically delivered consistent out-sized returns, essentially ranking in the top decile. This makes sense, as the smartest and most capable entrepreneurs will only seek the top-tier venture partners as investors before pitching to the remaining venture “herd”.

After two decades of direct venture investing and, more recently, 14 years as a limited partner in many top venture funds, it has become incredibly obvious to me that a venture FoF invested in the very top performing venture capital partnerships has historically out-performed the Venture Capital Index.

Realistically, single strategy venture funds are notoriously a “hit or miss” gambler’s bet despite the exceptional track record of a very few funds. Our focus is first on investing with leading, top performing venture funds as well as a very few early successes, emerging manager funds, and second on those funds deployed within the technology growth segments on which we maintain a strong belief in its high value creation growth potential and delivery of superior returns.

With a growing opportunity for investors to construct optimal portfolios by better assessing risk opportunities across the entire venture capital class, investors are turning to the expertise, knowledge and resources that FoF firms provide. Simply stated, a venture FoF is a multi-manager investment strategy of holding a portfolio of venture capital funds rather than investing directly in venture-backed securities.

FoF represent a means by which an investor can reach the relatively high minimum capital commitment ($1 million+) through pooling their investment with others, thus gaining access and broad exposure to a select group of funds. In addition, a FoF typically scrutinizes venture capital general partnerships for accuracy of reporting, historical performance and value creation of invested entities, among others.  A good FoF may also provide pooled access to the very best performing, top-tier venture funds.

Generally, a FoF has greater leverage in scrutinizing a venture firm’s investment talent while assessing the accuracy of its financial reporting. They’re also assessing more than the reported returns, such as multiples of cash back rather than straight IRR. FoF seek a safer, more diversified investment base from which to drive reasonable returns, across shorter investment cycles, versus today’s typical 10-12 years.

The reasons for the impressive growth of FoFs is that they provide diversity among the very best venture fund managers, access to top-performing funds, reduce risk and hold out the promise of net returns higher than the average venture capital return rates. Investors are more willing to invest in FoF for the benefits provided by this pooled investment structure, continual due diligence and ongoing oversight compared to investing in a single strategy venture fund.

Essentially, FoFs can offer an investor access to the top-tier performing best venture capital fund managers not otherwise accessible directly.

Selecting a venture firm or fund manager

The selection process of either brand name venture firms or emerging fund managers should entail research of their respective track record of investments, actual hands-on value creation involvement within their investments, the firm or emerging fund managers’ lure and stature within the entrepreneurial community (deal flow source) and, most importantly, the ethical reputation and transparency in reporting performance returns.

Do some serious research here, as the term “success has many fathers” applies in spades to self-published venture materials. You may wish to consult with an experienced venture law firm or venture advisor who can draw on substantial limited partner and general partner expertise, and expose the many significant incongruities and styles in how funds generate and distribute returns.

I’ve noted that consistent above-market returns are achieved from only a few select venture capitalists who diligently identify and invest in technologies and markets on the leading edge of disruptive innovation. They tend to focus on building companies at the forefront of market forces, creating outstanding growth and exit opportunities. These few venture capitalists are notorious for sourcing and developing fast-growing companies in large market growth sectors. They’ve also built a substantial reputation for value creation and thus are sought after and welcomed into the hot start-ups by seed angel investors as well as the best founding entrepreneurs.

Clearly there are pockets of venture investments globally, however, the epicenter of premier technology innovation continues to emerge from Silicon Valley. This is a unique place with a supportive ecosystem ready to back entrepreneurs’ requirements for launching start-ups successfully. The weather is excellent, the lifestyle is wonderful, and the scenery exquisite. But more importantly, Stanford University, UC Berkeley, USF and University of Santa Clara provide an abundance of research and continually spin off new patents along with a steady flow of budding intellectual, entrepreneurially-driven graduates.

Hence, 80 per cent of venture capital and angel investors operate in Silicon Valley, and, not surprisingly, 90 per cent of the highest venture returns occur here. I believe there is a fundamental reason that venture-backed Apple, Cisco, Facebook, Oracle, HP, Google, Linkedin, eBAY, Salesforce.com, Twitter, Netflix, Zygna, Genentech and so on are all thriving and located within close proximity of these the top performing venture funds.

This is a period of significant transformation that is creating extraordinary venture investment opportunities. A little research and you’ll find some of the very same venture capitalists invested in many of these hot start-ups. It seems that learning from success tends to create more success.

Igor Sill, managing director of Geneva Venture Group, is a Silicon Valley venture capitalist and founder of Geneva Venture Partners. He manages his own angel investment fund at Geneva Venture Management and is also a Limited Partner in Goldman Sachs Investment Partners, Benchmark Capital, Norwest Ventures, Granite Ventures, The Endowment Fund, Fortress Partners and ICO Funds through his family office. Sill lives in Silicon Valley and has 23 years of tech investment experience.