Brian Nichols is the co-founder of Angel Squad, a community where you’ll learn how to angel invest and get a chance to invest as little as $1k into Hustle Fund's top performing early-stage startups.

There's a whole category of investors that most founders never think about. They're not writing checks directly into startups. They're not showing up to pitch meetings. They're basically invisible to the founder ecosystem. But they're the ones funding a huge portion of the VC industry.

Fund of funds invest in other venture funds. Instead of picking individual startups, they pick fund managers. Then those fund managers pick startups. It's investing with an extra layer, and that extra layer changes everything about how the money flows and who ends up with power in this ecosystem.

How This Actually Works

A fund of funds raises money from limited partners, just like a regular VC fund does. But instead of deploying that capital into 20 or 30 startups, they deploy it into 10 or 15 different VC funds. So if you're a limited partner in a fund of funds, your money is spread across multiple fund managers, who then spread it across multiple startups.

The pitch from fund of funds is diversification. You get exposure to a bunch of different funds, which means exposure to hundreds of startups, without having to do all the work of picking individual fund managers yourself. For big institutional investors or family offices that want venture exposure but don't want to build a whole team to evaluate fund managers, this makes sense.

Here's the math. If you invest directly in a VC fund, you're paying that fund's management fee (usually 2%) plus carry (usually 20% of profits). When you invest through a fund of funds, you pay their management fee and carry on top of the fees from the underlying funds. So you're getting hit twice.

This fee stacking is why fund of funds need to be really, really good at picking fund managers. They need to deliver returns that justify the extra layer of fees. Only some do. Many don't.

Why Fund Managers Care About Fund of Funds

If you're raising your first fund as a new VC, fund of funds are often your target LPs. They're set up to take risks on emerging managers. Established institutions want to see your track record first. Fund of funds will invest in you when you're still proving yourself.

This matters because breaking into venture as a new fund manager is incredibly hard. You need to raise money before you can invest, but LPs want to see returns before they give you money. Fund of funds solve this chicken-and-egg problem by writing checks to unproven managers.

For a first-time fund manager trying to raise $10 million, getting a $2 million commitment from a fund of funds can be the difference between launching and not launching. That commitment gives you credibility to go raise the rest from individual LPs.

The flip side is that fund of funds often come with strings attached. They might want board observer rights. They might want to co-invest directly in your best deals. They definitely want regular updates and detailed reporting on how their money is being deployed.

What This Means for the Ecosystem

Fund of funds concentrate power in weird ways. A handful of fund of funds firms are LP investors in a huge percentage of early-stage VC funds. This means they have influence over which fund managers get to raise money and which don't.

If you're a fund manager and you get backing from a well-known fund of funds, other LPs take notice. It's a signal that someone credible believes in you. But if fund of funds pass on you, it can make it harder to raise from other institutional investors.

The other effect is that fund of funds push fund managers toward more traditional strategies. If you're raising money from fund of funds, you need to fit their model of what a successful fund looks like. This can discourage experimentation and keep the industry pretty homogeneous.

Fund managers who take money from fund of funds also end up with less control over their LP base. If 40% of your fund comes from fund of funds, and those fund of funds have different expectations about reporting or co-investment rights, you're juggling multiple masters.

When Fund of Funds Make Sense

For individual investors, fund of funds rarely make sense. The fees are too high. You're better off picking three or four strong fund managers and investing directly, or just putting your money in index funds.

For institutions, fund of funds can make sense if you genuinely don't have the resources to build a direct venture program. But even then, you're accepting lower returns in exchange for convenience.

For new fund managers, fund of funds can be crucial early LPs. They'll write checks when nobody else will. Just understand what you're signing up for in terms of reporting requirements and potential strings attached.

The Performance Question

Here's the uncomfortable truth: many fund of funds underperform. After you account for the fee stacking, the returns to their LPs are often mediocre. There are exceptions, but they're rare.

The best-performing fund of funds have figured out how to get access to the best fund managers, often because they were early believers before those managers became hot. If you were an LP in Sequoia or Benchmark's first funds through a fund of funds, you did great. But getting into those funds today is nearly impossible.

The rest of the fund of funds world is competing for access to emerging managers and hoping they pick right. Some do. Many don't. And their LPs end up with venture-like volatility but without venture-like returns.

There's also this weird dynamic where the best fund managers often don't need fund of funds money. Once you've proven yourself, you can raise directly from institutions and family offices. So fund of funds end up concentrating their investments in newer, riskier managers.

The Future of Fund of Funds

As venture becomes more mainstream, fund of funds are growing. More institutional money wants exposure to startups, and fund of funds are an easy way to get it. But they're also under pressure to justify their fees.

Some fund of funds are moving toward direct co-investment alongside their fund managers to capture more of the upside. Others are dropping their fees to stay competitive. A few are getting more creative with their structures to deliver better returns.

But the fundamental challenge remains: adding a layer of fees and a layer of decision-making between the LP and the startup makes it really hard to generate top-tier returns. The best fund of funds are the ones that figured this out early and got access to the best managers before everyone else wanted in.

If you're thinking about becoming an LP in venture, understand what you're getting into with a fund of funds. You're paying for convenience and diversification, but you're giving up returns to get it. For most people, that trade-off doesn't pencil out.

For fund managers raising their first fund, fund of funds can be critical partners. Just make sure you understand what they want in return and whether those expectations align with how you want to run your fund. And if you're a founder looking to better understand how capital flows through the venture ecosystem and how to position yourself for fundraising, Angel Squad brings together operators and investors who can break this stuff down in practical terms.