Fund of Funds (hereinafter referred to as FOF) invests in other funds. In other words, its investment targets are other funds. As a significant capital source of funds, FOF has formed a considerable investment scale and a relatively mature investment norm.

In the field of equity investment, FOF is also an important capital source of VC/PE funds. FOFs contributed 18.2% of the total capital to PE funds in Europe in 2006, becoming the second-largest capital source (only second to pension funds, which contributed 27.1% of total commitments). At present, FOFs in Europe and US are represented by Horsley Bridge, Singular Guff, Grove Street Advisor, and so on. These FOFs have increasingly enlarged presence in China by investing in mainland China focused VC/PE funds. For instance, Horsley Bridge is a LP of SAIF, Lightspeed Venture Partners, DCM, GSR Ventures and other famous VC funds.

FOF Operation Style

FOFs collect capital from a wide range of investors and then invest into specific equity investment funds to share capital gains. In the operation process, FOFs play three important roles: linking investors and investment firms, eliminating asymmetric information, and reducing risks.

Investors invest in FOFs and indirectly invest in VC/PE funds via FOFs. By doing so can they avoid making lots of preparations to directly invest in VC/PE funds and diversify risks. Some institutional investors can build a good investment relationship with VC/PE funds by leveraging the FOFs¡¯ sources. For instance, CalPERS has established a long-term investment and cooperation relationship with a FOF management fund - GSA (Grove Street Advisors). Why GSA can attract institutional investors like CalPERS? Because it can manage to help its LPs establish a good relationship with VC/PE funds. We will take CalPERS as an example to illustrate how a FOF operates:

1. GSA first allocates a certain proportion of funds from a FOF (such as CEV I), which was raised by CalPERS, to invest in a competent VC/PE firm. Meanwhile, GSA will help the VC/PE firm get access to CalPERS.

2. When the VC/PE firm raises a second fund, GSA will reallocate a certian proportion of funds from the FOF. Meanwhile, it will help CalPERS become a LP of the VC/PE fund. The follow-on investment can help CalPERS directly get in touch with the VC/PE fund, reducing investment cost.

3. When the VC/PE firm raises a third fund, CalPERS will directly invest in the Fund, thus forming a long-term, stable investment relationship with the VC/PE firm.

FOFs build a bridge between LPs and GPs, making capital and management perfectly combined. Meanwhile, the operation and management of FOFs is different from that of VC/PE funds. FOFs seldom conduct equity investments, while VC/PE funds conduct direct equity investments. In general, the appearance of FOF in China will facilitate the development of VC/PE market, because it provides investors with a new investment pattern, and offers VC/PE funds another important capital source.

China Needs to Develop Local FOFs

China's local VC/PE funds have not fully developed due to limited capital sources. They raised capital from governments and enterprises. Pension funds, endowments, and insurance funds, and FOFs have not been eligible to become capital sources of equity investment funds. 

At present, there is only one type FOF in China - guidance funds launched by governments of various levels. Pursuant to Article 22 in the Interim Measures on the Administration of Venture Capital Firms, the state and local governments may establish venture investment guidance funds so as to support the establishment and development of venture capital firms by way of holding shares, providing financing guaranties, etc. The concrete management measures shall be formulated separately. Under the guidance of the Interim Measures, more and more government guidance funds have been established. As of the end of 2007, five such funds have been established (See Table 1).

Government guidance funds mainly invest in VC funds. Nevertheless, the capitals of government guidance funds are mainly from government fiscals, whereas FOFs abroad have diversified capital sources. Moreover, government guidance funds have their missions to promote the transition of local economies and the development of enterprises, having obvious political & regional preferences. Therefore, government guidance funds have brought the local VC funds they invested the following flaws: failing to get adequate capital, lacking flexible management and efficient decision-making, thus lacking the capability of competing with foreign-funded VC funds. It is imperative to develop local FOFs in accordance with the market rule. It is important in the following three aspects:

1. To establish and improve China's equity investment environment

The establishment of government guidance funds has played out its role, but it still has not basically tackled the issue that local VC/PE firms have difficulty in raising funds. The central and local governments should create a good regulatory regime for the market, namely, they should standardize and guide the equity investment market by promulgating, implementing, and supervising the laws and regulations. After China operates FOFs in accordance with the market rule and the governments focus on playing regulatory roles, the complete ecological chain will be formed in the equity investment market, further improving the environment of equity investment in China. 

2. To permit pension funds, insurance funds, and banks to enter equity investment market

Given high potential risks of equity investment, pension funds and financial institutions adhering to "prudent" investment principles have not been eligible for entering the equity investment market. Through the re-allocation of funds, FOFs can simplify the process of investing in VC/PE funds and reduce the investment risks, therefore, they probably obtain the approval from the regulatory agent, building a bridge for pension funds to enter the equity investment market. 

3. To increase the local VC/PEs' capital supply, and promote investment in the form of RMB

As mentioned earlier, local VC/PE funds' capital sources are mainly from the governments and enterprises, so they are of small size and have kind of mismanagement. Nevertheless, it will bring local VC/PE funds adequate capital and mature management norms to develop local FOFs.