Private equity is a selective game. Not everyone can invest directly into a top firm’s private equity fund. There is access to these funds, however, that allows investors to indirectly infuse their capital. A fund of funds, or FOF, is used across multiple types of securities, such as stocks (ETFs), hedge funds, mutual funds and private equity. This multi-manager investment strategy holds a portfolio of other funds managed either by the same investment company or by multiple firms.
The biggest advantage of this type of investment, in my opinion, is not diversification – after all, when you flatten the risk, you also flatten the return somewhat; and even then, the return can be partly consumed by double-layered management fees. Private equity funds of funds typically charge a 1% annual management fee and a performance fee of 5%. That’s on top of the management fees and performance fees of the underlying funds, which average 2% and 20%, respectively.
The biggest advantage of this investment vehicle is, rather, that you can get access to some of the best managers of underlying private equity funds who are otherwise not accessible to individuals or even to family offices and small institutional investors. Some of the very best PE fund managers are selective about who they allow to invest, sometimes open only to large institutions or a FOF.
Private equity funds of funds pool the assets of multiple participants and invest in diversified portfolios of private equity funds. These vehicles usually aim to commit to top-tier and boutique private equity funds, including both buyout and venture capital funds. Each private equity fund, in turn, invests in privately held companies typically dispersed by geography, industry, and stage of development.
A fund invests in a range of 10 to 50 different private equity funds. Some take a broad investment approach, investing in all sorts of funds, including venture capital and buyout funds, sector-specific and geography-specific funds, and general funds. Others are specialist investors and limit themselves to funds that only invest in one sector or geography.
The FOF manager is vetted through a formal due diligence process, which consists of background and credential checks of both the FOF manager and the managers of the underlying assets.
Investors in a fund of funds enjoy broader diversification then could be attained through a single manager or fund. A fund of funds also offers reduced administrative burdens for investors by providing consolidated reporting and capital calls.
A Nov. 2017 Preqin report on private equity fund of funds detailed the challenges that FOF managers face against traditional private equity funds. The report, which analyzed investor interviews, revealed that investors are concerned with the double sets of fees associated with funds of funds (i.e., fees for the FOF and fees from the underlying funds). Additionally, investors are becoming more sophisticated, opting to invest directly in private equity funds instead.
Research supports the view that the popularity of private equity funds of funds is waning. According to the Preqin report, such funds made up less than 5% of capital raised by private equity worldwide in 2017 as opposed to 15% of total private equity in 2007. As of early 2019, funds of funds raised just $1.6 billion compared with $62 billion from buyout funds and $17 billion from venture capital funds.
Antoine Drean, founder and chief executive of Triago, a placement agency that advises private equity investors and funds, predicts the market will comprise just two categories of private equity funds of funds in the future: the large global houses (e.g., Boston-based HarbourVest, which manages some $58 billion in private assets under management, and Goldman Sachs Private Equity Group, with around $140 billion in assets under management) and the niche players that only invest in one strategy, sector or geography.
Secondary players, or funds that buy stakes in funds being sold by existing investors, make up a third group that are having a good time now as investors frantically juggle their portfolios and financial institutions rush to sell non-core assets. Secondary investors are drawn the market due to shorter investment durations, especially since the PE market is highly illiquid.
The secondary market is growing quickly. In 2017, the market traded $45 billion, but 2018 broke records with a total $66 billion traded in the secondary market. This trend continued to grow in 2019 and will continue as FOF managers offer more secondaries vehicles.
Despite growing investor sophistication, FOF managers argue that investors still do not have the level of resources required to identify, perform due diligence and establish relationships with the 10,000 or so private equity funds worldwide. “There is a clear rationale for investors to outsource to funds of funds,” said Neil Harper, managing director of Morgan Stanley’s Alternative Investment Partners. “It is the form of outsourcing that will be changing. Investors will be consolidating commitments, reducing the number of funds of funds they invest in and going for those with proven track records.”[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Basic Investment Principles 101 – From Asset Allocations to Zero Coupon Bonds 2019 and Goal Based Investing – Planning for Key Life Events 2019. This is an updated version of an article originally published on January 30, 2013.]
David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…
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