Financial Poise

Private Equity Funds of Funds

The biggest advantage of investing in a private equity fund of funds, 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 percent annual management fee and a performance fee of 5 percent. That’s on top of the management fees and performance fees of the underlying funds, which average 2 percent and 20 percent, respectively.

The biggest advantage of PE fund of funds 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 and funds of funds.

Resources

1. The most concise and authoritative definition of private equity fund of funds that I could find is from the Northern Trust website. It was  nominally written by Robert Morgan, Sr. VP in Chicago. Here is the meat of the definition:

Private equity funds of funds pool the assets of multiple participants and invest in diversified portfolios of private equity funds. These funds of funds 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.

Investors in funds of funds enjoy broader diversification than could be attained through a single manager or fund. Funds of funds also offer reduced administrative burdens for investors by providing consolidated reporting and capital calls.

2. The best fundamental article I could find, explaining how they work, is “Private Equity Fund of Funds,” even though it’s posted on a dubious website called Private Equity – Deal Flow. The reason I think the site is dubious is that there is no clue who owns the site or who writes the content; there is no copyright notice, no contact info, no publication date for any of the articles. (The domain is owned by FDVT Inc. in Norwell, MA, and the administrative contact, according to Whois.com, is Breena Curson: breena@fdvt.com.) Nevertheless, some of the site’s editorial content, including this, is very well written.

3. The savviest article I found is “Private Equity Fund of Funds Investors Balk at High Fees,” written by Marietta Cauchi and distributed in November 2011 by Dow Jones Newswires. The lead is: “Private equity funds of funds are struggling to raise cash as investors balk at paying two lots of fees and are finding it cheaper and easier to make their own investments directly into funds.” Here are some excerpts:

Private equity funds of funds invest 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- and geography-specific funds, and general funds. Others are specialist investors and limit themselves to funds that only invest in one sector or geography.

Research supports the view that the popularity of private equity funds of funds is waning. For example, such funds now make up just 6% of the total money raised by private equity worldwide compared with 17% in 2007, according to London-based Preqin.

[Antoine Drean, founder and chief executive of Triago, a placement agency which 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 (such as Boston-based HarbourVest, which manages some $25 billion in private equity investments and Goldman Sachs Private Equity Group, with around $35 billion 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.

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.”

4. Finally, an article notable for its interesting stats and graphs — although it’s slightly outdated, with a publication date of December 2006 — is “Investing in Private Equity through a Fund of Funds,” produced by the Fort Washington Capital Partners Group, with offices in OH and NM.

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About David M. Freedman

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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