Synonyms

Diversification; Intermediation; Private equity

Definition/Description

Private equity funds of funds represent financial intermediaries which invest in private equity funds.

Private equity funds typically have a limited partnership structure, with investors in the fund becoming limited partners (LPs) and fund managers acting as general partners (GPs). By pooling capital from outside investors to invest in other private equity funds, private equity funds of funds provide an additional layer of intermediation (Harris et al. 2018). Funds of funds furthermore open opportunities around debt leverage with consequences for both LPs and portfolio firms. On the one hand, this may allow for a greater flexibility in an era of high interest rates, when many PE partnerships have faced challenges in securing additional credit. On the other hand, this may make it harder to accurately calibrate risk for both LPs and individual portfolio firms.

Private equity investments in direct funds often suffer from several drawbacks including illiquidity, limitations in terms of minimum or maximum investment levels, modest diversification, and high access and monitoring costs (Harris et al. 2018). Against this backdrop, by using their expertise and fund resources, funds of funds GPs provide investors exposure to direct funds while requiring smaller commitment sizes and providing access to different strategies, vintages, sectors, or geographical areas. This means that LPs with limitations in capital and/or expertise can amass a more diversified portfolio than would otherwise be the case.

Introduction

Funds of funds provide a key link between outside investors and fund managers. Alongside the diversification, expertise and investment commitment level advantages compared to direct fund investing, LP investments in funds of funds also potentially benefit from access to top performing funds which may otherwise limit access to new investors (Harris et al. 2018). Moreover, managers of funds of funds are entrusted to perform due diligence on underlying funds and play a key role in fund selection and monitoring, and in terms of leveraging of debt. In addition, Gresch and von Wyss (2011) report that funds of funds are less influenced by general market developments throughout the fund’s life when compared to direct fund investing, which may provide additional flexibility particularly in a high interest rate environment.

However, the above benefits should be considered in the light of fees charged by managers of funds of funds, in addition to the fees of underlying funds. In their study of listed private equity funds of funds, Jegadeesh et al. (2015) estimate average funds of funds base management fees at 1% of the assets managed by the fund of fund, with an average incentive fee of 6.88% of excess profits above the hurdle rate that the fund of fund earns.

Considering LPs cost concerns with respect to the additional layer of fees, funds of funds must generate a more advantageous risk-return profile than alternatives available to investors, which may also lead to more complex arrangements around the leveraging of debt, opening up an additional layer of risk for LPs and target firms alike.

Fund of Funds: What We Know

Funds of Funds Performance Compared to Public Markets

Using after-fees performance data between 1987 and 2007, Harris et al. (2018) find that funds of funds generated returns equal to or above those from investing in public equities, with a mean public market equivalent (PME) of 1.13 when benchmarked against the S&P500, and a mean PME of 1.04 when benchmarked against the Russell 2000 total return index. The authors further document average PMEs compared to the S&P500 over 1.00 for each vintage year, with earlier vintages performing better than more recent vintages. Moreover, Harris et al. (2018) show that both funds of funds with a buyout focus as well as those with a venture focus generally outperform the public market. The outperformance of private equity funds of funds when compared to public markets is in line with studies Harris et al. (2014) and Manac et al. (2022) documenting that direct funds have generally outperformed public markets.

Funds of Funds Performance Compared to Direct Fund Investing

While funds of funds have outperformed public markets, comparing fund of fund performance with direct fund performance presents a mixed picture. Analyzing data between 1979 and 2010, Gresch and von Wyss (2011) document that funds of funds exhibit an advantageous risk-return profile compared to aggregate direct fund investments based on TVPI and IRR measures. Moreover, they find that funds of funds lead in terms of cash flow timing as investors on average commit capital later while receiving back capital at the same pace as investors in direct funds.

Harris et al. (2018) document that funds of funds exhibit weaker performance compared to portfolios of direct funds. Providing more granularity to this comparison, the authors further show that while funds of funds focusing on buyouts or that are generalist significantly underperform direct funds, funds of funds with a venture focus perform approximately the same as portfolios of direct funds. However, considering that investors in direct funds may be limited in terms of fund access or manager selection skills, Harris et al. (2018) further claim that funds of funds in venture capital often outperform direct investing, earning their fees on fees.

Although the focus of this entry is on private equity funds of funds, it is important to acknowledge other types of funds of funds, such as hedge fund funds of funds. When exploring the performance of hedge fund funds of funds, Brown et al. (2004) find that individual hedge funds outperform hedge fund funds of funds on an after-fee return or Sharpe ratio basis. However, Ang et al. (2008) document that due to access limitations, hedge fund funds of funds should not be evaluated relative to public database reported hedge fund returns and that using appropriate benchmarks, funds of funds on average deserve their additional fees.

Funds of Funds and the Maturing of the Private Equity Industry

Sensoy et al. (2014) detail how the private equity industry has matured and how this has changed the relations between participants in the industry. In this context, managers of fund of funds may explore different options with the goal of attracting investors, such as merging with and acquiring other firms.

Harris et al. (2018) argue that the double layer of fees associated with investing in funds of funds make the case for building an internal capability of investing in buyouts and generalist funds particularly appealing. Phalippou et al. (2018) note that private equity fees may become divorced from monitoring challenges and riskiness, and hence may lead to less-than-optimal risk sharing between GPs and LPs. These risks may be accentuated in the case of fund of funds.

Conclusion and Discussion

The traditional model of private equity around a partnership to assume ownership and control of a single target firm for a finite time period has mutated into many different types of private equity activity, extending to private equity as a provider of credit in its own right. Fund of funds retain the traditional emphasis of private equity on relatively high levels of leverage and active management of portfolio firms. Diversification may mitigate risk, but complexity over debt arrangements may exacerbate it. It may also pose greater demands on private equity expertise, which more established funds might be better equipped to fulfil.

Private equity funds of funds provide an important intermediation role by providing investors access to diversified portfolios of private equity funds. They potentially provide specialized expertise, diversification benefits, and improved access to top performing funds at lower commitment levels to outside investors compared to direct fund investing. However, these benefits are to be weighed against the additional fees charged by fund of funds managers on top of the fees charged by underlying funds, with complexity in fee structures potentially associated with a shifting of risk to LPs and potential agency concerns.

While early vintages fund of funds delivered strong performance and sustained fundraising, the maturing of the private equity industry has led to more moderate increases in fundraising and lower or comparable performance compared to portfolios of direct funds, albeit funds of funds have displayed outperformance compared to public markets (Harris et al. 2018). Against these difficulties, managers of funds of funds seek various methods to improve fundraising and performance, while also acting on decreasing fees.

Cross-References