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Accessing venture capital and private equity through fund of funds

Investing via a fund of funds can give you access to the best funds and ensure that you have a diversified private equity portfolio. Wilshire Associates outlines the benefits of fund of funds.

Commitments to private equity investments have risen dramatically (up 57 per cent) since 1995, according to a recent Goldman Sachs and Frank Russell Capital survey. On average, respondents to the survey said they expected returns from private equity investments to be seven percentage points higher than the returns from US stocks. With such high expectations, it is easy to understand why asset allocation studies are pointing sponsors in the direction of higher venture capital and private equity allocations.

Unfortunately, implementation decisions will leave some sponsors with results that fall short of their expectations. Performance data from our Private Markets Universe shows that only top quartile leveraged buy-out and venture capital partnerships achieve a return of seven percentage points above the S&P 500 index. The data also highlights the wide dispersion of returns across partnership investments.

Clearly, implementation is the key to meeting objectives in the private markets. Implementation requires a diverse set of skills, including: identifying investment opportunities across private equity sectors, gaining access to superior general partners, performing due diligence, negotiating deal terms, and monitoring partnership investments. Sponsors must decide whether to perform these tasks themselves or to seek outside assistance. Given the complexity of the issues and the potential cost of mistakes, many sponsors prefer to hire advisors.

Private equity advisory services include non-discretionary consulting, discretionary management and fund of funds. With non-discretionary services, the consultant conducts partnership due diligence while the sponsor retains fiduciary responsibility for investment selection and monitoring. Staff and investment committee time spent reviewing and approving investments can be considerable under this arrangement. Discretionary management addresses fiduciary responsibility and limits sponsor involvement but may not offer sufficient diversification for private market portfolios under $200m. For most sponsors, fund of funds vehicles offer a convenient solution for effective implementation.

Fund of funds vehicles raise assets from a group of sponsors with similar objectives and invest in a diversified portfolio of private market investments. They provide access to the best general partners as well as required diversification. More specifically, fund of funds can provide the following benefits:

A proven track record
Sponsors can analyse an unambiguous performance record of a fund of funds advisor. Useful information includes the advisor's experience allocating assets to different private market sectors (manager style) and the value added above a public market index, such as the S&P 500, or a universe of partnership investments (manager skill).

Access to the best general partners
There are a limited number of ‘top tier' private equity firms. They limit their capital under management and raise money from existing investors. They seldom go on road shows or make board presentations. With long track records of exceptional and consistent returns, these firms choose their limited partners from a small group of the most experienced investors. As a result, new entrants are often excluded from the best opportunities.
Investors are also excluded from good opportunities because they are unable to approve investments quickly enough. Established partners may raise assets quickly and find that their offerings are over-subscribed. While over-subscription is not an indication of a superior investment, the best opportunities have limited capacity. Through their established relationships, fund of funds advisors can provide access to the best and most experienced general partners.

Extensive research coverage across all private market sectors
Fund of funds advisors have developed extensive research capabilities, covering not only buy-outs and venture capital but also distressed debt, international private equity, hedge funds, and real estate. An opportunistic, or value-oriented approach, implemented across different sectors of the private markets, can increase returns and decrease risk. Analysing new investment opportunities, such as distressed debt or control investments in Asia, requires an experienced research team with good analytical capabilities. Only firms with established research are able to capitalise on these opportunities.

Fiduciary responsibility
Unlike registered investment advisors, general partners do not accept fiduciary responsibility. Sponsors who are reluctant to retain fiduciary responsibility for partnership selection can delegate investment discretion to a fund of funds advisor who will serve as a fiduciary to the sponsor's fund.

Diversification across strategies and market cycles
The high risk of individual partnerships makes diversification an important consideration in constructing a private markets portfolio. Risk is reduced by allocating assets across time, investment strategies and general partners. Allocations to highly leveraged strategies must also be controlled. As a general rule, leverage should be limited to lower risk strategies where the probability of negative events is low. Over a five-year market cycle, sponsors may wish to spread risk across 25 to 50 partnerships. Fund of funds are an efficient vehicle to achieve this level of diversification.

Cost efficiency
Fund of funds are able to spread research costs and legal expenses across relationships. Given their economies of scale and experience, advisors offering fund of funds vehicles offer cost effective solutions without taxing the limited resources of the sponsor.

Successfully meeting return targets in the private markets requires effective implementation. Sponsors should carefully consider the resources and costs associated with each implementation alternative. While the largest sponsors may choose internal management or establish a separate account with an advisor, fund of funds vehicles offer all investors access to the best private market opportunities at a reasonable cost. Just as sponsors successfully delegate investment discretion to their advisors in the public markets, they may achieve similar benefits though a fund of funds in the private markets. After analysing the alternatives, most sponsors will find that a fund of funds vehicle is their best solution.

Wilshire Associates is a full-discretion fund of funds manager, with commingled and segregated accounts managed for clients throughout the world. The firm's approach is to construct concentrated portfolios comprising of only high quality fund opportunities, with a focus on superior returns rather than broad (indexed) exposure.

The Wilshire Private Markets Group has on-the-ground investment research capabilities in Santa Monica, Pittsburgh, Amsterdam and Canberra, providing the basis for the firm's global reach in sourcing top quality investment opportunities for its clients.

Wilshire offers investors the ability to invest in a global private equity program through separate accounts or co-mingled funds. Wilshire raises one fund of fund each vintage year and has raised four of these funds. Each fund invests in the US and Europe with the ability for clients to specify their geographic preferences. Additionally, each fund follows Wilshire's time tested strategy of focusing on middle market buyouts and early stage venture capital that have provided Wilshire with top quartile performance.

Daniel E Allen CFA is a managing director & principal at Wilshire Assocaites. He sources and conducts due diligence on investments in Europe and is a member of the Private Markets Group Investment Committee. In addition, Mr Allen manages the Private Market Group's European office. He has over 17 years of global investment experience.
Thomas K Lynch CFA, JD is a managing director and principal at Wilshire Associates. He sources and conducts due diligence on investments in all private market sectors and regions and is a member of the Private Markets Group Investment Committee. In addition, Mr Lynch manages global operations for the group. He has 18 years of investment experience including pension and private markets consulting, portfolio management, and security analysis.
Erica C Bushner, CFA, CPA, is a managing director and principal at Wilshire Associates. She sources and conducts due diligence on investments in all private market sectors and regions and is a member of the Private Markets Group Investment Committee. She has 18 years of investment experience.

CONTACT INFORMATION

DANIEL ALLEN
Managing Director
Wilshire Associates
Prins Hendriklaan 43
1075 BA Amsterdam

Phone (31) 20 305 7530, e-mail dallen@wilshire.com
© Wilshire Associates, May 2001