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Private equity fund of funds

For those interested in investing in private equity but unsure where to start, the fund of funds may be the best option. In an extract from The Handbook of Alternative Investments (ed. Darrell Jobman, John Wiley & Sons 2002) Geoffrey Hirt, Thomas Galuhn and Paul Rice provide an introduction to funds of funds. They also outline important points to look for when making the investment decision.

PRIVATE EQUITY FUND OF FUNDS

Many investors may use a fund of funds approach to develop their private equity investment program. Fund of funds investors usually tend to have a smaller asset base than direct partnership investors and don't have access to the superior performing direct partnerships. They also have limited resources to manage this segment of their portfolio. However, some large investors use selected fund of funds managers to complement their portfolio of direct partnership investments. These investors are effectively out-sourcing the management of a segment of their private equity portfolio.

A private equity fund of funds is one way to create a more comprehensive, diversified private equity asset class in your portfolio. With a fund of funds, the manager makes investments in many private equity partnerships. A fund of funds can create a well-diversified portfolio consisting of indirect investments in hundreds of companies representing some or all of the categories of private equity.

Characteristics of Fund of Funds
One of the major advantages of a high-quality private equity fund of funds can be summed up as access to high-quality funds with proven managers, maximum diversification, and cost effectiveness. The major disadvantage to some investors is that there is an additional fee to the fund of funds manager over and above the fees paid to the direct private equity partnership.

The additional fee has to be considered in context. Can the fund of funds provide access to the top quartile of fund investment opportunities? What would be the cost of administering a private equity strategy on your own? Can you hire and retain in-house staff that compares favorably with those managers found at the fund of funds partnerships? Only after you consider these issues can you decide whether the additional fee of 3/4 to 1 1/4 per cent is an appropriate cost. As with all asset management fees, the larger your commitment, the smaller your overall fee. Although 1 to 11/4 per cent is a typical fee, total fees can drop to a blended fee of 75 to 85 basis points for a significant investor in a fund of funds.

Access to High-Quality Funds Is Important
A major advantage that experienced fund of funds managers have is the ability to access top-performing, direct-equity partnerships. This access is perhaps most important in creating superior returns for the private equity asset class. If we distinguish between tier one (top quartile firms) and tier two firms, we find that rates of return are wide. This is an extremely important point to consider. In examining Figure 9.2, we can see that between 1969 and 1999, the top quartile partnerships in venture capital and buyouts and all private equity more than doubled the median return. Those partnerships in the lower quartile generated a rate of return less than the Treasury bill rate over the same time period.

Figure 9.2 shows that venture capital funds had the highest performance over this time period, generating 30.5 percent in the top quartile versus a median of 1 1 .6 per cent and 2. 1 per cent in the bottom quartile. The top quartile of buyout funds returned 25.8 percent over this 30-year period, whereas the median returned I 1 . 1 percent and the bottom quartile had no return at all. When we look at all private equity, we see the top quartile returned 27.9 percent; the median was 1 1 .5 percent, and the bottom quartile returned 1.5 percent. If you are going to invest with a fund of funds, make sure they have access to partnerships in the top quartile.

FIGURE 9.2 Access to top partnerships is critical (difference between upper and lower quartile performance, 1969 to 1999).

Diversification Benefits for a Fund of Funds
Diversification for a fund of funds is much easier than for an individual partnership. Not only can a fund of funds specify a mix of venture capital, buy-out funds, and mezzanine funds, but it also can diversify by industry sector.

One partnership may specialize in biotechnology, whereas another may focus on computer hardware or software. Each industry sector needs industry analysts and executives with experience in that sector.
There also are a large number of privately owned companies compared to publicly owned companies. Dun & Bradstreet estimates that more than 150,000 companies in the United States have revenues of $10 million or more, and of these about 85 percent are privately owned companies. Watson Wyatt, a consulting firm, estimates that the private equity markets are seven times larger than the public equity markets. That leaves an extremely large number of companies available to private equity investors and provides an opportunity for a diversified portfolio across many different U.S. industries.

Small pension funds or financial institutions investing in a fund of funds can achieve better diversification than they could if they managed their own private equity investments. For example, fund of funds investing in 25 private equity partnerships may have investments in more than 400 private companies, whereas on their own, they could never invest in that many companies. In addition, a large fund of funds probably has more influence with the partnerships than a small investor would have.

Administration and Cost Effectiveness
The minimum investment for a fund of funds catering to institutional investors often starts at $2 million or more; for the most part, fund managers would prefer larger commitments such as $25 million or more. If we take a look at a typical investor, be it a pension fund, endowment, or insurance company, the relevant question is what size does it have to be before St makes sense to manage its own private equity allocation?

Although the minimum cost of entry to establish the proper staffing is important, size may nor be the major issue for the potential investor thinking about going it alone. The ability to acquire people with the skills necessary to outperform fund managers who have honed their skills over many years may be difficult. This industry has a steep learning curve, and the potential that new fund managers will make mistakes that penalize their performance always exists. Traditionally, public pension funds have not been able to compete financially for skilled managers with private fund of funds firms. In fact, during the l990s a flight from public pension funds to private equity funds occurred by managers of alternative investments. So, in the end, a pension fund manager has to decide to either go it alone or engage a fund of funds manager.

Copyright © 2002 by John Wiley & Sons, Inc., New York. All rights reserved.

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