In private equity fund of funds, investors commit to a fund, which in turn makes commitments to a predetermined number of underlying funds. Investors achieve diversification through exposure to a high number of funds, and in turn a high number of companies, with just one commitment. This article seeks to analyze the performance of fund of funds, their strengths and weaknesses, and the types of investors they make sense for.

Why Do Investors Choose Fund of Funds?

There are several reasons why investors utilize fund of funds to obtain private equity exposure. The graph below shows the most cited reasons for investing in a private equity fund of funds.

Motivations for Investors Utilizing PE Fund of Funds

Exhibit A. Source: Preqin Special Report: Private Equity Funds of Funds, March 2014. Participants had the ability to select multiple response.

• Diversification: Many private equity investors do not have the ability to commit directly to enough funds each year to achieve appropriate diversification. Through a fund of funds, just one commitment can provide exposure to multiple vintage years, strategies, and sectors. Investors can also choose to invest in specialized fund of funds that emphasize a particular strategy, such as small buyout or venture capital.
• Manager Expertise/Specific Fund Access: High quality fund-of-funds managers have a network and experience level that enables them to commit to difficult-to-access managers that investors may not be able to commit to on a direct basis. This is particularly prevalent in the venture capital industry where top quartile funds are consistently oversubscribed.
• Convenience: Many institutional or family investors lack the capacity or resources to identify and underwrite private equity funds on a consistent basis. These constraints can include the following:
  • Annual commitment pace and amounts may not enable commitments to enough funds each year, especially considering the minimums that often exist to commit on a direct basis
  • Investors may not have the time capacity to discuss more than a few funds per year.
  • Investors may not have the back-office bandwidth to handle the administration of a large number of private equity funds.

Through a fund of funds, the burden of manager selection and commitment pacing falls on the fund manager.

Downsides of Fund of Funds

While they help create diversification in a convenient way for investors, there are some notable downsides to fund of funds.

• Double Layer of Fees and Carried Interest: The underlying funds that a fund of funds commits to charge a management fee and carried interest, most commonly either 1.75% or 2% and 20%, respectively. On top of this, fund-of-funds managers typically charge a management fee between 0.5% and 1% and carried interest between 5% and 10%. This results in what is referred to as a “double layer of fees,” as investors are paying a fee to gain access to each fund and an additional fee for each underlying fund. The management fees lengthen the j-curve while the carried interest limits upside.
• Length of Funds: The commitment period of a fund of funds commonly ranges from three to five years. The underlying funds in the portfolio have terms that most commonly range from 10 to 12 years. As a result, if a fund of funds makes a new commitment in year five, and that fund has a 12-year term, the fund would not be expected to liquidate for 17 years. Of a sample of 40 funds from PitchBook’s database raised in 2000, as of December 13, 2019, only 12 have been fully liquidated 19 years later. Managers sometimes mitigate this through selling the remaining portfolio in the secondary market prior to full liquidation.
• Blind Pool: At the time that an investor makes a commitment to a fund of funds, the underlying funds are not known (known as a “blind pool”) and they are relying on the manager to execute their stated strategy. This contrasts with investors in a direct program who can consider funds on an individual basis. It is therefore imperative when investing in a fund of funds to do so with a trusted fund manager that will execute the stated strategy. It is also beneficial when a manager can provide a list of expected early commitments in the fund, which reduces blind pool risk.

Fund of Funds Performance: Buyout

The May 2017 study “Financial Intermediation in Private Equity: How Well do Fund of Funds Perform?” by Robert S. Harris, Tim Jenkinson, Steven N. Kaplan, and Ruediger Stucke found that of funds raised in a 20-year period between 1987 and 2007 (performance as of year-end 2012), showed that there is "significantly lower returns for fund of funds that focus on buyouts or are generalist funds compared with portfolios formed by ‘random’ direct fund investing.”

An analysis of PitchBook data indicated that median returns for direct buyout funds have been consistently higher than for fund of funds. Although the gap has closed somewhat for recent vintage years, this is in part due to the earlier stage of the funds. A more significant difference is noticed when analyzing the threshold for first quartile funds, as fund of funds display less upside as a result of high diversification and a double layer of carried interest capping returns. The fourth quartile threshold has been higher for fund of funds in recent vintage years due to downside protection from diversification.

Exhibit B. Source: PitchBook data as of December 4, 2019 showing most recent reporting quarter with IRR.

Fund of Funds Performance: Venture Capital

According to the study mentioned earlier by Harris, Jenkinson, Kaplan, and Stucke, the persistence of returns among venture managers is much higher than their buyout counterparts. A fund raised by a manager whose previous fund was in the first quartile had a 48.1% chance to repeat as first quartile again. Similar findings were reported by Adams Street Partners’ “The Persistence of PE Performance” in 2017, as depicted in the table below, which shows that first quartile venture funds between 1979 and 2010 had a 43% chance of repeating in the top quartile.

Exhibit C. Source: Adams Street Partners, "The Persistence of PE Performance."

Does this mean investors should just make direct commitments to venture funds that were previously top quartile? This is often not possible, as consistently top-performing venture funds tend to be oversubscribed and not available to new investors. From a performance standpoint, as concluded by Harris, Jenkinson, Kaplan, and Stucke, “in contrast [to buyout-focused or generalist fund of funds], fund of funds in venture capital perform roughly on par with portfolios of direct funds, even after the additional fees… Venture capital fund of funds create more risk reduction through diversification than is the case for buyouts. In general, our results suggest that fund of funds focusing on venture capital provide more advantages than those investing in buyout funds."

Conclusion

The data and studies discussed show that for a sophisticated investor, a buyout portfolio of direct commitments has consistently outperformed buyout or generalist fund of funds. Contrarily, venture capital fund of funds have performed on par with portfolios of direct venture funds with increased diversification and lower risk. Therefore, Canterbury recommends that most clients gain buyout exposure directly and venture capital exposure through fund of funds.

This is, of course, subject to exceptions. For example, Harris, Jenkinson, Kaplan, and Stucke’s study showed that while generating lower returns than direct buyout portfolios, fund of funds have still historically outperformed the public markets. Fund of funds are therefore a fit for investors that have neither an advisor nor the capacity or bandwidth to construct a direct portfolio of high conviction buyout funds. Additionally, an investor with the ability to gain access to top tier and difficult-to-access venture managers could consider a direct portfolio in that space.