Research

The potential benefits of funds of funds are lively debated in the private equity industry. How can a fund of funds manager justify the additional fee layer? Do funds of funds deliver excess returns? We argue that fund of funds investors may indeed benefit from attractive risk-adjusted returns: firstly, because diversification does reduce volatility; and secondly, because diversification may even increase returns. Nevertheless, funds of funds managers that want to justify their services going forward will have to add value beyond the common claim for premier fund selection and diversification. In this article, we show how investors can benefit from an integrated private equity asset management approach, combining the traditional benefits of a fund of funds, with additional support to the investor in strategic and tactical asset allocation decisions. By assessing the relative attractiveness of different private equity segments and instruments, funds of funds managers can considerably improve returns to their investors and clients.

Traditional Benefits of Funds of Funds

Even after the significant decline in fundraising activity since 2000, annual commitments to private equity funds have increased by approximately 20% per annum over the last ten years, according to data from Thomson Venture Economics. The number of private equity funds increased considerably and the number of funds of funds (FoFs) raised per calendar year increased from approximately 20 vehicles in the mid-1990s to 120 in the year 2000. In 2004, around 60 vehicles were fund raising and figures from Thomson Venture Economics suggest that private equity FoFs have raised more than US$10 billion.

Thus, approximately every tenth dollar available in the private equity industry is committed through FoFs. With returns from private equity depressed recently, investors have come to closely scrutinise FoF investments. Are the promises of FoFs still valid? How will the industry adapt over time? Below we summarise some of the areas where FoFs have traditionally added and continue to add value to an investor’s programme. However, we argue that investors should call for an integrated approach to private equity investing. Beyond the traditional benefits, FoF managers have to support their clients in their asset allocation. It is the expert’s responsibility to analyse the private equity industry and assess what segments and investment styles will generate the best relative value.

Manager Selection

Manager selection is certainly the foremost area of expertise of a professional FoF. A well structured due diligence process, financial and operational understanding and access to the top funds are the core competences of a traditional FoF. Experienced firms around the globe follow similar principles in the due diligence process and strive for the same goal: to select managers that generate superior returns for their investors in their respective industry segment. Although diligent fund selection should certainly limit the downside of a private equity portfolio (‘avoid accidents’), most investors would rather pick a FoF for the upside potential through manager selection. Unfortunately, the available FoF performance data is too scarce (and also often too immature) to prove or refute the promise of superior returns. Performance data from FoFs (available from the websites of large US institutions due to Freedom of Information Act legislation) seem to indicate that major FoFs neither stand out as big winners nor as big losers¹.

Portfolio Diversification for the Purpose of Risk Reduction

No risk-averse long-term investor would pick only one fund in a sub-segment (such as US venture capital, vintage 2004), but choosing all conceivable funds in a sector may circumvent top quartile returns (‘levelling’). To determine the ‘golden mean’, we have analysed more than 2000 private equity funds tracked by Thomson Venture Economics. We have performed a historical simulation to quantify the impact of portfolio size (in terms of number of funds) on the volatility of a FoF’s final performance. We selected a random fund portfolio over three consecutive vintage years² and calculated the volatility of the final performance of such portfolios. Our analysis (see Chart 1) shows that investors need approximately 15 funds for a life cycle of three years in a given sub-segment (eg US buyout) in order to diversify the unsystematic risk. Basically, one can more than halve the volatility of the final outcome with the appropriate diversification. Given the broad range of funds available, this number of funds can nowadays be chosen without compromising on returns. Many investors, however, lack the necessary size for appropriate diversification, and only FoFs will allow these investors to reduce manager specific risk in selected segments.

Chart 1: Volatility Reduction

The above illustration is based on a historical simulation using Thomson Venture Economics data for US buyout funds. The volatility of a FoF’s final performance can thus be significantly reduced.

Portfolio Diversification for the Purpose of Return Enhancement

Seeking portfolio diversification for the purpose of enhancing returns may seem to be a contradiction for many investors, given that the principal reason for portfolio diversification is to reduce risk. However, the following pragmatic study illustrates that it is not. When we analyse the pooled average performance of US venture capital, vintage years 1990 to 1999, we observe that the pool of all funds (‘the most diversified portfolio for each vintage year’) outperformed the top quartile in 50% of the cases. This phenomenon occurs due to the significant right-skewness of private equity return distributions – returns that significantly exceed the median are more probable than returns that significantly undershoot the median. In fact, the pooled average outperforms the median return per vintage year on all US private equity funds of vintages 1990 to 1999 on average by more then 700 bps! In other words, it is likely that the performance of a single fund is lower than the performance of a pool of funds. For an investor with a given return target, it is wise to diversify the portfolio to increase the probability that this return is actually achieved.

Negotiating Terms and Professional Reporting

These are both further areas of expertise of a FoF manager. Negotiating terms is an element of value creation that is often not recognised by investors. FoF firms negotiate with private equity firms to ensure that terms are in line with industry standards. Thus, these intermediates are important ‘watchdogs’ to ensure proper downside protection and alignment of interest between limited partners (LPs) and general partners (GPs). Many GPs are even willing to accept more LP-friendly terms to get a renowned investor in their LP register, which should ultimately attract further investors.

Reporting, on the other hand, is cumbersome for most investors. Gaining the know-how, setting up the necessary software and staffing a qualified team means significant costs that are inappropriate when an institution is invested in just a handful of private equity funds. Professional FoF managers that have to deal with more than a hundred fund investments in their various vehicles, by contrast, have the necessary economies of scale to justify such expense. Thus, established FoF managers can provide their investors with a state-of-the-art (nowadays increasingly available online) reporting that reduces the administrative burden for their clients. However, the recent discussions about the ‘Freedom of Information Act’ might change the amount of information distributed to LPs. FoF firms do not want to find themselves in the same struggles as large US institutional investors being banned from the LP register of top-tier US VC funds.

While these benefits are valid arguments for a FoF commitment, investors can and should call for additional benefits. In what areas can FoF develop in the future?

Relative Value Assessment

Integrated private equity management

Over recent years, FoF managers have emerged that are prepared to add value beyond traditional fund manager selection. While these managers still offer the traditional FoF benefits, they also propose to take over responsibility for their client’s investment activity in other areas. On top of manager selection, we believe that a FoF manager with an integrated private equity asset management approach can support its clients in three major areas:

• Strategic asset allocation
  Diversification within the private equity asset class is a critical component for all long-term private equity investors. Specifically, we believe that only globally diversified private equity portfolios will achieve optimal risk/return profiles.
  
  
• Investment level steering
  Private equity investments are characterised by a series of uncertain cash flows in terms of both timing as well as size. Without an effective commitment planning based on a sophisticated quantitative modelling, private equity investors struggle to reach and maintain their private equity target allocations. More specifically, investors can avoid pitfalls such as cash dilution or opportunity cost through either under or overshooting the target allocation over time.
  
  
• Relative value assessment for various private equity investment opportunities
  An investor’s private equity programme must maintain the flexibility to take advantage of market opportunities. For example, investors must be nimble enough to determine not only when to buy, but also to determine in which private equity segment the best opportunities can be found at any given time. 

The remainder of this article considers how FoF managers can add value through assessment of the relative value of differing private equity investment opportunities.

In a similar fashion to the public markets, asset allocation within private equity is an important driver of risk-adjusted performance. Unfortunately, asset allocation for private equity is by far more difficult than for the public markets. To judge the attractiveness of a private equity investment opportunity, both the investment case as well as the exit case must be considered. FoFs may support the investor in its asset allocation decisions by assessing the relative attractiveness of private equity sub-segments (venture capital, buyout and mezzanine; United States, Europe and Asia) and investment styles (primaries, secondaries and direct investments). For example the following questions call for an answer:

• What would your performance have been if you had been with the right managers in the wrong sector? What would your performance have been if you had been with the wrong managers in the right sector?
  
  
• What are the benefits of secondaries or direct investments?

Before analysing the benefits of such an assessment, let us discuss two prerequisites to successfully implement such a strategy, namely an extensive industry network and a broad internal database.

Private equity industry network

To include secondaries and direct investments in a private equity portfolio, an extensive GP network is necessary to provide for the necessary deal flow. Moreover, while private equity firms are generally not selective when it comes to accepting money for primary commitments, secondaries and direct investments are not ‘common property’. A number of highly successful fundraisings for secondary funds in recent years, and the increased appetite for secondary transactions displayed by investors, often lead to auctions. What are a FoF’s advantages in such competitive situations? GPs often favour buyers with a solid primary business. After all, private equity groups would like to keep or grow their investor base and would rather give transfer consent to potential long-term investors. For them, the ideal secondary investor will likely re-up to the next fund. Pure secondary players start to give more notice to these facts, reserving a part of their fund for primary commitments, in order to help them in obtaining transfer consents when purchasing secondary portfolios.

When looking at direct investments, how can a private equity investor exclude the potential ‘negative selection bias’? Why would a GP share the best investment opportunities and give up the performance fee on these deals? There are two reasons why a GP may do so in the case of a FoF. Firstly, FoF managers are often large investors and thus have the necessary leverage (in terms of commitment size) to secure co-investment rights. Secondly, FoFs can add value to the GP through their extensive industry network. After all, private equity is a people’s business and putting the right people together can help GPs to solve some of their issues.

Internal database

For FoF managers with an integrated approach, administration is much more than reporting and data warehousing; it is the data backbone that allows assessing their private equity portfolios in depth. Clearly, such managers have a competitive advantage both for secondaries and direct investments. They can often move more quickly in secondary transactions, as they might already be invested in some of the funds being transacted or even have insight from advisory board seats. Knowing both the general partners as well as the portfolio companies is a key advantage that allows for fast execution of secondary transactions. For direct investments, a thorough analysis of the investment company and the characteristics of the transaction are necessary to determine whether it is worth taking a higher concentration risk on a single deal. FoF managers with portfolios of more than a hundred funds and thus potential exposure to thousands of privately held companies clearly have an advantage in assessing a deal’s risk-adjusted performance potential. 

A firm having the necessary private equity industry network as well as the data backbone may conduct a relative value approach. Such an approach involves analysing the benefits of regions, financing stages and investment styles and may add further value to the investor, as described below.

The Relative Value Assessment for Regions and Financing Stages

Analyses on the importance of sector selection in private equity are scarce. For illustrative purposes, we have analysed the impact of sector selection for the four sectors venture capital and buyout, US and Europe. We have ranked these sectors per vintage year and managers and have analysed the sector and manager dispersion, measured as top quartile, median and lower quartile. This easy analysis of the performance of private equity funds for the two dimensions, regions and financing stages, yields interesting results (see Chart 2). What are the conclusions we can draw from this easy analysis:

• Clearly, manager selection is more important than sector selection. The spread between the top and the bottom quartile is approximately 50% higher than the dispersion between a ‘good’ and a ‘bad’ sector.
  
  
• Good manager selection in a bad sector only shows low double-digit returns, whereas choosing a mediocre manager in a good sector can deliver returns in excess of 15%.
  
  
• Investors do not invest into private equity to achieve median returns! There are two ways to increase private equity returns: Through manager selection and assessment of attractive sectors.
  

Illustration of manager and sector dispersion for private equity funds. This illustration is based on the IRRs of private equity funds as tracked by Thomson Venture Economics.

The Relative Value Assessment for Investment Styles

The case for direct investments and secondary investments as beneficial additions to a primary fund portfolio is quickly made. Secondaries on the one hand allow for a quick increase of a private equity portfolio’s investment level, early distributions and attractive IRRs (if bought at the right price). Moreover, the visibility of the return potential is significantly higher for secondaries than for primaries. Adding directs, on the other hand, may increase the upside potential of a diversified portfolio as the exposure to selected companies has been carefully increased. Moreover, directs may decrease the overall fee load as direct deals are often offered at reduced, or even eliminated, fees and carry. Thus, the investor is basically not charged an excess fee on the direct allocation.

Clearly, assessing the relative attractiveness of a private equity sector is far from being a trivial exercise, even more so when taking the different investment styles such as primaries, secondaries or directs into account. The return drivers of private equity performance differ for differing investment styles:

• Besides the more qualitative indicators such as GP quality, the most important (assessable) indicator for primary funds is the investment environment (debt availability, entry multiples paid in recent transactions, capital overhang and competition for deals, etc). The average holding period of four to six years is normally too long for investors to be able to assess the exit (and thus return) potential of a primary fund investment. Recall that some of the investments made by a fund may only be exited 10-12 years after the inception of the vehicle. 
  
  
• While directs have similar return drivers as primaries, the particular investment case can be analysed in more detail. Investigating the business plan with detailed figures, meeting the management teams, understanding the assumptions for growth as well as the various exit scenarios will enable the investor to assess the risk-return characteristics of the single investment, which clearly differs from the primary ‘blind pool investing’. The price for an investment is basically the price that allows to achieve the target return given a set of exit scenarios (multiples and probabilities).
  
  
• The return drivers for secondaries are often completely different. Depending on the maturity of the secondary (‘manager’ or ‘financial’ transaction), important value drivers might vary from the investment environment and the manager’s skills (for very young and immature secondaries) to the immediate exit environment (for tail-end situations). Similarly, the discount achieved on the transaction certainly has a much lower impact on a recently closed and largely unfunded fund with more primary-like characteristics, as compared to a fully funded fund where companies were already written up or realised. While young and immature secondaries are often not targets for pure secondary players, they might fit very well in a private equity portfolio, thus further reducing fees paid to underlying funds even when purchased at no significant discount to NAV.

Conclusion

Integrated private equity FoF managers ideally add value both through premier fund selection (‘focus on managers’) and through asset allocation (‘focus on sectors’). Most FoF managers traditionally focus on fund selection only, with the asset allocation decision remaining with the investor. Because the relative attractiveness of the various segments, regions, vintages and instruments within the private equity asset class frequently change over time, investors should address asset allocation more systematically. Firms acting more as asset manager that as pure FoF can add value for their investors by allocating to the whole range of private equity investment styles in their portfolios. On top of a diversified primary portfolio, secondaries and directs may increase the performance potential of a portfolio. Integrating a relative value approach in the overall private equity investment process supported by structured quantitative and qualitative analysis adds value beyond pure manager selection.

This article was first published in A Guide to Private Equity Fund of Funds Managers by Private Equity International.

Note: André Frei and Michael Studer are members of the Risk & Quantitative Management team at Partners Group, which is responsible for the risk and quantitative management of the firm's private equity and hedge fund investments. They have authored several quantitative private equity research publications and together they have developed the latest generation of Partners Group's private equity commitment and cash flow models, which are used for commitment steering and cash flow management of Partners Group's private equity mandates and securitised private equity products.

Partners Group is a global alternative asset management firm with approximately CHF 11 billion in private equity, private debt and hedge fund investment programmes under management. The firm manages a broad range of funds, structured products and customised portfolios for an international clientele of institutional investors, private banks and distribution partners. Partners Group is headquartered in Zug, Switzerland and has offices in New York, London, Singapore and Guernsey. The firm employs over 140 people and is majority owned by its 29 partners, principals and its employees.

This material is provided for educational purposes only and not as an offer to sell, or solicitation of any offer to buy any security. It does not constitute investment advice and should not be relied on as such. This material may include information that is based, in part or in full, on assumptions, models and/or other analysis (not all of which may be described herein). Partners Group makes no representation or warranty as to the reasonableness of such assumptions, models or analysis or the conclusions drawn therefrom. Any opinions expressed herein are current opinions as of the date hereof and are subject to change at any time.

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