Private equity fund of funds are investment vehicles that pool capital from people to invest in several different private equity funds. Through these funds, investors can create a highly-diversified and comprehensive portfolio of indirect investments in several companies from some or all of the categories of private equity. Private equity fund of funds helps to spread the risk of the investments made whilst maintaining healthy returns. Smaller investors, who do not have access to larger private equity funds due to capital constraints, often invest into Private equity fund of funds to increase their exposure to the asset class.
A Private equity fund of funds holds the shares of many private partnerships that invest in private equities. In this way, firms increase cost effectiveness and thereby reduce their minimum investment requirement. This also allows scope for greater diversification, since a fund of funds might invest in hundreds of companies representing many different phases of venture capital and industry sectors.
In addition, because of its size and diversification, a Private equity fund of funds has the potential to offer less risk than an individual private-equity investment. One of the most important 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 disadvantage it may bring to some investors is that there is an additional fee to the Private equity fund of funds manager over and above the fees paid to the direct private equity partnership.
Many investors may use a Private equity fund of funds approach to develop and strengthen their private equity investment program. Private equity 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 their portfolio. However, some big investors use selected Private equity fund of funds managers to complement their portfolio of direct partnership investments. These investors effectively out-source the management of a segment of their private equity portfolio.
Key Features of Private Equity Funds of Funds:
- Investment Strategy: A Private Equity Funds of Funds will seek to obtain superior investment returns relative to medium to long term returns in the market. To achieve this goal, a Private Equity Funds of Funds invests in other Private equity funds with similar or higher return goals such as Venture Capital funds or Hedge Funds.
- Preferred Returns: A vast majority of Private Equity Funds of Funds provide preferred returns to investors which is a fixed percentage of the annual rate of return, ranging from 6%-12%.
- Management Fees: The Management fees charged includes an annual amount equal to a fixed percentage of total capital commitments during a specified investment period ranging from .75%-1.5%.
- Typical Investors: A full range of high net worth or high income individuals as well as smaller institutiona l investors.
- Leverage: A Private Equity Funds of Funds has the ability to borrow short term loans to cover Partnership expenses or to “bridge” Capital Contributions.
Benefits of Private Equity Fund of Funds
A successful Private Equity Funds of Funds offers prospective investors with an attractive combination of the following factors:
- Access to deal flow is especially a compelling factor since several Leveraged Buyouts or Merchant Banking funds and larger Venture Capital and Hedge Funds require minimum investment that are beyond the reach of many individual investors. A Private Equity Fund of Funds can eliminate these obstacles by pooling much smaller commitments from individuals.
- Expertise is a factor which may be attractive to a wide range of institutional as well as individual investors. The Private Equity market is characterized by a relative lack of transparency and the only way to obtain crucial market information is by being an active market participant. A Private Equity Fund of Funds can help bridge this gap for investors whose resources or portfolio allocations allow for only for more limited investments in Private Equity Funds.
- Economies of scale arise from the fact that a sponsor of a Private Equity Fund of Funds can perform a thorough business and legal review of prospective investments that would be expensive if undertaken by each investor in the Private Equity Fund of Funds.
- Diversification is achieved because the investor in the Private Equity Fund of Funds acquires relatively small interests in a number of underlying Private Equity Funds. The pooling of capital at the Private Equity Fund of Funds level allows this even for investors who do not satisfy the minimum investment threshold at any of the underlying Private Equity Funds. An extremely large number of companies are available to private equity investors and provides an opportunity for a diversified portfolio across many different industries. Small pension funds or financial institutions investing in a Private Equity fund of funds can achieve better diversification than they could if they managed their own private equity investments. For instance, Private Equity 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.
- Private Equity Funds of Funds are less risky since they invest capital in a maximum of twenty direct investments.
- As they invest in diversified private equity asset classes, Private Equity Funds of Funds significantly improve the risk/reward profile of a portfolio.
- An access to high-quality funds managed by a professional team is provided.
- A major advantage that experienced managers of Private Equity fund of funds is the ability to access top-performing, direct-equity partnerships. This access is very important in creating superior returns for the private equity asset class.
Disadvantages of Private Equity Fund of Funds
- Private Equity Funds of Funds market is opaque and illiquid.
- The access to performance figures in Private Equity Funds of Funds is very limited
- Additional charge of asset management fees levied on investors. This can reduce the investor’s profits and total returns compared to what could be achieved through mutual funds or ETF’s.