DR.CHENJIAZI ZHONG

PE fund of funds have been around for nearly as long as the buyout industry. This type of investing became mainstream during the mid to late 1990s, as institutional investors sought additional ways to achieve diversification and deploy capital. PE fund of funds are often referred as PE multi-manager investments. Ten years ending the calendar year 2012, PE fund of funds returned 8.6 percent.

According to Preqin, the largest PE research and consultancy firm, PE fund of funds had raised $6.1 billion by the first half of 2013. Although the amount was way less than that of direct PE funds which had brought in $152.6 billion, managers of endowment funds and pension funds still maintain a high-level interest in PE fund of funds investment, and they still ranked as the second most popular alternative asset.

Private Equity Market Share by Fund Type

Benefits of Private Equity Fund of Funds

Investing in PE fund of funds allows investors to access to the PE market in a quick and efficient manner. Although the structure adds a second layer of fees, PE fund of funds provide LPs a different set of benefits which cannot be achieved through direct PE funds:

• Diversification – PE fund of funds offer greater diversification and allow for downside protection which can substantially reduce overall risk, especially in the case of new technologies, new teams, and emerging markets.
• Manager Selection Skills – PE fund of funds managers provide expertise to investors who are looking to invest in strategies or geographies where they do not have previous experience. Fund of funds managers play a key role in discovering top-performing funds or future stars.
• Resources and Information – PE fund of funds enable investors to access to specific markets, specific funds, and address any information gap through managers’ expertise in fund governance and due diligence.
• Size of commitment size – As they typically require less capital upfront, PE fund of funds offer LPs and other investors the chance to gain exposure to some of the best-performing funds in the sector with much smaller commitment size.

Good fund of funds managers have demonstrated superior capability and skills in network, fund screening, and portfolio allocation.

Some investors, however, are intimidated by the fee structure of this type of investment. To address this consideration, separate accounts with PE fund of funds were set up, and they have been increasingly popular among endowments and foundations since a couple of years ago as they can be less costly for slightly larger mandates. Investing via separate accounts allows investors to span any combination of primary, secondary, or direct investment strategies. Additionally, this vehicle can also be utilized in asset allocation and risk reduction strategies.

Relationship between Predecessor and Successor PE Fund of Funds

According to the PE investor survey conducted by Preqin, 31% of the top-quartile PE fund of funds manager continue to generate a top-quartile follow-on fund of funds, while only 17% of top-quartile managers underperform and produce a vehicle in the bottom quartile. Conversely, of the managers running a bottom-quartile fund of funds, 33% go on to generate a bottom-quartile performance. This chart demonstrates how important it is for LPs to build and maintain a long-term relationships with GPs and top-performing fund of funds managers, as they are more likely to continue to be winners in the PE market world.

The Dynamics of LP-GP Relationship

In addition to the illustration of the performance between predecessor and successor PE fund of funds, the Yale Endowment is another good example in this topic. Yale’s value-added PE investing approach emphasizes long-term partnerships with the PE managers who work closely with portfolio companies to create fundamentally-valuable entities.

There is a symbiotic relationship between LPs and GPs. An LP’s investment strategy is built around a small number of relationships with GPs who focus on specific stages or sectors of the market. GPs, for their part, want financially strong, dependable, knowledgeable, and long-term LPs, who should be familiar with the PE business. In addition, LPs are expected to contribute new capital to GPs as soon as the capital from the latest active fund is fully invested. Therefore, relationships between LPs and GPs follow a life cycle, and are forged through various rounds of investment, eventually resulting in a virtuous circle of growing experience and fund size.

PE Fund Manager-Investor Relationship Life Cycle

• In the PE market, the search for and due diligence of funds is a costly exercise, and therefore LPs usually prefer familiar fund managers to unproven investment proposals.
• Long-term relationships may provide access to quality deal flows of co-investment opportunities in portfolio companies within an established framework.
• It is especially desirable for investors to hold on to good fund managers, as the best teams always have established investor base, which may eliminate the need to seek out new funding sources when making new investments.

Empirical studies also suggest that experienced PE market players profit over protracted time periods from long-term LP-GP relationships.

Minimize Conflicts of Interest

It is ideal that PE fund managers commit a meaningful amount of capital alongside their investors in each PE fund of funds they raise, which reinforces the managers’ alignment of interest with their investors. Beyond that, conflicts of interest need to be minimized in order for the PE managers to focus their attention to the fund. Besides, management independence is another key requirement in this regard. Furthermore, in conducting fund due diligence, if market conditions are changing or better investment opportunities are available, the investment objectivity and expertise of the PE managers need to be re-scrutinized, even if the current fund is structured to align interests and to avoid conflicts with previous or parallel funds.

References:

• The 2013 Preqin Private Equity Fund of Funds Review