Why Fund of Funds Investing?

A private equity fund of funds is formed to invest capital in a selection of other private equity funds, which in turn invest capital directly in portfolio investments. Investing in a fund of funds allows an investor to diversify the investor’s private equity fund holdings. The fund of funds invests in private equity funds which are focused on various geographic and industry sectors, as well as in private equity funds at various stages of their life cycle.

Significantly Reduces the Risk of Loss of Capital

The primary reason to invest in a fund of funds is to significantly reduce the risk of loss. A properly diversified portfolio of private equity funds will provide a fund of funds investor with diversification across market sectors, investment styles, company size, industry sector and geographic region.

The risk of loss associated with a single direct private equity investment has been shown to be significant, at a 30% probability or more. The risk of total loss has been shown to be effectively eliminated by instead investing in a single private equity fund. Nevertheless, the risk of some loss still remains high at a 30% probability. But by investing through a fund of funds, the probability of any loss being realized by an investor has been shown to be almost entirely eliminated.

Source: Weidig & Mathonet report, “The Risk Profiles of Private Equity”, January 2004

This reduction in the risk of loss to near negligible levels can justify the additional cost in fees paid to a fund of funds manager, as it effectively represents an “insurance premium” against loss.

Investing in a fund of funds also serves to dampen the J curve effect.

Access to Private Equity Funds

Fund of fund investing also provides investors with much better access to private equity opportunities. Most private equity funds require a minimum investment ranging from $5 million to as much as $50 million or more, and the better private equity fund managers find that their existing investors fully subscribe for each new offering, leaving limited access for new limited partners. By pooling capital through a fund of funds, and by choosing a fund of funds manager that has strong relationships with private equity managers, investors are able to participate in a form of investment that is generally only available to institutional and very large private investors.

Professional Fund Selection and Management

To invest directly into portfolio companies and private equity funds, an investor generally requires significant resources to identify and evaluate potential investments and to negotiate and conclude investment transactions. To optimize performance within a private equity portfolio, investors should actively monitor portfolio activity following the initial investment decision, taking advantage of the best co-investment opportunities, responding to changes in circumstances and seeking to add value to the portfolio in a variety of ways. Traditionally, only large investors with a substantial allocation of their own assets to private equity could justify building the internal team of dedicated professionals needed to effectively invest directly in private equity.

A prudent, cost-effective manner for most investors to participate in private equity is through a fund of funds. A professional fund of funds manager will generally have the resources to identify proven private equity fund managers, negotiate transactions and create and maintain a diversified portfolio. A fund of funds can also provide large institutions with an efficient and cost-effective method of investing in smaller funds, which would otherwise be impractical due to time allocation issues and cost.

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