Only One Type of Private-Equity Fund of Funds Earns Its Fees
- June 19, 2017
- CBR - Finance
Private-equity investments can be enticing, but also complicated. It can be expensive for institutional investors, endowments, and pension funds to find and monitor private-equity investments—which can then be illiquid and difficult to scale.
A private-equity fund of funds, which holds a portfolio of other funds, potentially provides diversification and economies of scale, as well as specialized investment services. But are the advantages worth an extra layer of fees? Private-equity FOFs typically charge investors an annual fee of around 1 percent, and management gets 5 percent of all gains. That’s on top of the standard “2-and-20”—2 percent of total asset value and 20 percent of any additional profits—usually charged by each of the private-equity firms in which FOFs invest. Research by University of Virginia’s Robert S. Harris, University of Oxford’s Tim Jenkinson, Chicago Booth’s Steve Kaplan, and Rüdiger Stucke of private-equity firm Warburg Pincus suggests that one type of private-equity FOF has been able to overcome that fee hurdle.
The researchers assessed the five-year performance of nearly 300 FOFs started between 1987 and 2007, differentiating between funds that focus on buyouts and those that invest in venture-capital private-equity funds. Firms that focus on buyouts usually invest in mature companies and buy all of a company’s equity. Venture-capital firms, by contrast, invest in start-ups and growth companies, taking lesser equity stakes.
Both the buyout and venture-capital strategies delivered average returns net of all fees that matched or surpassed the performance of public-equity markets (as measured by the S&P 500 and the Russell 2000 stock indexes) over the sample period.
When the two strands of private-equity FOFs were compared to investing directly in private-equity funds, the results were different. FOFs that focused on buyouts underperformed a strategy that invested directly in buyout funds. FOFs that focused on venture-capital funds did just as well as investments made directly in venture-capital funds.
Venture-capital FOFs tend to offer more diversification, with an average of 28 individual funds within FOFs, compared to an average of 21 for buyout FOFs.
- Robert S. Harris, Tim Jenkinson, Steve Kaplan, and Rüdiger Stucke, “Financial Intermediation in Private Equity: How Well Do Funds of Funds Perform?” Working paper, May 2017.
- ———, “Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds,” Working paper, August 2014.
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