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.

Previous research from the same team helps explain how the average venture-capital FOF has managed to overcome its extra layer of fees. In 2014, the researchers found that venture-capital funds have more performance “persistence” than buyout funds: in other words, top performers tend to continue to do well. This suggests astute FOF managers who can identify top-tier venture-capital firms can deliver a higher level of return that helps offset the increased fees. Established venture-capital FOFs also likely deliver added value by being able to access venture-capital managers who other investors would be unable to invest with on their own. And in the current research, the researchers find that 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.

“[T]he evidence suggests that VC FOF managers are more likely, through fund selection and/or access, to overcome their additional layer of fees than are buyout FOFs,” the researchers write. “In addition, our analysis suggests that VC FOFs create more risk reduction through diversification than is true in buyout.”

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