It’s been a challenging year for public and private markets alike, marked by geopolitical turmoil, increasing interest rates, surging inflation, and continuing volatility. Given the current macroeconomic environment, savvy investors are turning their attention to private equity as a compelling wealth-building strategy with its potential for long-term value creation, diversification benefits, active management, and access to innovative companies.
By investing in PE, you have access to the real economy and to companies and projects owned by shareholders that are aligned with you as an investor, since their success depends on the investment's performance.
Fund of Funds
There are many ways to invest in PE: directly, by acquiring stakes in private companies, or indirectly, by committing capital to PE funds or by using the most widely diversified private equity investment vehicle, the PE funds of funds (FoF).
PE FoF is a pooled investment fund in which capital commitments from many investors are allocated to a diversified list of PE funds based on several investment criteria (target geography, sector, size, etc.). A FoF is advantageous for both investors with small private equity allocations (as they can diversify their portfolio without having to invest large amounts) as well as for investors with large private equity investment allocations (as they can gain access to smaller corners of the PE market). Moreover, financial returns can be more attractive than investing in companies or funds directly.
Potential for higher returns
Speaking of financial returns: data from Pitchbook shows that the 10-year IRR1 of FoFs is 14.2%, just under that of private equity as a whole (16.9%), despite the enhanced diversification. In addition, FoFs are the third best strategy in the private markets space over both the short and long term (up to 10 years).
Further evidence of why FoFs are attractive is also highlighted by Cambridge Associates (a leading private markets advisor) data which shows >10% net IRR over the 25 years and that FoFs beat public markets consistently over any benchmark. Furthermore, TVPI2 are always above 1x across all vintages, so you are almost certain to never lose money with FoFs.
Enhanced diversification for risk mitigation
The benefits of investing in a PE FoF for a private investor are numerous:
- diversification and risk mitigation
- superior manager selection
- consistent and diversified allocation across managers, industries, geographies, and stages in the business cycle
- regular reporting and portfolio insights
- long-term focus and exposure to new markets
By investing in FoFs, investors can gain exposure to a broad range of diverse investment opportunities without having to select and manage individual funds and portfolio companies themselves. By pooling investors' money, FoFs can negotiate access to coveted funds and lower fees with the underlying funds, thereby potentially improving the performance and reducing the overall cost of investing.
Additionally, investors can benefit from economies of scale as the FoF manages a larger pool of assets, spreading certain costs across a larger investor base.
Last but not least, given that the promoters of PE funds and FoFs are usually among the biggest investors in their funds (which is called the 'GP commitment'), outside investors benefit from that alignment.
When selecting a FoF, it is essential for investors to carefully evaluate the specific FoF's strategy, track record, fees, and overall fit with their investment objectives before making investment decisions.
Do you want to find out more about investing in a private equity fund of funds? Read all about it here in our quarterly PE Fundraising Report.
notes:
- The internal rate of return (IRR) is the annual rate of growth that an investment is expected to generate.
- The Total Value to Paid-In Capital (TVPI - also known as the ‘Investment Multiple’) is a measure of the performance of a private equity fund. It represents the total value of a fund relative to the amount of capital paid into the fund to date.