4.3 PE FoFs

Question 1

Fee structure of PE FoFs? Why still better to invest in FOFs?

Answer 1

Double layer of management and incentive fees.

For institutional investors still more cost efficient that in house

Question 2

Otterlei and Barrington (2003) findings?

Answer 2

That an in-house team’s annual costs can be substantial compared to that of a typical FoF, and even a 5% carried interest charged by FoF managers has little adverse effect on PE investors’ net returns.

Question 3

Successful PE funds require which 3 elements?

Answer 3

1) Broad network of contacts in order to gain access to high-quality funds

2) Well-trained investment judgment

3) Ability to assemble balanced portfolios

Question 4

Probability of total loss of direct investment?

Answer 4

30%

Question 5

How do FOFs provide reasonable downside protection?

Answer 5

Via greater diversification across GPs, vintage years, stages of investment, industries, and geographies

Question 6

Benefits of FoFs for investors?

Answer 6

1) ACCESS: FoFs’ better access to top fund managers may also be because these managers consider FoF investors a more stable and experienced source of capital.

2) EXPERTISE: FoFs can also manage the challenging task of liquidity management that requires insight, an industry network, adequate resources, and access to research databases, as well as skills and experience in due diligence, negotiation, and contract structuring.

Question 7

Differences of PE fund investment and FoF investment among 4 categories: diversification, cost, selection & monitoring skill and access

Answer 7

Question 8

PE FoF key traits?

Answer 8

1) offer investors diversified access to PE

2) aim to add value by selecting top-quartile PE funds

3) may offer economies of scale

4) allocations to oversubscribed
PE funds.

Question 9

PE FoFs differ in which 3 key dimensions?

Answer 9

1) Geographical focus

2) Focus (VC / growth equity / buyouts) or size

3) Portfolio Construction (diversification)

Question 10

Diller and Herger (2009) findings?

Answer 10

Using two dimensions (i.e., number of fund commitments per year and number of vintage years) find that diversifying across 15 funds over 3-5 vintage years can reduce the loss of invested capital to zero and increase a PE fund portfolio’s average performance.

Question 11

Dompé (2019) findings?

Answer 11

20-25 is the optimal size for a portfolio of PE funds diversified across stages, vintages, and geographies.

Once an optimal size is attained, adding more funds has negligible effect on risk reduction and may reduce the value added from manager selection.

Question 12

2 broad categorizations of PE FoFs?

Answer 12

1) Primary FoFs - invest in individual funds at their inception, 20-50 funds, over several vintage years. Similar J curves to individual PE Funds

2) Secondary - acquire LP interest in secondary market. Hundreds of LP interests, know which investments the funds holds. Have shorter J curves than individual PE Funds

Question 13

3 phases of PE FoF portfolio construction?

Answer 13

1) Portfolio construction (top down)
- number of PEs for adequate diversification
- spread across vintage years, geographies, PE Categories

2) GP and Fund selection (bottom up)
- qualitative & quantitative assessment of funds
- avoid investing if commitment amount is a large % of the total fund

3) Ongoing monitoring
- Regular interaction with the GP to know the status of the fund’s portfolio companies and the GP’s outlook on risks and opportunities.
- Regular performance analysis of the fund.
- Regular valuation of the fund.
(Some LPs sit on the fund’s LP advisory board to monitor potential conflicts of interest between the PE fund and the GP)

Question 14

PE FoF investors rely on the FoF managers for what? Why should they evaluate them?

Answer 14

To perform portfolio construction

The investors should evaluate these managers to determine if they are able to select and access top quartile GPs.

Question 15

Pros of PE FoFs investing?

Answer 15

1) Diversification benefit

2) Professional management - experienced investment teams, long-term horizon; targeted pool of capital; economies of scale

3) Access to funds, specific strategy, or geography

4) Lower capital commitment - single PE fund’s minimum investment is around $1 million

Question 16

Weidig and Mathonet (2004) findings?

Answer 16

1) For Venture capital, the probability of a total loss of invested capital is around 30% for direct investments and close to zero for funds and FoFs

2) the probability of a loss for a fund is around 30%, but small for a FoFs.

Question 17

Cons of PE FOF?

Answer 17

1) additional layer of fees:
- 0.5-1% management fee of committed capital
- 5-10% carried interest of realized gains

2) GP relationship remains with the PE FOF manager (unless introduced)

3) Less transparency

4) Lack of liquidity
- longer lives than PE funds (because of diversification across vintage years)
- close ended
- less activity of secondary markets

Question 18

4 Value propositions to PE FOF investors

Answer 18

1) easy access to PE

2) smaller PE Program

3) complement existing PE program - access to other GPs or regions, etc

4) Increased complexity of PE Operational Due diligence (ODD) - FOFs help those lacking ODD expertise

Question 19

Gresch and von Wyss (2011) findings in relation to PE FOF performance?

Answer 19

They compared investments in PE FoF’s to those in single PE funds, using IRR and multiples of invested capital, and find that PE FoFs have lower return dispersions (i.e., possible range of returns; serving as a measure of risk) than single PE funds in the same vintage year

Question 20

Harris, Jenkinson, Kaplan, and Stucke (2015) benchmark PE Fos and portfolios of PE funds to public equity market performance using the Kaplan-Schoar PME (KS-PME).

What are the results? What are the interpretations?

Answer 20

1) PE FoFs offer diversification benefits by reducing performance dispersion.

2) PE FoFs have higher returns than public equity investments, but at a cost of higher illiquidity.

3) PE FoF returns are lower than returns on a portfolio of PE funds, possibly due to FoFs’ double layer of fees.

Question 21

St dev of KS-PMEs buyout and VC funds to S&P?

Answer 21

1) buyout - half of SnP

2) Vc - third of SnP

Question 22

Funds of funds have included what types of account over the past decade?

Answer 22

Secondaries, co-investments and separate accounts

Question 23

Which form of private equity investment format suffers from the greatest illiquidity?

Answer 23

Open ended FOFs - limited monthly/quarterly liquidity