My second annual look at the performance of a sampling of funds of funds, though peppered with caveats, finds once again that many generate unappealing returns.
Diversified funds of funds—co-mingled or single-backer pools of capital raised by advisory firms and doled out to buyout and venture capital funds—remain a popular means for institutional investors to outsource their private equity programs. Narrowly-focused, or specialized funds of funds, meantime, offer investors a chance to dive deep into caverns of the market that they don’t have the time and resources to explore themselves.
Proponents of funds of funds point out how difficult it is for investors to achieve top-quartile performance on their own. Veteran advisors can provide access to invitation-only funds, as well as expertise in unearthing and vetting firms that will go on to manage the top-performing funds of tomorrow. Perhaps most important, many funds of funds offer a mix of primary commitments, secondary purchases, and co-investments that would be impossible for smaller investors to achieve on their own.
Critics of funds of funds point to the fees charged by managers—a management fee, and often a share of profits on all or a portion of the fund—as one reason to be wary. These fees get layered on to the already-generous fees charged by the underlying fund managers. That diversified funds of funds, by virtue of their size, are doomed to do little more than match median returns in the asset class is another criticism. And median returns in private equity are notoriously unspectacular. So what do the numbers say?
This year I collected return data from seven institutional investors that together committed $8.7 billion to 46 funds of funds from 1985 through the end of 2002. (To minimize the impact of the J-curve effect, in which returns remain depressed in the early, un-ripened years of a private equity fund, I decided to keep the cut-off at 2002, the same as last year.) For the 39 of the 46 that provide valuation data, advisors have to date drawn down $6.7 billion, and returned $8.0 billion between distributions and an estimated value of remaining holdings. The pooled investment multiple is therefore just 1.2x. Likewise the median investment multiple of the 39 individual funds is 1.2x as well. Twenty-seven of the 46 funds supply IRRs; for those the median IRR is 9.7.
Since several funds of funds appear more than once in my sample, I melted out the duplicates to create a smaller sample of 31 distinct funds of funds. But the results were similar—a pooled investment multiple of 1.2 (for all 31 funds), a median investment multiple of 1.2 (31 funds), and a median IRR of 8.5 (17 funds).
The numbers represent a slight improvement over last year—see Buyouts, August 6, page 52. But a direct comparison isn’t possible, in part because I kept the cut-off year the same, in part because I discovered data for a handful of new funds of funds this year.
Last year’s column—entitled “Funds of Funds: Are They Picking The Best?”— generated a flood of requests to see my mathematical handiwork. In addition, several folks wrote that they were unsurprised by the data, some wrote that they were surprised the numbers were so low, and several pointed out weaknesses in my analysis. Here’s a summary of the criticism:
• My sample represented only a sliver of the funds-of-funds universe, and isn’t representative.
• My analysis made no distinction between diversified funds of funds and specialized funds of funds, which tend to be younger, follow different strategies, and charge different fees;
• I didn’t adequately account for the j-curve, since funds of funds tend to get drawn down over several years, as do the underlying funds; the five-year cushion used last year (expanded to six this year) wasn’t enough;
• Comparisons to the S&P 500 (which I included last year) are unfair since private equity funds are never close to fully invested at any given time;
• My sample is tilted toward venture capital funds (which have performed poorly in recent years) since so many LPs use funds of funds to gain access to this sub-genre;
• Just as with the funds they back, some advisors consistently outperform their peers—a point I failed to make in my piece;
• Occasionally, pension funds back funds of funds for reasons that include channeling money to in-state groups, a goal that can lead to poor returns.
All are valid points that I urge you to consider in evaluating this analysis of funds of funds. Also please note that many of my return-data sources provide caveats of their own on their Web sites. For a copy of my spreadsheets (listing my data sources, and all of the funds used in this analysis), or to help me to increase my sample size, send an email to email@example.com.