New research adds fuel to debate over need for private equity funds of funds

Research shows funds of funds underperform direct investment in private equity funds

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Adams Street Partners' Gary Fencik: "In the past, consultants introduced you to their clients. In many cases, they are now a direct competitor."

A growing number of consultants consider the plain-vanilla private equity funds of funds a quaint relic of days gone by, a tool that has outlived its usefulness.

Underlying this chorus is new research showing funds of funds underperform direct investment in private equity funds. Also, investors in funds of funds are paying an extra layer of fees at a time when private equity returns are expected to be lower, competition is driving down private equity fees overall and the cost of implementing a direct investment program also is falling.

Private equity funds of funds not only underperformed private equity funds but also failed to provide the 8% return investors need, according to new analysis by TorreyCove Capital Partners LLC, a La Jolla, Calif.-based private equity consulting firm. The research shows 60% of a sample of 567 mature funds — vintage years 2000 to 2009 — only provided an average net return of 6.4%.

“There is considerable evidence that funds of funds in general underperform in private equity,” said Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, Boston. However, Mr. Lerner added: “This does not apply to everyone,” explaining individual firm results can vary quite a bit.

A 2005 analysis comparing returns of various types of limited partners suggested very low average returns for funds of funds. Studies using more recent data have come to similar conclusions, Mr. Lerner said.

The discussion is coming just as the private equity funds-of-funds community is declining. Consolidation is causing big changes, with more than 20% of the managers expected to fade away because of an inability to raise new funds, industry insiders say.

Fees on top of fees

“Returns have not been very good in the fund-of-funds space,” said David Fann, TorreyCove's CEO. “When you layer fees on top of a layer of fees, it does affect performance.”

Returns for top-quartile buyout funds dropped to 16% in 2009 from 34% in 2000, according to TorreyCove's analysis of data from London-based alternative investment research firm Preqin. Overall, the one-year horizon returns for private equity as a whole have dropped to 5.5% as of June 30, 2012, from a peak of more than 20% a year earlier, according to Preqin's annual global private equity report.

And the difference between the expected net return of private equity funds of funds and the expected net returns of the underlying private equity funds is growing to close to 20%, TorreyCove found.

Over a 10-year period ended Sept. 30, 2012, funds of funds offered roughly a 7% annualized internal rate of return compared with approximately 23% for buyout funds and 19% for all private equity, according to Preqin data obtained by Pensions & Investments.

But funds-of-funds executives aren't taking the criticism lying down, saying they have a few issues with the TorreyCove analysis. The executives say consultants in general should not be picking fights with funds of funds because a number of those consultants are now competitors. Many funds-of-funds firms manage discretionary assets as well as separate funds of funds themselves. (TorreyCove does not manage assets including fund of funds.)

“In the past, consultants introduced you to their clients. In many cases, they are now a direct competitor,” said Gary Fencik, partner at Chicago-based private equity funds-of-funds firm Adams Street Partners LLC.

Said Gordon Hargraves, partner at Private Advisors LLC, a Richmond Va.-based private equity funds-of-funds manager: “I have huge respect of David (Fann) and TorreyCove, but TorreyCove is really reiterating a blinding glimpse of the obvious — when it comes to private equity, no one is interested in median returns; average performance is never exciting.”

Firms that underperform will not survive, Mr. Hargraves said. However, fund-of-funds performance has not been that bad. Typically, the private equity benchmark is a certain amount of performance over a public market return. “Over the long term, private equity outperforms the public markets,” Mr. Hargraves said. “And ... the median fund of funds outperformed the public markets — not as much as everybody likes, but they outperformed.”

Some outperformed

Analysis of data from Cambridge Associates and Thomson Reuters show funds of funds have sometimes outperformed stand-alone private equity funds.

For the 10 years through 2008, the lowest quartile of funds of funds offered negative internal return rates only in one vintage year, while the lowest quartile of private equity fund performers had negative net IRRs in each of the years. And the median returns of funds of funds consistently outperformed stand-alone private equity funds. For example, the median funds-of-funds net return in 2008 was 3.4% vs. the stand-alone private equity median return of 1.3%.

Some funds-of-funds managers had issues with TorreyCove's research. They said it fails to adequately consider risk and the J-curve difference between investing in a basket of funds and a single fund. The J-curve is the phenomenon of negative returns in the early years of a fund's life when it is investing capital and higher returns in later years when the fund is earning profits.

“You can't compare a 2006 fund of funds to a 2006 buyout fund,” Adams Street Partners' Mr. Fencik said. “The 2006 fund of funds is committing capital to funds over several vintage years. Each underlying fund has a five-year investment period. A direct fund has only one five-year investment period. It's not an accurate comparison.”

Funds-of-funds managers are offering up their own research that says the best funds of funds have consistent outperformance with lower risk than most direct funds.

A new white paper by Adams Street Partners asserts funds of funds provide more predictable outcomes than a standard diversified private equity portfolio.

For starters, there is a 32% risk that a single private equity fund will lose money. By comparison, the chance of losing capital in Adams Street's funds of funds is about zero, according to the white paper. The average expected multiple on invested capital of Adams Street funds of funds — 2.02 times the investment — is greater than either the Cambridge Associates LLC U.S. Private Equity index — 1.96 times the investment — or the Thomson Reuters Private Equity Fund Performance Survey, which cited 1.75 times the investment.

Probability of losing money

TorreyCove's research agrees the probability of losing money in a private equity fund of funds is a low 10%. But it also said that 65.8% of the funds raised between 2000 and 2009 earned a multiple of less than 1.3 times the investment.

“Investors get their money back, but they don't make a real economic return,” Mr. Fann said.

The top quartile of funds of funds had an internal rate of return of 9.9% and 1.35 times the investment.

And the return picture for private equity funds of funds is not getting any prettier in 2013, with expected returns for leveraged buyouts down to the low to midteens. The extra fees for funds of funds reduce internal rate of return by close to 20% for underlying private equity funds earning net IRRs of 10% to 20%, the TorreyCove research said. This fee drag is harder to justify, Mr. Fann said.

Net fund-of-funds returns include the costs of assembling a private equity portfolio. TorreyCove's analysis assumes there is no cost associated with putting together a portfolio of private equity funds, Mr. Hargraves said.

Mr. Hargraves agreed with one of TorreyCove's conclusions, which is that specialty funds of funds have a place in investor portfolios. (Private Advisors manages funds of funds composed of U.S. small-company private equity funds.)

Another issue with funds of funds could be overdiversification. The typical fund of funds would hold 50 to 60 funds within a four-year investment period, which could lead to portfolios that are overly diversified, he said.

This article originally appeared in the June 24, 2013 print issue as, "New research adds fuel to debate over need for funds of funds".