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.