Study: Traditional fund of funds model broken

Broadly diversified private equity fund of funds are no longer an attractive strategy for limited partners, according to recent research from advisory firm TorreyCove Capital Partners.

Out of a sample of 567 global fund of funds with vintage years between 2000 and 2009, TorreyCove found that about two-thirds generated a total value multiple of less than 1.3x. The firm did not look at funds after 2009 due to performance bias from funds still in the early part of the J-Curve. 

“The value proposition of diversified private equity fund of funds generally haven’t been met,” said TorreyCove chief executive officer David Fann.  “It’s probably not the best way to build a private equity portfolio.” 

While 64 percent of global buyout funds and roughly half of all direct private equity funds between 2000 and 2009 cleared an 8 percent IRR hurdle rate, only 40 percent of fund of funds produced IRRs above 8 percent, according to TorreyCove data. The firm also found that “despite the inherent diversification, [more than] one of every 10 global fund of funds still lose money for investors”.

“If you’re investing at least $50 million a year you could probably set up a separately managed account,” Fann said. “The fee structures are lower and there are some [other] advantages there too. You could stop the program if you had a liquidity problem or if you had a change of leadership [and] you could postpone making new commitments.”

TorreyCove, which advises Oregon’s $79 billion state pension system, primarily invests its clients’ capital directly into private equity funds, though occasionally helps clients invest in fund of funds.

“It doesn’t mean we’re going to stop. The take away here is you’ve got to be really selective [in] finding good platforms,” Fann said. “If someone said they wanted to build a portfolio in emerging and frontier markets, a fund of funds might make sense.”

What the advisory firm doesn’t expect to target are fund of funds that provide exposure to a variety of strategies such as large, small and medium-sized buyouts, venture capital and distressed debt.

“We see a world in which most institutional players will move away from traditional fund of funds,” Fann said. “Most of them will have customized solutions where fund of funds will continue to serve a purpose in niche strategies and perhaps segments of the high net worth segment.”