Private equity investments can be made either directly into private companies and funds or indirectly through a fund-of-funds structure. This article examines the differences between Private Equity Fund of Funds vs Direct Investments, including the pros and cons, fees, diversification, risks, and suitability for different types of investors.
What is a Private Equity Fund of Funds?
A private equity fund of funds is an investment vehicle that takes capital from multiple investors and allocates it across a portfolio of private equity funds and deals. The fund of funds provides instant diversification and acts as general partner.
Key characteristics of private equity fund of funds include:
- Pools capital from multiple limited partners into one fund entity
- Invests in 10-30+ underlying private equity funds as limited partner
- Managed by a fund of funds manager who selects/allocates to sub-funds
- Adds layer of fees for fund of funds manager on top of underlying funds
- Provides quick diversification across PE strategies, managers, geographies
- Commonly used by smaller investors to gain PE exposure
Major reasons to invest via a fund of funds are diversification, access to top-tier funds otherwise unavailable, and skill of the fund of funds manager. But the additional layer of fees detracts from net returns.
What is a Direct Private Equity Investment?
In contrast, a direct private equity investment involves allocating capital directly into a private company, private equity fund, or deal. Types of direct PE investments include:
- Investing as limited partner directly in a private equity fund
- Co-investing alongside a PE fund in a deal
- Purchasing secondary shares in a PE fund or company from an existing investor
- Investing directly in a private company seeking capital
Direct investments provide more control in choosing the specific investments versus relying on a fund of funds manager. But they require significant research and due diligence. Large institutional investors like pensions and endowments often favor direct investments in their core PE portfolio for greater control and economics.
What is the Difference Between Direct Investment and Fund of Funds?
The key differences between direct private equity investing versus utilizing a fund of funds include:
Control – Direct provides full control over investment selection versus fund of funds manager discretion.
Fees – Fund of funds adds another layer of fees on top of the underlying investments.
Diversification – Fund of funds provides turnkey diversification versus needing large capital to diversify directly.
Due Diligence – Extensive due diligence required on each direct investment versus relying on fund of funds manager.
Investment Size – Fund of funds offers smaller minimum investments, while direct investments often require millions per deal.
Liquidity – Direct investments are highly illiquid compared to some fund of funds products.
In summary, fund of funds offers easy diversification and access to top managers for smaller investors willing to pay an extra fee layer. But direct investments provide maximum control over deal selection without intermediary fees for larger LPs able to perform due diligence.
Pros and Cons of Private Equity Funds of Funds
Pros of Investing in Private Equity Fund of Funds
- Provides instant diversification across many funds/deals
- Requires less minimum investment than direct PE
- Managed by experienced investment professionals
- Access to top-tier funds closed to smaller investors
- Streamlined administrative and tax reporting
- Potentially lower risk profile
Cons of Investing in Private Equity Fund of Funds
- Additional layer of management fees reduces net returns
- Less control over investment selection and management
- Difficult to customize strategic objectives
- Adds intermediary between investor and investments
- Returns dependent on fund of funds manager skill
- Long multi-year lock-ups still required
Funds of funds provide a simpler way to gain exposure to private equity especially for investors below institutional size. However, the extra fees cut into net returns unless the fund of funds manager is extremely skilled.
Pros and Cons of Direct Private Equity Investing
Pros of Direct Private Equity Investing
- Full control over investments
- Avoid extra fund of funds layer of fees
- Customizable to precise objectives and preferences
- Build relationships with underlying PE managers
- Opportunity for co-investments and sidecars
- Strong net returns in success case
Cons of Direct Private Equity Investing
- Requires large minimum investment per deal
- Highly illiquid assets
- Extensive due diligence requirements per investment
- Diversification requires large aggregate capital
- Tax reporting can be complex
- High risk if concentrated into few deals
Direct private equity investments provide maximum flexibility and economics for successful LPs with money and resources. But the capital demands, illiquidity, and due diligence requirements make direct PE investing unfeasible for many investors below institutional scale.
Private Equity Fund of Funds Fee Structure
Fund of funds managers typically charge the following fees:
- Management Fee – Annual ~1% of assets under management
- Performance Fee – Up to 10% of total fund profits
In addition, the underlying private equity funds invested in by the fund of funds also charge typical PE fees of ~2% management and 20% performance fees.
So investors pay two layers of fees – one to the fund of funds manager and one indirectly to the underlying GPs. This results in higher total fees compared to direct PE investing, where investors only pay the GP fees.
However, investors must consider the tradeoff of higher net returns possible through direct investing against the simplicity and diversification of the fund of funds model that smaller LPs may require. And top quartile performing fund of funds managers with experience and proprietary deal access may justify their fees.
Typical Direct Investment PE Fees
Direct private equity investment fee structure:
- Management Fee – ~2% of capital committed to deal
- Performance Fee – ~20% of profits above hurdle
Direct investment allows paying just a single fee layer directly to the general partners of the PE funds or companies invested in. This avoids additional fund of funds costs.
However, fees on direct co-investments alongside a PE fund or separate account vehicles could include some shared management fee to compensate the PE firm for due diligence and operations. But overall fee drag is still lower than fund of funds.
Private equity fund of funds provide broad diversification by investing across approximately 10-30+ underlying PE funds and strategies. Exposure to various vintage years, geographies, sectors, investment types, and fund managers is quickly achieved in a single fund of funds investment.
In contrast, direct PE investing requires large dedicated capital to multiple funds and co-investments to approach the same level of diversification. For example, an LP would need to commit $50+ million each to 10+ funds to match the diversity of a $500 million fund of funds. Otherwise, direct exposure is concentrated to only a few managers and deals.
However, some fund of funds are focused vehicles themselves dedicated to particular strategies like growth equity, regions like Asia, or sector themes like technology. So diversity depends on the fund of funds objectives – broadly diversified versus specialized approaches both exist.
Direct investing allows the limited partner full discretion in selecting the private equity funds and deals to invest in, and rights to exercise governance through advisory boards. The LP does its own due diligence and builds relationships directly with underlying PE firms.
Conversely, investing via a private equity fund of funds means the fund of funds manager has full control over investment selection across the portfolio of underlying funds. The investor has a passive limited partner position in the fund of funds entity with little input into deal selection.
This manager discretion could be a pro or con depending on the skillset of the fund of funds GP. Top-quartile managers with experience, proprietary networks and deal flow access add value through their selections. Lesser skilled managers could be a detriment.
Suitable Investor Types
Private Equity Funds of Funds are well-suited to
- Smaller institutions or family offices with under $500 million in assets
- First-time or retail private equity investors
- Those without private equity expertise or infrastructure
- Investors wanting passive approach to PE exposure
- Those seeking wide diversification and risk mitigation
Direct Private Equity Investing best matches
- Institutions like endowments and pensions over several billion in assets
- Sophisticated investors with experience analyzing deals
- Those wanting maximum control over investment selection
- Investors able to make larger minimum PE commitments
- Those focused on specific strategies or geographies
In summary, fund of funds appeal to a broader cross-section of investor types thanks to their accessibility and turnkey diversification. But direct PE investing is primarily for large, sophisticated LPs with dedicated PE programs equipped to perform due diligence and portfolio management.
Investing through a diversified fund of funds vehicle reduces some portfolio risk versus making concentrated direct PE investments. The fund of funds participates in 10-30+ underlying funds and deals to mitigate exposure to any single investment. Assuming no leverage, fund of funds provide a more stable return profile versus direct deal volatility.
However, fund of funds come with:
- Manager selection risk -Dependence on GP skill in selecting sub-funds
- Added bankruptcy risk – Extra entity to go bankrupt
- Increased fee drag – Double layers erode net returns
Meanwhile, risks of direct PE investing include:
- Concentration risk if allocating to few deals
- Higher volatility to individual deals
- Extensive due diligence requirements
- Lack of quick exit options in downturns
Both fund of funds and direct participation come with distinct risks types that should be understood by investors. There is a risk and diversification trade-off between the two approaches.
Lock-up Period Comparison
Private equity investments typically come with multi-year lock-ups given the illiquid, long-term nature of allocating to private companies and funds. However, fund of funds products exist with slightly better liquidity terms versus direct secondary PE purchases or single fund commitments.
Some PE fund of funds have redemption windows that enable exiting a portion of the investment each year after an initial lockup of 1-2 years. This quarterly or annual redemption option provides incremental liquidity unavailable in most direct PE funds.
Additionally, certain fund of funds are allocated across both liquid hedge fund strategies and illiquid PE. This blended approach provides some underlying liquidity to fund redemptions and reduce overall effective lockups.
So while still relatively illiquid investments, some fund-of-funds structures offer marginally better liquidity options compared to standard 10-12 year PE fund commitments or indefinite company stock lockups.
PE Fund of Funds Due Diligence
Given the dependency on the fund of funds manager to select underlying investments, proper due diligence on the GP team is critical.
Key areas to cover include:
- Experience and performance track record of key professionals
- Investment strategy, philosophy and decision-making process
- Composition of current PE portfolio and performance attribution
- Fees charged both by FOF and underlying GPs
- Terms around liquidity, redemptions, cashflows
- Fund structure and regulatory details
- Composition and history of investor base
Reference checks on the fund of funds GP team from their investors and underlying PE firms provide insight. The best fund of funds managers maintain strong relationships with industry leading private equity funds to access proprietary deal flow and co-investment opportunities.
A disciplined selection process is required to pick winning fund of funds providers suited to an investor’s preferences and risk tolerances.
Private equity investments can be made through fund of funds vehicles or directly into funds and companies. Fund of funds provide turnkey diversification, professional investment selection, and easier access for smaller investors. But they come with higher fees from two layers of costs which impairs net returns. Direct PE investing features higher potential returns with lower overall fees, but requires more capital, expertise, and diligence for deal selection and diversification. Wealthy individuals and smaller institutions favor fund of funds for their accessibility, while mega endowments and pensions favor direct PE investing for better economics, control, and customization potential. In summary, both fund of funds and direct secondary PE participation have merits suited to different types of investors and objectives.
FAQs About Private Equity Funds of Funds
What are the typical fees charged by a PE fund of funds?
Fund of funds managers charge around a 1% annual management fee plus up to 10% of profits. In addition, the underlying PE funds also charge typical 2% management and 20% performance fees which the investor effectively pays through the fund of funds.
What is the minimum investment for a private equity fund of funds?
Minimum investments are often between $1 million – $5 million for private equity fund of funds given the high cost of managing numerous complex, illiquid underlying fund investments. Some fund of funds offer lower minimums down to $250,000 for high net worth investors.
How diversified are fund of fund investments?
Top fund of funds invest across at least 10-30+ underlying PE funds and deals to mitigate risk. Exposure across vintage years, industry sectors, geography, PE fund managers and deal types provides broad diversity. Some fund of funds specialize in certain markets though.
Do fund of funds invest in direct companies or just PE funds?
Most private equity fund of funds focus their underlying portfolio on investing as a limited partner into proven, top-tier PE funds given thedue diligence and oversight required for company investing. Some also allocate a small portion to co-investments or direct investments to boost returns.
Why do fund of funds add an extra layer of fees?
The fund of funds manager is responsible for portfolio management, performing due diligence on underlying funds, diversification, managing liquidity needs, and administrative tasks that justify charging a management fee and performance fee to investors for these services. However, the extra fee drag costs performance.
In another related article, Top 5 Hedge Funds of 2023 Based on Performance and Assets Under Management