Yale’s endowment over the past decade has grown from just over $15 billion to over $25 billion with investment returns that have ranked first in the universe of institutions tracked by Cambridge Associates in nine of the last 10 years. Since Yale’s David Swensen pioneered the endowment model of portfolio construction some 30 years ago — a strategy that over-indexes to private equity and other alternative investments — high-net-worth (HNW) investors have sought to emulate Swensen’s strategy. These efforts on behalf of individual investors and family offices can fall flat for a number of reasons. However, those advisors that can access top funds and provide alpha through a substantial and diversified private equity allocation can quickly distinguish themselves among an audience seeking something more sophisticated than a 60/40 model comprised of public equities and fixed income.
In Yale’s most recent annual report, the endowment highlighted that over the long term it seeks to allocate roughly half of its portfolio to illiquid asset classes, such as leveraged buyouts, venture capital, real estate and natural resources. The endowment notes that its extended time horizon is well suited to exploit the inefficiencies of investing in illiquid assets through active management. And its returns in these strategies bear this out. Moreover, research from Cambridge Associates reinforces the idea that investors who allocate proportionally higher sums to private investments, outperform those that invest incrementally in the asset class. According to the most recent Cambridge Associates LLC U.S. Buyout Index, as of March 31, 2016, the net IRRs, net of fees, expenses and carried interest, exceeded 12% over the past 20 years, easily surpassing the less than 6% achieved by the Barclays Government/Credit Bond Index or the less than 8% produced by the S&P 500 Index over the same period of time. To unpack the private equity performance even further demonstrates that the U.S. Buyout Mid-Cap Index was the best performing segment over the past two decades.
The challenge for individual investors, as many often discover, is that few have access to the top-quartile private equity managers that are often a prerequisite to match or even approach the kind of returns institutions like Yale produce, which are far better than the pooled benchmark statistics. Moreover, many advisors to high-net-worth investors may discuss alternatives as an option, though are limited to less-than-adequate public versions that may not have efficient fee structures and may not generate the returns investors would expect from the asset class. Among those are liquid alternative funds that operate through a ‘40 Act structure, business development companies (often trading at a discount to NAV), and the publicly held management companies of the largest PE firms, whose interests are far more closely aligned to the limited partners in their private funds. For accredited investors, a handful of firms have rolled out publicly held, non-traded closed-end funds. But even if advisors can access fund investments, if they’re not backing the top-quartile managers, they risk exposure to the wrong kind of private equity, with mean returns or even worse, bottom-quartile returns. Enter the private equity fund of funds.
For the uninitiated, a fund of funds (or FoF) is a multi-manager strategy in which a fund is established to make several limited partnership commitments — diversified across strategies, managers, sectors and vintage years — to create a portfolio of private equity fund investments. Strategies often differ by FoF manager, but the value proposition for a high-net-worth audience is that a fund of funds offers deep expertise, hands-on management and oversight, and — most importantly — diversification and access to the top general partners in a given segment. Investment advisors typically offer exposure through feeder funds or pooled investment vehicles.