The Value Offered By A Fund Of Funds
What is often overlooked for those eager to invest in private equity is the skillset and bandwidth required to screen, identify and invest in the best managers. For instance, in just the lower middle market alone, where many of the best-performing managers reside, there are typically as many as 250 general partners in the market fundraising every year. In order to amass a portfolio of 10 or 12 fund investments across three or four vintage years requires due diligence into and analysis of roughly 1,000 funds over that period of time. This includes meetings with GPs and placement agents, calls to portfolio-company management teams, negotiating fund terms and ultimately making commitments to three or four funds in a given year. Assuming high-net-worth investors want to manage risk and optimize the return potential offered through the asset class, they would need to deploy roughly $100 million annually to justify the costs necessary to support a team that could effectively manage an alternatives portfolio.
Another factor that is often overlooked is just how difficult it is to access the best managers. Forty percent of all the buyout funds in the market last year closed within six months or less, according to Preqin data, and nearly all top-quartile funds finished above target or were oversubscribed. High-net-worth investors, on their own, would have difficulty accessing these top-quartile funds. Moreover, the best performing funds maintain strict minimum-investment requirements — with floors set at $5 million or even $10 million — making it far easier to accommodate larger pensions or endowments that can write checks of that size. Institutional investors also have processes in place to meet capital calls in a timely manner and can even step in as co-investors when the opportunities arise. It’s also worth noting that in the lower middle market — one of the most attractive segments in private equity — GPs raise significantly smaller funds than their large- or mega-market peers, often capping off at $300 million to $500 million. As a result, the top-quartile managers in this segment tend to be far more exclusive in selecting their LPs, leaving individual investors and family offices on the outside looking in.
The endowment model has proven so successful over time in part because private equity is among the top asset classes in producing true risk-adjusted returns. Yet like any other investment strategy, a diversified portfolio is crucial in managing the downside. This is another area that proves tricky for high-net-worth investors and family offices, as the investment minimums to make direct investments in funds can quickly eat up their allocations. Even among high-net-worth investors, those that can meet the minimum commitment requirements to invest in just one traditional private equity fund and then lock up the capital for six to 10 years, remain few and far between.
Given the spending requirements and rising liabilities facing universities today, the consistency and historic outperformance of private investments make the Swensen model the preferred strategy for endowment portfolios. This is becoming even more pronounced in an environment in which many investors have pared their return assumptions for equities and fixed income, which makes the uncorrelated and idiosyncratic returns available through leveraged buyout funds that much more in demand. For high-net-worth investors focused on capital preservation, asset class diversification, and the alpha offered through private equity, a fund of funds can provide advisors with an opportunity to not only meet these needs, but also differentiate themselves in a material way that resonates with sophisticated investors.
Daniel Cahill, a managing partner at Constitution Capital Partners and a member of the investment committee, is responsible for the strategic development, investments and management of the firm.