Private Equity - Fund of Funds 101

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📖 Background

Private equity fund of funds (FoFs) have always been a topic of debate. At first glance, they seem like an unnecessary middleman — why not just invest directly in private equity? But as with most things in finance, the reality is more nuanced.

For many investors, particularly those lacking the resources to source, evaluate, or scale into top-tier funds, FoFs offer a smart workaround.

💼 What are Private Equity Fund of Funds?

At their core, PE FoFs act as a bridge between investors and PE firms, essentially operating as Limited Partners (LPs) for private equity firms. They raise capital from institutional investors — pensions, sovereign wealth funds, endowments, and high-net-worth individuals — and invest that capital into a diversified portfolio of private equity funds.

Unlike traditional PE firms that invest directly in companies, fund of funds managers spread capital across multiple private equity funds, aiming to smooth out risk while maintaining exposure to the asset class.

The catch? All this convenience comes at a cost — extra fees. This added layer of investment management has drawn criticism from investors who prefer to invest directly.

💡 Why Do Private Equity Funds of Funds Exist?

If institutional investors can already invest directly in private equity funds, why add an intermediary? It comes down to four key factors:

1️⃣ Diversification: Large investors need broad exposure to different PE strategies, but may not have the bandwidth to vet and allocate across hundreds of funds. FoFs handle that heavy lifting.

2️⃣ Access & Scale: Some investors simply don’t have the capital to meet the steep minimums required by top-tier PE funds. A fund of funds pools resources to bridge that gap.

3️⃣ Exclusive Opportunities: Certain private equity firms limit access to new investors. A well-connected fund of funds might already be in, giving investors indirect access.

4️⃣ Deal Flow & Insights: Some LPs, such as pension funds, use fund of funds investments to gain exposure to deals and market trends they wouldn’t see otherwise.

That said, FoFs aren’t for everyone. While they offer advantages, FoFs may be unnecessary for institutions with the scale and network to invest on their own.

📑 FoF Investment Process (I)

Before we get into the process, let’s quickly recap the three ways investors can enter private equity:

1️⃣ Buying companies directly: This requires both financial and management expertise to run and grow the business. The trade-off? Limited diversification.

2️⃣ Investing in PE funds: Instead of acquiring companies outright, investors commit capital to private equity funds, which build portfolios of private companies — sometimes up to 20 per fund. This is the most common route for institutional investors.

3️⃣ Investing in a fund of funds: These funds take diversification a step further, investing in multiple PE funds rather than individual companies. The downside? Two layers of fees — one for the underlying PE funds and another for the FoF manager.

For FoFs, one word matters most: performance.

We’ve all heard the classic “past performance is no guarantee of future results”, right? Well, when it comes to fund of funds, that’s only half the story. In fact, track record is one of the most relevant data points here.

📊 FoF Investment Process (II)

When evaluating a fund of funds, past performance is the first filter. Unlike public markets, where returns are volatile and hard to predict, private equity funds tend to demonstrate more consistency. As a result, a manager with a strong track record is generally expected to replicate that success, reinforcing the assumption that past performance will potentially persist (TWSL).

But past returns alone aren’t enough. The next question: Can the team sustain that performance? This is where the three Ps come in — People, Philosophy, and Process.

1️⃣ People: Who’s actually making the investment decisions? Are the key team members from the previous fund still in place? What’s the turnover like? Stability in leadership and investment decision-making is crucial for repeatable performance.

2️⃣ Philosophy: What’s their approach? Do they focus on small, mid, or large-cap deals? Which sectors and geographies do they prioritize? How do they source opportunities, and what’s their decision-making structure? A clear, consistent strategy beats an opportunistic one.

3️⃣ Process: How disciplined is their investment process? How are deals sourced, diligenced, and exited? Are they methodical, or do they chase shiny objects? Strong processes drive predictable outcomes.

Assessing these factors helps investors filter funds that are more likely to maintain outperformance — ensuring they’re not just coasting on past wins, but have a playbook for sustained success.

🔍 Market Evolution

Tracking the growth of fund of funds within private equity is challenging due to fragmented reporting, but data from Preqin shows that the overall private equity market expanded from $2 trillion to nearly $8 trillion by 2023. The fund of funds segment has seen a similar trajectory, benefiting from rising institutional demand for diversified private market exposure.

Recent research from Invest Europe also provides fresh insights into listed private equity fund of funds, revealing a 49% average uplift in exit valuations compared to the last reported valuation. This suggests that FoFs may be more conservatively valued than direct investments, reinforcing their role in providing stability alongside diversification.

✒ Final Thoughts

FoFs make sense for investors who want exposure to top-tier managers without the hassle of fund selection. But with extra fees and long lock-ups, they’re a hard pass for those who can manage their own allocations at scale.

If you want to put these concepts into practice, check out my Fund of Funds financial model. It’s a complete financial model that helps analyze FoF investments with insights into different fund types, fee structures and return expectations.

That concludes this edition — I'd welcome your thoughts, so feel free to reply.

PE Bro

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Disclaimer: The views and opinions expressed in this article are solely my own and are provided for informational purposes only. This content is not intended to be financial advice. The examples and figures mentioned may vary and may not account for all possible scenarios or regional differences. Always seek the guidance of a qualified financial advisor or professional before making any investment decisions.