What is the future for private equity Fund of Funds?

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The crisis and subsequent recession have left their mark on the entire financial industry. Private equity fund of funds are no exception and are sometimes perceived to be especially vulnerable because of their additional layer of fees. However, on closer inspection, the picture that emerges is quite different, and suggests that a renaissance for private equity fund of funds may even be imminent.

First is manager selection and access to top-tier funds. According to a Preqin survey, over one-third of investors name manager selection and access as the biggest obstacles when considering private equity. Such concerns are justified as it is much more complex to select the right primary funds today than it was before the crisis.

There will be further consolidation in the market and a considerable number of managers will struggle to raise their next fund resulting in smaller than expected funds and subsequently negative effects on team stability.

Furthermore, in today’s post-crisis environment, value will be generated primarily through operational means. Limited partners must re-evaluate each team to determine whether their skill set caters to operational value creation. Past performance is now much less of an indicator of future performance than it was before the crisis.

This makes manager selection a cumbersome and difficult task that often goes beyond the capacities of most pension fund teams; many of which are grappling with internal cost reductions that require them to do more with less – in a much more complex environment.

Second is diversification. Time and again, it has become obvious that well-diversified portfolios weather economic cycles much better than concentrated portfolios.

For those pension funds that would profit greatly from the returns private equity can offer but do not have allocations large enough to warrant a full, in-house team, fund of funds are one of the only viable routes to sufficient diversification. The danger of damaging a portfolio through sub-optimal manager choices or lack of diversification is much greater than the minimal extra fee a fund of funds typically charges today.

Also, the industry has evolved. For those investors who find the allocation parameters of large fund of funds difficult to integrate, there are advisory account solutions available that provide significant flexibility in allocation while retaining the benefits of a sufficiently high level of diversification, combined with manager selection conducted by expert teams featuring deep benches of talent.