Financial Intermediation In Private Equity: How Well Do Funds Of Funds Perform?

Robert S. Harris

University of Virginia – Darden School of Business

Tim Jenkinson

University of Oxford – Said Business School; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); University of Oxford – Said Business School

Steven N. Kaplan

University of Chicago – Booth School of Business; National Bureau of Economic Research (NBER)

Rüdiger Stucke

University of Oxford – Said Business School

August 1, 2015

Darden Business School Working Paper No. 2620582


This paper focuses on funds of funds (FOFs) as a form of financial intermediation in private equity (both buyout and venture capital). Compared to investments in hedge funds or publicly traded stocks, private equity investments in direct funds are less liquid, less easily scaled and have higher search and monitoring costs. As a consequence, FOFs in private equity may provide valuable intermediation for investors who want exposure to the asset class. We benchmark FOF performance (net of their fees) against both public equity markets and strategies of direct investment into private equity funds. We also examine the types of portfolios private equity FOFs create when they pool investor capital. After accounting for fees, primary FOFs provide returns equal to or above public market indices for both buyout and venture capital. While FOFs focusing on buyouts outperform public markets, they underperform direct fund investment strategies in buyout. In contrast, the average performance of FOFs in venture capital is on a par with results from direct venture fund investing. This suggests that FOFs in venture capital (but not in buyouts) are able to identify and access superior performing funds.

Financial Intermediation In Private Equity: How Well Do Funds Of Funds Perform? – Introduction

This paper analyses funds of funds (FOFs) as a form of financial intermediation in private equity. While there is a large literature on direct fund investing in private equity, there is scant
evidence on FOFs which themselves invest in these direct funds. Compared to hedge funds or publicly traded stocks, private equity investments in direct funds are illiquid, not easily scaled and have high search and monitoring costs. By pooling capital across investors, FOFs create a second  level of intermediation that potentially provides specialized investment skills, diversification and lower cost services (e.g. due to economies of scale) for investors wanting exposure to private equity. Against these advantages must be weighed the additional fees charged by the FOF manager.

We benchmark FOF performance, net of their fees, against both public equity markets and strategies of direct fund investment. Our research takes advantage of detailed, fund-level cash flows from Burgiss on both FOFs and direct funds. We use information on their holdings to understand the types of portfolios they create for their investors. As with previous research on private equity, we distinguish between buyout and venture capital (VC) investments. We find that FOFs – both in buyout and VC – have generated returns above those from
investing in public equities. As a result, exposure to private equity through FOFs would have increased returns relative to public equities, although investors would bear illiquidity costs associated with private equity investing. These higher returns remain even after accounting for fees that occur at both the FOF and direct fund level. Our measures of FOF performance are through year-end 2012 and cover FOFs that started in years 1987 through 2007.

When we compare FOFs to direct fund investing, we find significantly lower returns for FOFs that focus on corporate finance (e.g. buyout) or are generalist funds compared with portfolios formed by “random” direct fund investing in similar direct funds. In contrast, FOFs in VC perform roughly on a par with portfolios of direct funds, even after fees. Moreover, strategies for investing in direct funds may be constrained by limits on fund access or manager selection skills. We show that VC FOFs often outperform direct investing handicapped by these limitations. In addition, given the highly dispersed nature of direct fund returns in venture, VC FOFs create more risk reduction through diversification than is true in buyout. In general, our results suggest that FOFs focusing on VC provide more advantages than those in buyout.

The remainder of the paper is structured as follows. In Section 1, we discuss the role of FOFs as financial intermediaries in private equity and related research on the performance of direct private equity funds. In Section 2, we explain our metrics of performance and data. In Section 3, we study FOF performance, both in absolute terms and relative to investments in public equity. We follow in Section 4 with a discussion of the types of portfolios FOFs form. In Section 5, we compare FOF performance to direct equity investing which we measure using portfolios of direct funds. In Section 6, we discuss the results in light of constraints on direct fund investing. We summarize our results and discuss their implications in Section 7.

1. Financial Intermediation by Funds of Funds in Private Equity

There is a large literature in economics on financial intermediaries. The explanations for intermediation typically depend on either transactions costs or information advantages. Transactions costs arguments rely on the intermediary’s ability to pool capital and supply lower cost services (e.g. due to economies of scale). Other explanations cite advantages that an intermediary can provide due to superior information.

Funds Of Funds

Funds Of Funds

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