An investor's route into private equity will depend mainly on their level of experience, according to Ed Francis.

Investors considering an allocation to private equity face a common dilemma: should they invest through a diversified fund of funds (FoF), directly into private equity funds, or through a combination of the two? Unfortunately, there is no simple answer to this question because the optimal composition of a private equity portfolio is unique to every investor.

However, there are advantages and drawbacks to each choice that investors can take into account when making the decision, such as fees, expected levels of risk and return, and access to best-in-class managers.

FoFs are a convenient way to make first-time allocations to private equity. They offer immediate diversification across different types of direct private equity funds, management teams, industries and vintage years, even if only small amounts of capital are allocated. They also help investors to acquire useful market knowledge and expertise.

FoFs have in-depth research capabilities that enable them to carry out detailed due diligence on direct funds and their managers, as well as continuing monitoring, reporting and administration. By doing this, they are able to select the best fund teams and build robust portfolios that reflect market trends.

Another advantage of FoFs, which has gained significance as demand has grown, is their ability to access top private equity funds that are oversubscribed. In some segments of the private equity market, heavy demand can make it difficult for investors to gain exposure to the best management teams. Top-tier US venture capital firms are a perfect example of this. FoFs nurture their relationships with managers in order to secure future capacity, and so they are sometimes able to gain access where other investors might be turned away.

Although funds of funds are appropriate for first-time private equity investors, experience in the asset class usually increases the motivation to go direct. The main reason is that investment in FoFs comes with a hefty price tag. The fees charged by direct private equity fund managers are already high, with an average management fee of 2% and a performance fee of 20%. A FoF manager will add 0.5 to 1% in management fees on top of this, and might also charge a performance fee of up to 10%.

These funds are based on commitments rather than on invested amounts and, as a result, fund of funds investors might end up giving up as much as 3.5 % of the annual returns from their private equity allocations to their own fees.

The second factor to consider is over-diversification. A direct fund normally gives investors diversification across 15 to 20 underlying companies. A FoF that invests in 15 to 20 underlying funds offers diversification across 300 to 400 underlying companies. This level of diversification makes FoFs a relatively safe bet for investors with limited experience of private equity. However, more sophisticated investors might not require this degree of risk reduction.

Finally, a FoF approach can extend the time that it takes to get money invested in private equity and exacerbates the ‘J-curve' in which initial returns are strongly negative as the impact of fees (charged on commitments) heavily outweighs any returns generated.

Most investors allocate only a small portion of their overall portfolios to private equity, often as a return enhancer rather than a risk diversifier. This means that they are seeking a different trade-off between risk-taking and profit-seeking from private equity than from other asset classes, and so less diversification is needed. In fact, over-diversification might undermine the reason for investing in private equity in the first place.

For these reasons, we believe that investors that have some experience of investing in private equity through funds should consider allocating money directly to funds in order to develop their private equity programmes. By doing this, they are likely to enhance their returns from the asset class (mainly because of lower fees) with an insignificant increase in risk at the total portfolio level.

Developments in the private equity market now make it easier for large, governance-rich institutional investors to start allocating directly to private equity funds. As the industry has matured, long-standing managers have gradually become institutional- quality firms.

Over the years, they have had successes and failures and gained experience of making deals in various phases of a market cycle. As they grow and raise further funds, they hire more qualified people, expand their resources and refine their processes.

The result is additional stability and resilience, and the ability to identify opportunities even in adverse market conditions. Making a decision to invest with long-established players is probably less risky now than it used to be (notwithstanding where we might be in the private equity cycle).

What would be our suggested portfolio composition for large investors that want to consider expanding their private equity programmes? We suggest allocating up to a half of an overall private equity programme to large well-established buyout firms.

Most of the funds managed by such firms are biased either towards the US or Europe in the location of their deals. Between two and four managers covering both Europe and the US are a reasonable number for this part of the portfolio. The remaining half of the portfolio can be allocated to specialist fund of funds managers. Recently, funds of funds have begun to polarise, with a clear distinction appearing between large, globally diversified players and specialist niche managers.

The emergence of these niche players gives investors more flexibility to choose funds of funds that specialise in sectors of the private equity market that complement the large buyout managers.

Specialist FoFs could be used in such areas as US venture capital, where it is difficult to gain direct access to good funds, or in mid-cap or small-cap buyouts, where returns are highly dependent on selecting the right manager and where access and due diligence can be more challenging than in the larger buyout area.

Some investors might also want to consider smaller allocations to other niche private equity strategies to make their programmes more balanced. Investing in a secondary fund, for instance, would be a reasonable move. Because secondary fund managers invest in more mature private equity holdings, they are likely to produce positive returns sooner than traditional private equity funds.

The initial capital drawdown period, before cash distributions start to be returned to investors, is comparatively long in private equity, and investing in a secondary fund could shorten the wait. However, the potential returns from a secondary investment are probably lower than from traditional funds. Another example might be to commit to a distressed investing manager, where there are currently some good opportunities.

To sum up, we believe that investors with limited experience of private equity will gain significant benefits from investing in large, globally diversified FoFs.

However, investors with private equity allocations of more than £75 million (and who are not governance-constrained) might want to consider direct investment for at least part of their programme. This is likely to add to overall return without increasing risk at the total portfolio level.

Ed Francis is a senior investment consultant at Watson Wyatt