Diversification is the byword for investing in listed equities. But for investing in private equity - a much more risky asset class - the importance of spreading one’s bets is far greater.
The basic route into private equity is via a fund investing in a basket of individual companies. However, most investors will require an extra layer of diversification.
They can do this in two ways. They can either build up their own portfolio of single funds, using the services of a gatekeeper. Or they can buy a fund of funds – an off-the-peg product enabling them to plug into a basket of private equity funds run by one overall manager.
So which route should pension funds take to achieve diversification? The first consideration is the size of their private equity programme. The typical minimums for investment in a single fund may squeeze out all but the bigger portfolios, or a small pension fund risks punting its entire private equity allocation on one fund.
“Most funds have a $5m (€4m) minimum, and if you only have $20m to invest, you can’t get the proper diversification,” says John Barber, managing director of placement agents Helix Associates.
In that situation, a fund of funds (or, more probably, several of them) may be the only way of ensuring enough of a spread of risk over the short term.
“Using a fund of funds does not necessarily dilute performance significantly,” says Barber. “One of the top fund of funds managers aims to achieve a 16% or 17% net return which, given the spread of risk, is not a bad yield.” The second major factor is the administrative burden involved in running your own single fund portfolio. Compared with publicly-listed funds, information on private equity vehicles is difficult to get hold of and - in spite of the increasing number of guidelines and standards - is still quite opaque.
Jane Welsh, senior investment consultant and head of the private equity research team at consultants Watson Wyatt, says: “Every time you invest in a single fund, you need to carry out a lot of due diligence and research. You also have to monitor the cash flow to and from a fund. You may, for instance, commit €10m, but that will be called by the manager over the years. Then cash is returned in dribs and drabs as companies are sold. All this cash flow management adds to the burden.”
Another issue is the ability to muscle in on excellence. Welsh says: “It is very, very hard to get access to the ‘best’ funds, especially in something like US venture capital. Companies that have historically generated fantastic returns tend to go back to existing investors, rather than new ones, for extra capital. So a fund of funds is the best mechanism to get exposure to highly sought-after funds.”
There is also the question of expertise. Fund of funds managers with a long and consistent track record - say 15 or 20 years - are likely to have the kind of experience that most in-house teams just cannot match. And this experience will be at a premium where they operate in niche areas.
However, for the big pension funds with lots of internal resources, Welsh says it makes sense to go direct.
“You are not paying an extra layer of fees, and that can pay for a lot of internal resources,” she says. “So the larger funds ought to have their own programmes, complemented by funds of funds in specialist areas such as venture capital or distressed debt (the debt of companies in real trouble).”
But even for pension funds big enough to contemplate running their own private equity portfolio, funds of funds can be a useful way to take a first step into what is a fairly esoteric field.
However, pension funds should be wary of expecting to be automatically shown the ropes as part of the deal. While they may receive the full panoply of brochures and reports, these may not give them the details on what is going on in the underlying funds. Some pension funds, however, are able to drive a hard bargain in insisting on a blow-by-blow account of what their fund of fund managers are doing to the extent, say, of inclusion in video conferences with managers of the underlying funds.
Steen Villemoes, Nordic representative of Altius Associates, the private equity gatekeeper, reckons that a €20m-a-year commitment to private equity is the threshold below which funds of funds are the only feasible option.
However, he cautions: “It is quite a costly way to build up exposure because of the extra layer of fees. Funds of funds are also inflexible, whereas investing directly in funds means you can define your mandate and influence the commitment pace. Funds of funds also lack the ability to give you a portfolio overview.”
He also points out one other danger. “Funds of funds do carry a higher risk of being overexposed to the same fund than building up a portfolio of direct funds,” he says. “One thing I would not recommend is to run several similar mandates - such as global mandates - with different fund of funds managers. Funds of funds are by definition discretionary mandates, and if you have more than one manager for a specific area, you can get overlapping of funds so you may lose some diversification.”
At the other end of the scale, there is also the question of too much diversification. “You only need about 10 or 11 single funds to achieve diversification,” says Barber. “That number means you can easily invest in a specialist for Europe, a specialist for the US, and so on. I would make my choice of manager for each market and leave it at that. But a portfolio of 25 to 30 funds in a single fund-of-funds vehicle is ridiculously over-diversified. That will mean you are likely just to get average returns, because any outperforming fund will not have much effect on the total portfolio. And having too many funds of funds is going to over-diversify even further.”
On top of all these issues is, of course, the question of fees. While investing direct involves the expense of in-house resources, funds of funds are generally more expensive as a product, since there is an extra layer of fees in addition to the fees of the underlying funds.

Funds of funds tend to invest over a period of, say, three years. Fees are charged on the basis of full or drawn commitments but are paid over time, usually quarterly in advance.
“Annual management fees for funds of funds range from 50 basis points (bps) at the lower end to 1.5% at the top, but they are improving over time,” says Barber. “These are charged for the fund of funds’ own investment period, which usually lasts for three years. The fee then drops to more of a ‘maintenance’ level of 40-50bps in the case of the higher-charging managers, and is more static for those that had lower fees to begin with. But it may be seven or eight years before all the money is put to work.”
In addition to the basic management fee, some fund of fund managers also charge a performance-related fee. The fund of funds vehicle has to deliver, say, a 15% internal rate of return, after which the manager might be entitled to 5% of the remaining profits.
However, investing direct also means paying fees to your adviser.
Gatekeepers’ fees vary enormously. Alternative ways to charge include a flat annual retainer of, say, E200,000 per client; a 50bps charge on overall commitments; a fund of funds-type charge, say 1% on commitments and then 5% above a 15% return; or €20,000, for example, for an individual fund analysis and recommendations.
These days, however, most arrangements are probably based on a percentage of commitments.