Private equity funds of funds are increasingly under fire. Not only do they reduce returns, but they do not minimise risks. Cyril Demaria questions the use of these costly intermediaries

Fund managers do not appreciate them, because they are a source of infinite questions and paperwork. Placement agents criticise their lack of expertise and sometimes blunt ignorance. Entrepreneurs think that they do not create any value, unlike high net worth individuals or family offices. Until now, private equity fund of fund managers justified their perks by showing evidence - the growth of the fund size raised from institutional investors. Their promise was: we offer the best adjusted risk-return profile, despite the opacity which characterises the private equity sector.

Bad performance
However, studies have shown that they are the worst performers for private equity fund investments(1). Endowments show a performance of 14% above average(2). Private and public pension funds, as well as insurance companies are better performing than fund of funds managers. Hence, the 5-10% carried interest is not necessarily their main interest in the business - but the 1% annual management fees.

This difference in performance is not necessarily due to access to the funds or the long experience of endowments and pension funds. On the contrary: the top performers among private equity fund investors are quick to select new private equity managers, notably emerging teams. Yale and Harvard endowments rank among the oldest and best performers and they are also detectors of emerging teams.

No risk reduction
The crisis shows that funds of funds also do not reduce risks. Instead of choosing risk averse strategies (development capital and mezzanine, for example), they have selected and invested in managers showing - thanks to the fair market value method - stellar unrealised performances. The conservatism of fund of fund managers has pushed them to invest in brands and large buyout funds at the height of the cycle.

Herding led them into Asian venture capital, which is currently experiencing repeated scandals and a strong downturn. Performance reflects these bad decisions. According to Private Equity International, the median of the European private equity fund of funds performance beats  the long-term perfomance of listed shares only in three out of the past nine years.

As stated by Lerner and Schoar, the fact that banks and funds of funds do not use the information optimally (reinvesting with managers showing a mediocre track record) impacts the equilibrium of the private equity sector. The presence of investors who are uninformed or insensitive to performance allows mediocre managers to continue to raise funds and reduces the efficiency of one of the few governance elements in private equity - not reinvesting. The verdict is clear: private equity fund of funds managers are either incompetent, or not interested in the performance - and hence only motivated by management fees.

A few guiding points
If this debate matters, it is because small and medium-size pension plans still rely on advisers to chose private equity funds out of their natural geographical reach.
There are a few external factors helping to filter out advisers who are not relevant to the selection process:

Annual staff turnover: the first criteria lies in the aptitude of the gatekeeper (ie, fundless fund of funds managers) to retain his employees and create stable and solid teams. Private equity is an activity that requires a vision and resources available on the long term. It is not only partners but also investment and operations teams that create value. Loyalty reveals the ambiance of the firm, and also the interest of the staff in the work (hence the intrinsic quality of the processes). Gatekeepers must check details and have to be committed to identify sources of potential difficulties with fund managers, notably over time. If teams change often, the collective memory of the firm suffers dramatically. In fact, a great deal of knowledge remains informal in the private equity sector.

Often, only managing partners are travelling and are gaining exposure to the business, cutting their teams to the contact with the field of operations, which is the only way to check the reality and truth of the marketing pitches of fund managers. If the staff remains limited to paper due diligence, most of the intelligence of the staff is irremediably wasted. The capitalistic structure of the gatekeeper and its performance distribution schemes should allow pension funds to further deepen their knowledge of their advisers.

The number of employees per unit of revenues generated: management fees have been created to grant a team with the material possibilities to do its work, not make money. Profits should be made only from the carried interest (or equivalent). Measuring if this is really the case is key to determine the alignment of interest between the advisers and the family offices and high net worth individuals. Dividing the management fees and other recurring incomes by the number of staff members should help to set at least a benchmark. Numbers should not diverge dramatically, as gatekeepers are mostly based in the same major cities (New York, San Francisco, London, Paris, Zürich/Zug/Pfäffikon and Singapore). If there is a divergence, it is time to ask for the profit and loss of the management company and analyse the incentive structure of the team - and to ask the difficult questions. An active international presence: private equity is a local business. How can fund of fund managers evaluate the dynamics, the local markets and check the documents provided by private equity fund managers if they are not based locally? Few advisers have local offices, notably in Latin America or Africa, or in the main European markets. The pan-European logic does not really help them to identify and evaluate the work of small and mid-market buyout teams, and even less of venture capital teams. This is why fund of funds managers invest by brand more than on the reality of work. The lack of conflicts of interests: advisers are increasingly subject to major conflicts of interests as they are managing fund of fund programmes, segregated accounts, co-investment programmes, mandates and even direct investment funds. This not only creates an investment allocation problem - forced cross-sales and lack of Chinese walls can create confidentiality breaches on the part of advisory firms. A commitment to transparency: most advisers produce biased information, notably for future marketing purposes. Data such as the company creation date, hires and lay-offs, size of effective assets under management (and not the theoretical maximum), management fees collected and even more information are difficult to access and unclear to pension managers. The next step is hence a systematic audit by a third party of the due diligence material communicated to the clients of advisers, with a sanction in case of inaccurate but also of prejudicial lack of information.

Even though simple, these five criteria are not yet matched in market practice. This tends to demonstrate the current culture of private equity advisers, who are not addressing these issues and are rather trying to circumvent them. Temporary employment contracts, double counting of employees depending on the investment programme, representation offices without any investment activities, sub-contracting of certain tasks in low-cost countries or even mutualisation of certain operations with competitors are frequent. Some fund of fund managers have even requested an independent rating to show the quality of their governance, before abandoning it because the results did not fit their own expectations. This amounts to no less than breaking the thermometer because it does not show the expected temperature.

Corporate governance in private equity should evolve dramatically towards an organised transparency and good faith. If not, fund of fund managers and advisers will become regarded as simple economical  parasites that must be eliminated. Some private equity fund managers, such as Sequoia Capital, which has been dominating the American venture capital landscape for more than 20 years, have already barred fund of funds managers from their investor list because they are perceived as burdensome and harmful for their business.

1. Lerner (J), Schoar (A), Wong (W), Smart institutions, foolish choices? The limited partner performance puzzle, Harvard University, MIT, NBER, 58 pages, 2006
2. Lerner (J), Schoar (A), Wang (J), Secrets of the Academy: the drivers of University endowment success, Harvard Business School, MIT, NBER, 26 pages, 2008