Help me understand the investment strategy of a FoF

I work as a tax accountant, and one of my clients is a big FoF. They have 50+ funds investing in hundreds of different PE/HF funds, with most of the ownership percentages well below 1%.

I understand the concept of diversification but it still seems really crazy to me. Can anyone shed some light on this sort of investment strategy? Seems like throwing darts while blindfolded to me..

 

Although they might have over 50 vehicles, its highly unlikely that a single investor is invested in all those vehicles. I'd guess that those vehicles have difference focuses, whether it be middle market PE, Secondaries, Venture, EM, etc... They probably offer a menu approach, allowing their investors to pick and choose what they're interested in. I'd also imagine a lot of those vehicles are pretty old, it takes forever for a FoF to actually wind-down and liquidate, upwards of 20 years in some cases. Commenter has no idea what he's talking about.

 

I've seen FoF strategies move away from an advisory type of role where the FoF is pickign managers and move towards more of a managed account platform where they offer an avenue for investors to invest hedge funds but don't actually select the managers or the allocation of the managers. The investor may find this attractive because they do all the legal and ops work for them - they setup all the ISDAs, MSFTAs, CSAs or whatever kind of docs they need now with change in regulations. The newer FoF model is more of an admistrator than an advisor. Obviously, the traditional model still exists, just seen a few new firms move that way.

It is still a hard sell though, at least in my view because the top funds don't need to work with FoF. FoF thus have manager selection bias, the funds they can get access to are either smaller or so desperate to gain access they are willing to go through the headaches of working with a FoF.

 

I would actually say that PE firms want to deal with FoFs. They are long-term providers of capital and are considered to be sophisticated investors. In terms of fundraising, its quite important to lock up one of the large FoFs at the beginning of the process; the GP can then point to that and say we have the stamp of approval from a sophisticated investor, which helps generate momentum with other LPs.

 

fund of funds means they don't have money to invest in the deal, thus reached out to an established pe firm (with a committed fund) and asked for money (thus a fund of a fund). beware of these guys as it really means they don't have money (no money = no deals to invest in). as far as the work, i'm not too sure. i would be skeptical in this environment to work for a fund of funds.

 

noah9: That is exactly wrong. A fund of funds is a shop that takes money from investors and will then invest in other private equity funds.

They do this for different reasons, but their value add largely comes from being able to select top PE Funds, added diversification, they add another layer of valuation to deals, they can be more selected about capital distributions during capital calls, can offer small investors capacity at large funds that typically do not take capital contributions from retail or small institutional investors etc...

That having been said, there is substantial debate over whether the value add is sufficient to warrant another level of fees in the fee structure - often an additional 2 and 5 but this varies between shops.

Your day to day will be largely similar to that of a PE shop, although it will be more limited. You will be doing a lot of LBO modeling, DCFs etc... Good experience if you want to get your foot in the door of a PE shop later on.

 
Best Response

I actually think the opportunities within the fund-of-fund industries will be excellent in the near future. Many traditional pension funds and endowment funds that function as LP's are having liquidity issues from their positions in the public markets, as a result, they are being forced to liquidate their private equity positions at significant discounts (CalPERs as an example). This has nothing to do with the underperformance of the PE investments. Most 2001 vintage funds and upwards have minimum IRR hurdle requirements with GP equity clawbacks. So it must be painful, as an LP, to know that to meet your public equity margin calls, you are forced to sell a guarunteed 9% or so IRR. But for a fund-of-funds, they must be chomping at the bit - at the very least they make 9% IRR (net) and that's if they buy at cost. More likely they are getting guarunteed 15% IRR and probably more...

 

Two ways really:

Primary - this is the simpler of the two. This is analyzing the PE firm's historical track record and management and determining whether you will give them capital. After that, you hold calls quarterly and monitor their investments over the life of the investment. This is really boring.

Secondary- the thrilling part, you buy other people's commitments ie limited partnership interests in funds... This is where discounts and fund cqshflows are predicted and calculated in order to reach a set investment IRR/multiple.. This area is really hot right now as everyone and their mother is facing allocation interests and seeking to sell their portfolios...

 

It is essentially a way to play in the space without being a major player. When large deals are syndicated by a Carlyle, BX etc, other smaller houses or FOF will participate on funding.

-------------- Either you sling crack rock or you got a wicked jump shot
 

PE FoFs investment in private equity funds.

How they add value (or at least claim to):

1) Access to top funds (e.g. Sequoia) 2) Professional selection skills 3) Streamline administration. Private equity portfolio administration is a bitch (e.g. lack of standards, etc.).

 

PE FoF's evaluate fund managers. Typically, they expect to commit 80% of their investment into the fund and then 20% as co-investments into companies directly as partners with their fund managers.

Hours are probably the same. You still have to evaluate deals (for the co-investments), and you have to attend meetings with the fund managers to track their portfolios.

There's less "sourcing" involved in a FoF, as that's essentially outsourced to the funds themselves.

Management of portfolio companies also get outsourced.

Compensation is lower, comparatively speaking.

A major part that is extra in FoF is some version of risk management. You see, PE funds have a committed fund, which they then draw down as needed. Unlike hedge funds, they don't hang on to their committed money -- they ask for it when needed.

The smarter among you out there will realize that this poses a nice leverage opportunity -- FoF's can commit more money than they actually have themselves, betting that not all funds will extract at the same time. As with all leverage, you increase "risk".

Furthermore, FoF's, unlike PE shops, DO have to keep all their money on hand. So there's usually another piece that involves figuring out what to do with all that cash. The cheap way is to put them into municipal bonds. But there are, of course, better ways -- usually in some form of more liquid hedge-fund type vehicle.

And you always have crunch times.

 

Not sure about the management fees, but yeah they do take away another 10% from performance making it 30-35-or whatever % the HF asks.

And yeah it's a huge scam, from the other side though they do get clients into some of the funds they want but man are you missing out on a whole lot of returns.

People like Coldplay and voted for the Nazis, you can't trust people Jeremy
 

*When people are too lazy to do their own research with regards to locating hedge funds and/or alternative investment groups - They use Fund of Funds group to locate "Funds" that they can invest in.

ie: You're worth $50MM and want to invest in a hedge fund but don't know which one - Yet you want a group that is over 5 years old and has never lost money - The Fund of Funds would locate such a firm in which you could have rob you blindly as you sit idly and unwilling to do your own research and manage your own money.

In essence; Middle Men - And yes, they do get paid with your money, not by the hedge fund.

 

did you have a bad experience with a fund of funds? it sounds like you don't like them

GateBreaker:
*When people are too lazy to do their own research with regards to locating hedge funds and/or alternative investment groups - They use Fund of Funds group to locate "Funds" that they can invest in.

ie: You're worth $50MM and want to invest in a hedge fund but don't know which one - Yet you want a group that is over 5 years old and has never lost money - The Fund of Funds would locate such a firm in which you could have rob you blindly as you sit idly and unwilling to do your own research and manage your own money.

In essence; Middle Men - And yes, they do get paid with your money, not by the hedge fund.

 
GateBreaker:
*When people are too lazy to do their own research with regards to locating hedge funds and/or alternative investment groups - They use Fund of Funds group to locate "Funds" that they can invest in.

ie: You're worth $50MM and want to invest in a hedge fund but don't know which one - Yet you want a group that is over 5 years old and has never lost money - The Fund of Funds would locate such a firm in which you could have rob you blindly as you sit idly and unwilling to do your own research and manage your own money.

In essence; Middle Men - And yes, they do get paid with your money, not by the hedge fund.

Yep - that's exactly what it is.... Would you like some sauce to go with that foot?

 

Well, there is a bit more to it than that, but essentially you are right. If you are an individual, you may not have enough money to make a diversified PE portfolio due to minimum buys ins. If you are a pension fund, you might be trying to insulate yourself for being blamed for making a bad decision, or you may honestly not have the staff or expertise. The best justification is relationship-based; a fund of funds can probably have more leverage to get into the best funds which are very hard to get allocations to, as one might imagine.

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