Funds of Private Equity Funds Provide Diversification and Expertise
Diversification is an investment strategy designed to reduce risk, specifically unsystematic risk, by selecting a variety of investments that are unlikely to respond to market fluctuations in the same way. There are many different types of risk endemic to private equity funds, with two being long time horizons and access to liquidity. These risks can be exacerbated by the long lock-ups required, typically seven to twelve years and in some cases longer. As a result, it is paramount that institutional investors select funds that will be negatively correlated to each other over that period of time.
In addition to being able to provide a well-diversified private equity portfolio, funds of private equity funds can leverage their expertise and strong, extensive relationships in the field to design portfolios that have broad exposures to various strategies and geographic regions.
Experienced funds of private equity funds typically have access to a deep pool of managers and can create customized portfolios based on particular investors’ needs. These funds typically have an extensive due diligence process in place and have identified institutional quality private equity funds for their portfolios. Therefore, it is easier and much more cost effective to work with a fund of private equity funds to construct a portfolio and select managers rather than go direct.
During the past week, a family office based in New York mentioned that it had looked for private equity funds, but it did not have success finding qualified managers. Instead, it is considering hiring a fund of private equity funds to add exposure in its portfolio. Similarly, a European-based healthcare organization is looking for a fund of private equity funds to provide it with broad exposure to distressed, buyout, turnaround, and emerging markets opportunities.
With the recent credit crisis not too far removed, many fund of private equity funds have access to fund managers that they otherwise would not have had access to even twelve months ago which makes for plenty of opportunities to construct well diversified private equity portfolios. The only issue is whether there will be enough inflows of capital from institutional investors to fuel these opportunities, but according to Dow Jones despitebeing down from record inflows of $32.4 billion raised in 2007, funds of private equity funds raised $21.6 billion in 2008, the fourth highest total on record. Given those numbers and the influx of distressed, buyout, and emerging market opportunities we feel the asset flow into funds of private equity funds looks strong for the rest of 2009.