What is the future for private equity Fund of Funds?

The crisis and subsequent recession have left their mark on the entire financial industry. Private equity fund of funds are no exception and are sometimes perceived to be especially vulnerable because of their additional layer of fees. However, on closer inspection, the picture that emerges is quite different, and suggests that a renaissance for private equity fund of funds may even be imminent.

For pension funds fighting steep uphill battles against demographics, the current low interest rate environment poses a real challenge. Traditional, ‘safe’ investment strategies such as fixed income and home market equities no longer generate returns sufficient for the interest coverage required. With the issues surrounding the Euro, currencies are not an option given and, after being burned, many are backing away from hedge funds.

In contrast, private equity performed very well for those who had well-diversified portfolios prior to the crisis. Whilst private equity is not immune to lower return environments the ‘heavy losses’ incurred by portfolios at the end of 2008 never materialized, and any losses incurred have now been recovered. History has shown that private equity investments made during or shortly after recessions tend to deliver particularly strong performance.

Consequently, sentiment toward private equity has improved recently. In a new survey by Russell Investments, only 22% of investors believed they were over-exposed to private equity, while 43% report they are on target with the remaining 35% seeking to increase allocations. Interestingly, for the 78% that want to increase or stay at their current exposure, the expected distributions from their portfolios are likely to work against them soon.

During boom times the industry expanded rapidly with record amounts invested in 2006, 2007, and 2008. The pressure on general partners to sell these investments, now five to seven years old, is increasing fast. At the same time, the leverage situation is improving and many strategic acquirers have accumulated substantial cash reserves for future purchases.

Furthermore, whilst investments are up they are nowhere near the amounts invested during boom years. Thus, we expect to enter a phase of strongly positive net cash flow from private equity portfolios as investments from the boom years are sold. Investors who intend to maintain their allocations to private equity, but held off on new commitments in reaction to the uncertainty in the markets will have to commit soon to avoid a rapid erosion of their private equity allocations in the next four to six quarters.

Investors in fund of funds will see the effect somewhat later, but the erosion is inevitable as the basic premises remain the same. Leading on from this, there are a number of compelling reasons for investors to access private equity via fund of funds.

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