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Aon Retirement and Investment Blog

Investing in Private Equity Funds of Funds versus the Public Markets

Private equity investing can offer meaningful returns over the public markets and forms a part of the investment portfolios for many institutional investors. The private equity markets have become increasingly institutionalized and efficient; however, we believe that many of the factors driving performance[1] will persist into the future so private equity will remain attractive. Private equity investors may implement in three ways: direct investing in funds through limited partner interests, investing as a limited partner in a fund of funds, or investing alongside a general partner in a co-investment vehicle.
Investors with smaller exposures often do not have the resources or economies of scale to invest in multiple direct funds and therefore use fund of funds. However, returns for funds of funds are subdued by a second layer of fees. Whilst researchers have done many studies on whether direct private equity provides meaningful returns over the public markets, investors have less information on private equity funds of funds.
We conducted research to determine whether it is beneficial to invest in funds of funds as a means to generate alpha over the public markets by using a Public Markets Equivalent (PME) analysis. The PME calculation is a well-established form of performance measurement for private equity funds. It assumes that while capital is not invested with private equity managers, it will be held in other liquid assets (i.e., public equities). We performed the analysis on funds with $200 million or more in assets from vintage years 1997 - 2010 (Data Source: Burgiss).
We find that for mature vintages (1997 - 2005), on an aggregate basis, funds of funds over $200 million outperformed the equivalent PME by between 0.77% and 4.28% over the period examined, depending on which average measure and index are used. More recent vintages show reduced outperformance relative to the older, more mature vintages. Immature vintages (2006 – 2010) of funds of funds over $200 million outperformed the equivalent MSCI World (TR) PME by 0.20% to 0.76% over the period examined, depending on which average measure and index are used, and underperformed the equivalent Russell 3000 (TR) PME on all measures. Along with the J-Curve effect, we believe that the lower performance is partly related to the market cycle, as these vintages were invested at the height of the market and through the Great Recession. (Data source: Burgiss)
We believe many of the factors that drove past performance are likely to persist in the future, albeit to a lesser extent due to increased competition. We also believe the current state of the private equity market is sufficiently similar to the past that funds of funds outperformance relative to the PMEs is likely to persist, albeit at reduced levels, which we estimate at 150 to 200 basis points.
This finding agrees with other research that has also concluded that funds of funds have provided greater returns than the S&P 500 Index and an equal to or greater than return compared to the Russell 2000 Index while examining a greater number of vintage years and using different measures of performance (Harris, Jenkinson, Kaplan, and Stucke 2015).
The key risks to consider when investing in private equity include those associated with the wide dispersion of returns produced by different managers, which also holds true with fund of funds managers. It is therefore important to carry out careful review to try to pick the top performing managers.
Past performance is no guarantee of future results.
Tom Wyss is a Consultant on Aon Hewitt’s private equity team in Chicago. 

[1] Please see our white paper for a list of performance factors.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.

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