November 7, 2019


This article is the fifth in a series of seven, exploring private equity investment. It considers the traditional challenges of investing in private equity and suggests potential solutions. In this article, “P” refers to the “Problem” and “S” refers to the potential “Solution”.

Private equity manager selection is a specialist skill

P: Private equity is a specialist investment class. Few investors are very knowledgeable about in terms of how the structures work, never mind having the ability to select private equity managers (also called General Partners or GPs). As for the asset class, generally, manager selection in private equity is a specialist skill.

S: A good investment consultant can guide an investor to select suitable GPs. Funds of funds in private equity play a multi-manager role, offering investors already-blended exposure to private equity. Such funds of funds are available in different vehicles.

Large governance budget required

P: If an investor uses an investment consultant, a decision needs to be made for every allocation to a new fund, which requires much time spent discussing the pros and cons, etc. In retirement funds it can be particularly time-consuming, given that a board of trustees must reach agreement on any opportunity presented.

S: Allocating to a fund of funds structure (in whichever form) will reduce the number of decisions that need to be made (one decision to invest in the “multi-manager” rather than a decision for each of the underlying private equity funds) for the lifetime of such a fund (usually also 10 years). A permanent capital vehicle, such as a fund of funds in a listed company vehicle, can reduce the number of decisions to one in total.

Restricted accessibility and concentration risk

P: Depending on the size of the investor (even for large retirement funds) accessibility can be tricky. An investor will not usually be allowed to allocate less than R50 million to a private equity fund. Furthermore, making only one allocation to one private equity fund would imply concentration risk (insufficient diversification). So if performance in that fund is bad, the entire private equity allocation will perform poorly.

S: Typically, a private equity investor seeking diversification would want to allocate to at least five funds at any point in time. This would imply a minimum allocation / commitment to private equity of 5 x R50 million = R250 million. Based on Regulation 28’s limit of 10% exposure to private equity, this would imply the retirement fund should have at least R2.5 billion of investible assets, which precludes most retirement funds from the opportunity.

However, funds of funds bring down the minimum investible assets substantially. A fund of funds will already provide diversified exposure to underlying private equity funds. An allocation of R50 million to one fund of funds (Regulation 28 limit is 5% to one fund of funds) would imply that any retirement fund with investible assets of R1 billion or more could effectively gain access. This still excludes many retirement funds.

If the fund of funds uses a listed company as the investment vehicle, investors can invest as little as the share price for one share, which would make it accessible for all retirement funds, as well as individual investors that are able to purchase shares.

Lack of liquidity

P: Investors generally get nervous when faced with a 10-year lock-in. This is required for private equity investment. What if the cash is really needed?

S: The instances where a retirement fund would need to liquidate large portions of assets are limited, due to the vehicle being a long-term focused one. However, mass retrenchment exercises do happen. Investors into private equity funds would have to work through investment bankers to find a willing buyer for their stake in the private equity fund. This is tedious, cumbersome and usually results in a sale for less than the value of the stake.

Funds of funds sometimes offer to facilitate the sale of stakes in the funds of funds to other prospective investors, and some even provide a guaranteed buy-back clause, based on a predetermined discount to the value of the stake. Be cautious when studying these terms as the fund of funds may have control over the pricing of the investments in the fund and therefore the discount may be applied to an already discounted value.

Funds of funds in listed company vehicles offer the most seamless and simple liquidation, selling on the stock market. The price is often also at an ever-changing discount to the underlying value, based on the share price.

The fact remains that private equity investment is for the long term. Premature liquidation is never ideal, but there are ways to limit such risk.

Cash flow management can be time-consuming

P: When an investor commits money to a private equity fund, they don’t put down the entire sum, but will only pay when capital is “called”. Managing capital calls and receiving (and reinvesting) distributions (payouts from the fund) can be time-consuming.

S: Funds of funds limit the source of capital calls to one. Funds of funds in listed company vehicles remove capital calls completely by receiving all the capital on day 1. Cash flows are then managed by the listed company on behalf of its investors.

High fees should be considered as part of the investment case

P: Fees in the private equity industry are high. There tends to be a base fee of about 2%, with performance fees (called “carried interest” – usually 20%). Funds of funds charge an additional base fee and often an additional carried interest.

S: We explained in the third article that investors are provided with asset management services, plus “management consulting” services in private equity funds, which makes the fee much more attractive. Fees are also charged as a percentage of committed capital. So when the value of the underlying companies grow, the fee does not increase as it does for listed equity mandates. Nonetheless, when fund of funds fees are added as a second layer, an investor should study the fee impact in detail to determine whether such an investment will still be worthwhile net of fees.

Listed company vehicles for funds of funds enable the “multi-managers” to invest alongside their client investors to gain a performance-related upside, instead of additional carried interest, which can limit the cost of the fund of funds structure significantly.

J-curve of returns

P: Let’s say Sarah joins a retirement fund at a specific point in time. The fund makes a commitment to a private equity fund in the same year. Five years later, Sarah resigns and leaves the fund. In the first five years, private equity returns can be much lower – let’s say her return on the private equity portion was 5% per year.

Mike joins the retirement fund in year five (as Sarah leaves). In the last five years of a private equity fund’s lifetime, returns tend to be exponentially higher than the first five years – let’s say the return on the private equity portion was 25% per annum.

Sarah and Mike were both in the retirement fund for five years and invested in the same private equity fund, but Mike received a 20% per annum bigger return on those assets.

S: The only way to address this challenge is by investing in different vintages (private equity funds that begin in different calendar years) for diversification. Then Sarah and Mike will each be exposed to a couple of funds in the first five years and a couple of funds in the last five years of the funds’ respective lifetimes, with a significantly better spread of returns expected. A retirement fund will need big assets (as described above, at least R2.5 billion) or gain access through a fund of funds, in order to achieve this.

In summary, funds of funds solve most of the problems of investing in private equity (some vehicles better than others), but they do introduce an additional layer of fees, which should be weighed against the benefit of gaining access to private equity. It would be worthwhile for boards of trustees to investigate these opportunities on a case-by-case basis.

Willem le Roux
Principal Investment Consultant and Actuary