We’ve already looked at the fun distinction between FIG vs. Financial Sponsors vs. DCM vs. Leveraged Finance in previous articles, so today we’ll turn our attention to the 2nd most confusing topic: what you do at a fund of funds – and how a private equity fund of funds differs from other types.
PE funds of funds sit somewhere between traditional private equity and asset / fund management roles, so the recruiting process and what you do on the job are also “in between” both of those.
And that means that these roles could be great for you, terrible for you, or… somewhere in between (a shocking conclusion, I know).
Our interviewee today will break it down for you, including how to get in, what the recruiting process is like and how technical questions and case studies differ, what you actually do at PE funds of funds, and the types of candidates they’re looking for.
Then, in Part 2, we’ll dive into what you do on the job in more detail and all the juicy details on pay, deals, exit opps, and more. Let’s go:
From Commercial Banking to PE Fund of Funds: The Path Not Taken?
Q: You read this site. You know the rules of the game. Your story, please?
A: Sure. I went to a “semi-target” school in the US, graduated a few years ago, and started out with an internship in wealth management (since everyone does the wealth management internship first) and then a commercial banking internship. I had also completed a very informal private equity internship after my freshman year at university.
I won a full-time offer out of the commercial banking internship, and since the hiring market wasn’t great at the time – and since I didn’t want to work investment banking hours – I decided to take it and be happy that I had a job.
About a year into it, though, I found myself bored out of my mind. The work wasn’t that challenging, and although the hours were good (barely more than a “normal job”), I didn’t want to work there for the rest of my life.
Q: So this is where you’re going to tell me that you networked like crazy, set up 100+ informational interviews, and then got into the private equity fund of funds against all odds, right?
I did exactly the opposite of what you’ve recommended and I began by looking for jobs online and submitting my resume everywhere I could.
The work would be more interesting and the hours might be a bit worse, but still nothing like those in traditional investment banking.
I also knew that since I had several brand-name banks on my resume and that PE internship, I would have a better shot at applying for these roles online than someone without that experience.
Q: So this story ends with you landing the offer anyway?
A: Yes, I know, blasphemy, right?
I got interest from a few firms simply by applying online… BUT there were a few factors working in my favor:
- As I mentioned, I already had several brand-name banks on my resume from my internships and full-time job.
- I had the PE internship from my first year in university (and yes, I kept it on my resume since it was relevant for buy-side roles).
- Although I hadn’t gone to a “top school,” it was still solid and I had high grades.
- Finally, I focused on opportunities on the west coast of the US – there aren’t as many candidates here, so recruiting was arguably easier than in a place like NYC or London with hordes of qualified junior people.
If these points don’t apply to you, you’ll have to network aggressively and do more than apply online.
I won an offer at one of the Top 20 funds of funds after going through the recruiting process (disclaimer: not a “typical result”).
Private Equity vs. Private Equity Funds of Funds vs. Investment Banking vs. Hedge Funds vs. Asset Management vs…
Q: OK, I’m going to jump back into the recruiting process in a bit and have you fill in the details there.
But first, can you tell us what you actually do at a PE fund of funds?
A: Sure. This is an asset management role, and we invest only in private equity funds.
Effectively, we’re a Limited Partner of funds like KKR, Blackstone, and so on (at a smaller fund of funds, you would invest in PE firms with lower AUM).
At a normal PE firm, you conduct due diligence on companies and you may invest in them or buy them outright and then sell them; we do something similar, but with the funds themselves rather than the underlying companies.
So you evaluate the management team, their track record, their portfolio companies in their previous funds (if available), and how much the portfolio is really worth. We want to make sure that the General Partners will be able to generate high returns for us in the future as they have in the past.
We also spend a lot of time working with our own clients: pension funds, endowments, family offices, and any other institutions that have invested in us. We look at their own portfolios, their risk-adjusted returns, and see how much they’re allocating to different investment classes and geographies.
So it’s a mix of evaluating PE funds and their portfolios, and also “investor relations” work with our own investors.
Q: Right, but it sounds like you also do some work at the “company-level” if you’re evaluating the portfolios of these firms, right?
A: Yes, but it’s more about doing a “sanity check” on the valuation. Some of these firms own so many companies that it’s not feasible to do a detailed valuation for every single portfolio company.
So we’re trying to find cases where the market value differs dramatically from what the firm claims its companies are worth. Also, it helps us get a sense of each fund’s valuation methodologies as some are more aggressive than others – the revaluations help us standardize the returns internally.
The core difference is that we focus very heavily on the management teams at funds and assess how good they are and whether or not their investment strategy is repeatable and sustainable.
Q: OK, but that sounds very “fuzzy” to me. How exactly do you “evaluate” a management team?
A: A lot of it comes down to team and how long the team has been together.
As a specific example, some of the mega-funds have lost their appeal and become less attractive because so many teams split off and went elsewhere once the mega-buyouts stopped (or at least “paused”). As an investor, you would be worried that you may be losing the strongest people in the team.
As a result, many LPs are moving more toward the lower end of the market.
We also look for patterns in the investments that individual teams have made over time – we assess whether or not their returns are truly “repeatable” and if there are “one-time success stories” (or on the flip-side, “failure stories”) that increased or decreased returns.
Q: That makes more sense now. So you invest in both new funds (primary) and also buy stakes from existing owners (secondary)?
A: Yes. Many funds of funds will only do secondary investing in PE funds that already have 80-90% of their capital committed, but it varies by fund and sometimes the percentages at which they’ll invest are as low as 40-50%.
Also, many funds do co-investments along with the PE firm itself – so if we’ve put money into one of Blackstone’s funds and they want to acquire a new company, we might potentially invest directly in that company alongside them.
The advantage is that we can double-down on an investment if we really like it, and effectively “over-weight” our exposure to that company or industry.
And it’s also good for analysts and associates because you get more exposure to LBO modeling and the technical skill set – sometimes the job itself is light on those skills outside of these co-investments.
Q: So what percentage of the equity would you usually invest in alongside the PE firm?
A: It varies by fund and by company, but it’s framed more in absolute dollar terms than in percentages, at least on large deals.
The minimum might be $5-10 million, but it could go up to $50-60 million if we need to chip in that much.
Contributions are also pro-rated depending on how much an LP (us and any of the PE firm’s other investors) has invested in a particular fund.
Q: Awesome, thanks for explaining all of that. Anything else to add about what “private equity funds of funds” are and what you do?
A: Not really. Note that the time spent on each of these tasks – evaluating PE funds to invest in, making co-investments, “investor relations,” and monitoring existing funds and portfolio companies – varies tremendously based on the market and fundraising environment, and also based on how your fund operates.
If you’re set on going into traditional private equity in the future, as we’ll see in Part 2, you need to find a group that makes a lot of co-investments so that you get the LBO modeling and deal exposure.
Getting Your Foot in the Door
Q: So let’s say that you’ve gotten interviews lined up for a PE fund of funds, or you’ve at least seen some interest from various funds.
What’s the recruiting process like? Is it similar to traditional PE or hedge fund / asset management recruiting?
A: It’s similar to entry-level PE and hedge fund recruiting, where you go through 3-4 rounds and then also get the infamous modeling test and/or case study.
Most technical questions you’ll get are standard; it’s not as if a fund of funds can invent a new form of accounting and then quiz you on it.
Your “story,” of course, continues to be important and you’ll get lots of questions on “Why a PE fund of funds rather than traditional PE, or rather than a generalist group at a fund of funds?” and so on.
For those questions, go back to what we talked about before and bring up how you get more variety day-to-day at a PE FoF, including a mix of modeling and deal work, fund evaluation, portfolio monitoring, investor relations, and more, and how you’d rather do that instead of focusing only on one of those.
Q: Yeah, it seems like this is the closest you can get to a “generalist” role on the buy-side since people normally specialize very quickly.
What can you expect with the case studies?
A: I got one traditional private equity case study (“Build an LBO model for this company and make an investment recommendation”) and then a fund evaluation case study.
The second one was much harder for me since you can’t exactly find comprehensive online guides to evaluating PE funds.
Q: Well, you know that’s why we’re doing this interview, right?
A: Of course… anyway, before you even go into the interview process with a PE fund of funds, take a look at the filings of private equity firms that have gone public.
These will give you a good idea of what to look for and what to expect in these case studies, and with so many public PE funds these days you have no excuse not to do it.
In “fund evaluation” case studies, they’ll usually give you:
- A summary description of the fund, its investment strategy, and its current portfolio companies.
- Valuation estimates for the portfolio and the fund’s track record (IRRs over a longer time period).
- Information on the management team, how long everyone has been there, and the strategies that different Partners favor.
- The cash flow statement of the fund. They’re unlikely to give you a full set of financial statements, which makes it both easier (less to analyze) and more difficult (less information to base your decisions on).
Q: Great, so how do you evaluate this material and make an investment recommendation?
A: The most important thing is the fund’s track record and how they’ve performed historically, ideally with the same management team over a more extended period that includes both expansions and recessions.
Valuation, of course, is very important, and you also need to dig in to realized vs. unrealized gains.
Many PE funds artificially inflate their returns by including unrealized gains – the paper value of portfolio companies rising – rather than limiting it to only realized gains (actually selling companies for a profit).
Then, you need to analyze how much value the unrealized gains really hold and the probability of those gains being distributed to the investors as “realized” gains.
With the management team, you’re looking at how much turnover there has been, if the team is big enough to support the entire fund, whether or not there have been any lawsuits, and if any “conflicts” between Partners exist.
So an investment recommendation might look like this:
- I recommend investing in Private Equity Fund X, because historically they have delivered an average 21% IRR over the past 15 years, with little variation regardless of macroeconomic factors, and due to the strength of their portfolio and management team. All three of their funds are in the 1st quartile compared to its benchmarks in terms of IRR, TVPI, and DPI (typical PE fund benchmarks include Preqin and Venture Economics).
- Its portfolio is reasonably valued and public comps and DCF analyses indicate that the stated values are within approximately 5% of the market values.
- Since the inception of the fund, there has been no senior-level turnover. The team has proven that they can work well together, with an industry focus on consumer retail, healthcare, and technology and a differentiated strategy based on reducing the expense profile of companies.
- Furthermore, the PE firm’s IRRs are not being propped up by huge “one-time” wins – its most successful investment yielded a 40% 5-year IRR, but most of the others have been in the 20-25% range.
- Finally, the fund has very conservative valuation policies and has seen significant increases in portfolio company operating metrics. On average, the portfolio companies have YTD revenue growth of 12% and EBITDA increase of 21%. The fund has already distributed 70% of its invested capital and expects to exit 3-4 companies this year.
- Major risks include a downturn in its specialty sectors and the firm’s new fund being too large (40% bigger than its last fund), but the team is planning to hire 1 Director and 2 Post-MBA Associates to support the increasing fund size.
Q: Well, I hope everyone is taking notes.
I think this is the first explanation I’ve ever seen of case studies for PE funds of funds, or maybe case studies for funds of funds in general.
Did you have anything else to add there?
A: Not really – you can also benchmark against databases like Cambridge, Preqin, and others to assess how well a fund is performing vs. others raised in the same year, but normally they don’t give you that much information in case studies.
To Fund or Not to Fund: Who Gets In?
Q: So what types of candidates are they looking for? People straight out of undergrad or those with more experience?
A: Usually, funds of funds want people with at least 1-2 years of investment banking experience.
Some funds do recruit at the very top undergraduate schools in the US, but others skip them altogether and focus exclusively on those with full-time work experience.
There’s a fair amount of recruiting out of MBA programs and out of pension funds. Lots of people come from places like the Corporate Pension Funds (like GE or Kellogg), Public Pension Plans, and so on.
Some even come from traditional, direct investment private equity funds, but that background is probably less common than the others above.
I’ve never seen anyone recruited from a Big 4 or accounting background, but I’m sure it has happened before…
Q: So most of the juniors at your fund are from banking?
A: Around 80% come from investment banking, 20% were recruited straight out of undergrad, and I’m the only one here with a commercial banking background.
Q: Great. Thanks for your time!
A: Sure thing, my pleasure.
Private Equity Funds of Funds – Series