by Brian DeChesare Comments (10)

The Private Equity Fund of Funds: Compelling Career, or a Dinosaur Awaiting the Meteor?

Private Equity Fund of Funds

Everyone reading this site still wants to get into private equity, but related opportunities, such as the private equity fund of funds, are a different story.

While they share some elements with traditional private equity firms, funds of funds differ in terms of the job itself, careers, compensation, and exit opportunities.

There’s a lot of negative sentiment online about these firms, and while some of it is justified, I don’t think the situation is quite as dire as some people argue.

But funds of funds are more specialized opportunities that appeal to a narrower set of candidates than traditional IB/PE roles.

Before delving into the pros and cons, we’ll start with the industry overview:

What is a Private Equity Fund of Funds?

A private equity fund of funds acts as a Limited Partner for private equity firms.

It raises capital from institutional investors such as pensions, sovereign wealth funds, endowments, and high-net-worth individuals, and it invests that capital in specific PE firms.

The key difference is that funds of funds invest in firms rather than specific companies or deals.

Or, more accurately, they mostly invest in firms rather than specific companies or deals.

The fund of funds is an “extra layer” between a private equity firm and its normal set of Limited Partners.

Wait, Isn’t This Redundant? Why Do Private Equity Funds of Funds Exist?

“But wait,” you say, “Isn’t that what pension funds, sovereign wealth funds, and endowments are supposed to do? Isn’t it their job to pick PE and VC firms and hedge funds to invest in?”

Yes, it is, which is why many people believe that funds of funds “should not exist.”

But the industry exists for several reasons, summed up by Canterbury Consulting here:

  1. Diversification – Large institutional investors have diversification requirements, and they may not have enough in-house expertise to research hundreds of PE firms and then divide their capital appropriately. Funds of funds can provide this service for them.
  2. Access and Convenience, Part 1 – Individual investors, and even some institutional ones, may not have enough capital for a minimum investment in a new fund raised by a huge firm like Blackstone or KKR. But a fund of funds could pool capital from many other, smaller investors and use it to meet the minimum investment required by these firms.
  3. Access and Convenience, Part 2 – On the other side of the spectrum, some PE firms are niche and purposely maintain smaller funds to earn higher returns. They may not allow new money frequently, but a fund of funds that has already contributed capital may be able to invest more in the future. This fund of funds, therefore, might offer a way for new investors to own a part of a PE firm that is officially “closed off.”
  4. Deal Sourcing – Finally, some Limited Partners, such as corporations investing for their pension plans, are always seeking acquisition opportunities. If they invest in funds of funds, they’ll start hearing about potential deals as they review the acquisitions that the underlying PE firms are considering.

What Are the Downsides?

That said, there are some serious downsides to the private equity fund of funds model.

The most serious one is the double fees.

In addition to the management fee and carried interest charged by the PE firms (traditionally 2% and 20%), a PE fund of funds also charges management fees and carry.

These fees are lower – more like 0.5 to 1.0% and 5 to 10% – but they are still significant.

So, an investor in a PE fund of funds could potentially end up paying a 3% management fee and 30% carried interest.

The data on whether or not those extra fees are worth it is mixed but mostly points to “no.”

Another downside is the commitment period, which is often 3-5 years per fund of funds… on top of the existing commitments to individual PE firms, which might be 10-12 years.

So, investors who commit to PE funds of funds could potentially lock up their money for 15+ years.

Finally, there’s the “blind pool” issue: if an investor puts money into a new fund of funds, they don’t know which PE firms this fund will invest in – or even how decisions will be made.

Have Private Equity Funds of Funds Been Doing Well?

It depends on the metrics you use, but the short answer is that interest has been declining.

For example, according to Preqin, the PE funds of funds market saw overall AUM growth of 50% between 2009 and 2019.

That sounds impressive until you look at the broader private equity market, which recorded AUM growth of 150% over the same period.

And while private equity funds of funds accounted for ~15% of total capital raised by private equity in 2007, their share had fallen to only ~5% by 2017.

The problems above have led many pensions, endowments, insurance companies, and sovereign wealth funds to start their own in-house teams for fund selection.

Also, interest in secondary markets has picked up, so it’s now easier to buy and sell stakes in existing private equity funds rather than waiting for a new fund to form.

Finally, the fees are under pressure because consulting firms like StepStone and Townsend can help institutional investors evaluate and select PE firms for much less money.

So, the industry is not necessarily “shrinking,” but it is growing less rapidly than other asset classes, and its business model is under pressure.

How PE Funds of Funds Are Structured and How They Execute Deals

Private equity funds of funds focus on three main activities:

  1. Primary Investing: This means investing in new private equity funds that are currently raising capital.
  2. Secondary Investing: This means buying stakes in existing private equity funds from other LPs who want to sell their stakes.
  3. Co-Investing: This means investing in a specific deal that a single PE firm is doing, usually because the PE firm wants to bring in other sources of capital.

Some firms use a mix of all these strategies, while others focus on one or two.

There might also be requirements to put a certain percentage of capital, such as 80%, into new or existing funds, and the remaining 20% into co-investments.

Co-investing is the riskiest strategy but also has the highest potential returns.

Secondary investing is the least risky strategy because performance data already exists, so it’s easier to judge how well a specific PE fund is performing before investing.

The Top Private Equity Funds of Funds

The industry is quite small; across the U.S., there might be a few thousand professionals in it, and that’s if you also count middle and back-office staff.

A few of the biggest U.S.-based, independent funds of funds include Hamilton Lane, HarbourVest Partners, Pathway Capital Management, Fort Washington Investment Advisors, AlpInvest Partners, and Adams Street Partners.

Among banks, the Goldman Sachs AIMS (Alternative Investments and Manager Selection) group has the highest AUM dedicated to private equity fund-level investments.

If you go by performance rather than size, some of the top names worldwide include ATP Private Equity Partners, SwanCap Partners, Axiom Asia Private Capital, Bay Hills Capital, and Twin Bridge Capital Partners.

The Private Equity Fund of Funds Job

Based on the descriptions so far, you might think that a PE fund of funds job is similar to the standard private equity analyst or associate roles: work on deals, complete due diligence, source new deals, and monitor existing investments.

You do complete many of those same tasks as a junior-level professional, but the work required for each task is quite different.

The job is far more qualitative and dependent on “people skills”; there’s less financial modeling than in traditional private equity.

For example, you spend a lot of time reading people in meetings (virtual or in-person) and deciding which firm’s pitch is most credible.

In that way, it’s almost like a venture capital associate role.

In an average week, you might be working on the following tasks:

  • 3-4 Primary or Secondary Investments: You spend time evaluating each PE fund, including its management team, track record, and deal activity, and then drafting reports and presentations with your finding.
  • 1-2 Co-Investments: These are traditional leveraged buyout deals that a PE firm has invited your firm to invest in. You’ll do the modeling and due diligence and report back on whether they make sense for your firm.
  • Quarterly Client Calls and Portfolio Reviews: You’ll frequently update your firm’s Limited Partners on deals and performance data, and you’ll also comb through PE firms’ portfolio companies and do quick valuations to see whether or not their claimed performance data is credible.
  • Ad-Hoc Client Requests: These might include finding industry reports and performance data for certain companies and attending events and conferences.

You’ll spend the bulk of your time on the primary and secondary investments and some smaller percentage on the rest.

Not all PE funds of funds do co-investments, so in practice, you might spend 80-90% of your time on primary and secondary investments.

When you’re evaluating private equity firms, you look for a few key factors:

  • Team: Has the team worked together for a long time, such as 20+ years, and spent time together at the same firm? Do they have skin in the game because they’ve invested their personal funds in their firm? Is their strategy repeatable for the size of the fund they’re raising?
  • Returns: Are the returns consistent, or are they being propped up by one incredibly successful deal? How much of the claimed returns are realized vs. unrealized? Is there a reason why the proposed strategies might not work in the future, such as major industry shifts? How do the returns compare to industry benchmarks?

You’ll also complete reference checks and speak with many people the Partners at PE firms have worked with over the years.

You rarely have to do much sourcing because the senior people at your firm are responsible for that, and there tends to be high inbound deal flow.

The best part of the job is the exposure you get to senior people in private equity; the worst part is that the evaluation process can get repetitive and doesn’t require specific hard skills.

You may build some quick valuations and LBO models along the way, but you do not gain the same financial modeling skills that you do in investment banking or private equity.

PE Fund of Fund Salaries and Bonuses

As with traditional private equity salaries and bonuses, management fees and carried interest determine base salaries and bonuses in private equity funds of funds.

But since these fee percentages are both lower (0.5-1.0% and 5-10% rather than 2% and 20%), overall compensation also tends to be lower.

Base salaries for Associates tend to be in the $100K – $150K USD range (higher for secondary-focused firms and lower for primary-focused firms), and bonuses may range from 50% to 100% of your base salary – with a lower range, such as 25-50%, for primaries.

As you advance, these numbers do not necessarily increase by a huge amount because of the smaller fee pool.

For example, even Managing Directors and Partners might earn only around ~$500K – $600K in base salary and bonus.

But if the fund performs well, carried interest could add significantly to that, doubling or even tripling total compensation.

However, because carried interest takes years to accrue and be paid out, it’s fair to say that average compensation is well below what it is in direct investing private equity.

Senior professionals can still earn $1 million+ per year, but it’s more performance-dependent than it is at the large, direct PE firms.

Also, carried interest varies widely and tends to be higher for secondary-focused firms.

The good news is that it’s more common for firms to grant carry to mid- and junior-level employees, with some even offering it to Associates.

The bad news is that it doesn’t mean much unless you stay at the firm for a long period of solid performance.

Lifestyle, Hours, and Promotions

In exchange for this reduced compensation, you’ll also work less: expect around 50-55 hours per week at the junior levels, with occasional spikes when deals or funds are closing.

The hours are often worse if you work on many co-investments because you have to follow deal deadlines set by banks and advisers running sell-side M&A processes.

The hierarchy is similar to the one in investment banking or private equity: Analyst, Associate, Senior Associate, VP or Principal, Director, and MD or Partner, with some firms skipping or combining certain levels.

For example, some firms may not hire Analysts out of undergrad, and other firms might combine the Senior Associate and VP/Principal roles into an “Assistant Vice President” (AVP) job.

Typically, promotions happen whenever a new fund is raised – which means that you may be able to reach the top more quickly than in traditional private equity.

Private Equity Fund of Funds Recruiting: Who Gets In?

Funds of funds do a bit of undergraduate-level recruiting, but less than the PE megafunds, so most candidates come from investment banking, business valuation firms, Big 4 firms, or related groups.

Other relevant backgrounds might include private placement work experience or fundraising or investor relations in private equity.

Some candidates join from pension funds (both public and private), endowments, and similar institutional investors, and a few also join from direct investing PE firms.

At the junior levels, firms want people who understand the PE investment process and deals and who can also judge teams and communicate clearly.

Technical skills matter less than your social skills and ability to read people.

Similar to private equity recruitment, the process for junior-level hires tends to take place over 3-4 rounds, with interviews followed by a case study or modeling test.

Interviews and Case Studies

In interviews, you’ll still get many standard “fit” questions about your story, why the firm is a good match for you, and why you prefer a PE fund of funds to a direct investment firm.

If you’ve read this article, you should know the answers: you like analyzing the industry and firms at a higher level, you like the exposure to executives, and you want to build relationships rather than analyzing and monitoring individual companies.

In many cases, the technical questions will also be similar: expect the standard ones about accounting, valuation, and LBO modeling.

They could also ask about fund-level performance metrics, such as Total Value / Paid-In Capital (TVPI), Distributions / Paid-In Capital (DPI), and Residual Value / Paid-In Capital (RVPI), and the trade-offs between these metrics, IRR, and cash-on-cash multiples.

Allen Latta has a great series summarizing and explaining fund-specific metrics, so I recommend reading it if you’re preparing for fund-of-fund interviews.

Preqin also has a useful quick reference PDF with formulas and examples for many of these metrics.

Case studies and modeling tests tend to come in two variations: either a traditional LBO modeling test with a “fund of funds” spin or a qualitative case study where you have to evaluate a fund and recommend for or against investing.

The “fund of funds” spin might be something like separate returns for the GP and LP in the deal or a preferred return with a catch-up provision.

They’re not difficult, but many of these features are more common in real estate financial modeling and infrastructure private equity, so you may have to refer to models there to learn the ropes.

Fund Evaluation Case Studies

If you get a “fund evaluation” case study, expect the following:

  1. A summary description of the fund, its investment strategy, and its current portfolio companies.
  2. Valuation estimates for the portfolio and the fund’s track record, such as IRRs over a longer period.
  3. Information on the management team, how long everyone has been there, and the strategies that different Partners favor.
  4. The cash flow statement of the fund. They’re unlikely to give you a full set of financial statements, which makes it easier (less to analyze) and more difficult (less information to base your decisions on).

The most important point is the fund’s track record and how consistently the management team has worked together over a long period, including both recessions and expansions.

Valuation is important because many PE funds artificially inflate their returns with unrealized gains, so you need to assess the probability of unrealized gains turning into realized ones.

Also, you can’t rely too much on any single metric because each one can be manipulated.

For example, since TVPI includes unrealized gains (“Residual Value”), funds can manipulate it by applying high multiples to their portfolio companies.

But you also can’t rely exclusively on DPI, which is based on Cash Distributions, because it tends to be low early in the PE fund’s lifecycle.

If you have information on them, the fund’s terms, such as management fees, clawback provisions, hurdle rates, and preferred returns, are also important.

You don’t want to recommend investing in a fund that is heavily slanted toward its GPs at the expense of its LPs.

A reasonable investment recommendation in your case study might look like this:

  1. 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; their portfolio and management team are also strong. All three of their funds are in the 1st quartile compared to their IRR, TVPI, and DPI benchmarks.
  2. Its portfolio is reasonably valued, and comparable company analysis and the DCF indicate that the stated values are within approximately 5% of the market values.
  3. 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 healthcare and technology and a differentiated strategy based on reducing companies’ expense profiles.
  4. 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.
  5. Finally, the fund has 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 growth of 21%. The fund has already distributed 70% of its invested capital and expects to exit 3-4 companies this year.
  6. Risk factors 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 a Director and two Post-MBA Associates to support the increased fund size.

Private Equity Fund of Funds Exit Opportunities

So, can you get into traditional private equity from a private equity fund of funds?

The best answer is, “Maybe, but it’s a difficult transition and far rarer than you might think.”

The problem is that you do not develop the modeling, deal analysis, or “project management” skills that PE firms are seeking, and there’s a huge supply of IB Analysts with those skills who are also looking to move into private equity each year.

Yes, you might develop these skills if you work on co-investments, but you’ll still have less experience with the entire deal process than investment bankers.

So, you’ll most likely have to move to a smaller or startup firm to make this move.

If you want to work “at” a traditional PE firm, you’ll have a higher chance if you target investor relations or fundraising roles rather than investing ones.

Other potential exit opportunities from PE fund of funds roles include endowments, private and public pension funds, sovereign wealth funds, and occasionally investment banking.

Corporate finance is also a possibility, and you could also switch to a Big 4 firm or business valuation firm because they care less about experience working on deals from start to finish.

You would not be a good candidate for hedge funds, corporate development, or venture capital because the skill sets are too different.

In practice, many people stay at funds of funds and work their way up.

It can turn into a fairly cushy job if you’re at a good fund, and if you leave, you’ll often take a pay cut or work longer hours elsewhere.

The Private Equity Fund of Funds: Final Thoughts

So, are private equity funds of funds for you?

Rather than writing a pro/con list, I’ll say that it depends heavily on where you’re at and what your long-term goals are.

For example, if you’re at a bulge bracket bank in investment banking and your goal is to make as much money as possible, stay away from funds of funds.

On the other hand, if you’re at a Big 4 firm and you want a higher-paying job that gives you deal and investing experience, funds of funds can be quite good.

The best part of the job is the exposure you get to senior people in private equity and institutional asset managers.

You also get paid quite well for the hours, and you can potentially advance more quickly than at direct PE firms.

The worst parts of the job are the lack of transferable skills and the reduced exit opportunities.

So, if you’re planning to use a fund-of-funds role as a steppingstone into traditional private equity, you might want to re-think that plan.

But if you’re happy with a more specialized role, or you could see yourself at a pension, endowment, or sovereign wealth fund doing similar work, a fund of funds might be perfect for you.

M&I - Brian

About the Author

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys memorizing obscure Excel functions, editing resumes, obsessing over TV shows, traveling like a drug dealer, and defeating Sauron.

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  1. I would like to ask your opinion. I had 2 internship (undergraduate) offers from 2 little firms: one from a firm to work for the FoF PE team and one from PE firm to work in their fund.

    The FoF firm has a brilliant team with excellent background (people who came from McKinsey, BCG, Bain Capital…) and I think it is a great opportunity to network and learn from them. On the other hand, the PE firm a few people who come from IB or Big 3 and the vast majority of Big4.

    As you said, there are more transferable skills in the second firm, but I think that the first company will provide me better contacts for my future career. In fact, one intern who used to for the FoF firm has been hired in the PE firm.

    I don’t have a clear view of what to do when I finish my degree (Strategic consultancy, PE, IB), so given that situation, do yo recommed me to accept the FoF offer o PE offer.

    Thank you in advance and congrats for this great article!

    1. I would still recommend the PE offer in almost all cases unless you’re sure you want to stay on the FoF side or do some other type of fundraising in the long term. It’s much easier to go from PE to PE FoF than to do the reverse, if you ever change your mind.

  2. Hi, Brian, happy new year! Thank you for this detailed introduction.
    I have two questions and wish you could help me understand more.
    1. Would you please elaborate more about “a traditional LBO modeling test with a “fund of funds” spin”? Do you mean an LBO model with waterfall incentive structures?
    2. Some sovereign wealth funds are shifting to co-investments and direct investments, such as QIA, CPPIB. What is the difference between these roles in SWFs and those in FOFs?
    Thank you!

    1. 1) Yes, waterfall incentive structures or maybe slightly different LP/GP assumptions.

      2) They’re probably quite similar. SWFs, similar to FoFs, tend to pay less and have less demanding hours.

      1. Thank you, Brain!
        Sorry that I hve one more question …

        3 years ago, when applying for an FoF, I took a modeling test. They asked me to build an LBO model to show the case of acquiring 1% stake in a listed consumer company.
        I have no idea how to build this model because if it is for 1%, we could buy from the public market…
        After that, I joined an investment bank and tried to ask everyone I met, but I still could not find the answer.
        Do you happen to have some idea about this?
        Thank you in advance!

        1. A 1% stake is just a standard 3-statement model. Calculate the IRR and MOIC based on the price they invested 1% at and then the exit price at the end of the holding period, which is based on an exit multiple and the normal TEV bridge items.

          1. Thank you very much, Brian!
            If my understanding is correct, compared with when GP invests 100%, in the LP 1% co-investment case, LP’s initial equity contribution and return at exit are 1%, and those of GP are the remaining 99%.

            For your reference, I found a tutorial at another site (it is a 4-hour advanced LBO model. Not sure if it is ok to mention the url). It considers the case of co-investment via preferred equity with the optionality to convert. This makes the model more complicated since we have to consider whether the preferred shares will be converted.

          2. Assuming no changes in the share count, yes, that is true. Co-investing using preferred equity or a preferred convertible is obviously quite different, and you have to look at different cases there (split it into the conversion vs. no conversion outcomes).

  3. Brian – Arguably the best article that is out there about fund of funds. I want to add a couple of notes.

    Fund of funds can be a good first career for one unknown reason. You can quickly learn which career path you should follow. Because you conduct due diligence on other PE firms, you get to learn many hidden sides of PE firms (politics, comps, carried interest, promotions, departure, dispute, etc.). Also, since you have diverse exposures to many strategies rather than one specific strategy, you get to learn there are many lucrative career paths that are overlooked by people completely obsessed with mega fund prestige. Based on my experience, I got quickly disfranchised with the idea of working at mega buyout funds after realizing how top heavy their firms have become with a very slim chance of reaching the top. You can start realizing which firms or strategy is right for you, which is a bit hard to do if you only worked in directing investing role. Then, you can leverage that experience to go to MBA and make a lateral move if you plan to get into direct investing roles. Besides that I don’t see a major upside of career in fund of funds. The technical skill here is almost a joke. You will exclusively rely on DD materials and models provided by GPs. You will never fully understand the company you are investing at a meaningful level.

    At a very high level, Fund of Funds is declining without a doubt. Fund of Funds can be a good platform if you are investing in specific regions (Emerging market) or specific strategy (venture capital). Many institutional LPs don’t have resources to track every single market and fund of funds can help identify good managers and invest, especially in emerging market since information is not easily accessible. Also, if you want to invest in a good VC fund, unless you are an existing investor or have connections, it is nearly impossible to invest or get a good allocation because fund size is pretty small. Other than that, I don’t see any good reason to invest through fund of funds. Since most buyout PE firms have built an IR team and information is easily accessible anyway. I think diversification benefit is nothing more than a marketing phrase. Fund of Funds is sort of like the ETF in private market. ETF works well in public market, precisely because their fees are lower than active managers. ETF offers lower risk, lower gross return but higher net return. On the other hand, fund of funds provides lower risk, lower risk, lower gross return and lower net return, which is precisely opposite of what LPs are looking for in private market.

    1. Great, thanks for adding all those points. It seems like an MBA is a pretty high price to pay to move from a PE fund of funds into direct PE, so not sure how realistic that is for most people.

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