Executive summary:
- We believe a fund-of-funds approach to private markets allows for institutional investors to reap the benefits of a robust alts program without having to deal with all the complexities and hassles.
- In a fund-of-funds approach, all the benefits of a private-assets program are still provided, but all the burden of building and maintaining the program is taken off the investor. In addition, a fund-of-funds approach allows investors to access these benefits with relatively small commitment amounts.
- There is a significant dispersion between top and bottom-performing private markets strategies, which makes a fund-of-funds approach—where intentionally different strategies are incorporated—result in a smoother return pattern for investors.
How do you achieve a sub-ten-second quarter mile at the drag strip? Option one: Buy an old Mustang and spend years in your garage, turning it into a drag car, assuming you have the money, tools, technology, mechanical skills, and can handle the risk. Or option two: Buy a Tesla Model S Plaid. With astonishing simplicity, the car can demolish the quarter mile in 9.23 seconds, right off the showroom floor. After winning the race, you can still go pick up your kids from school.
Adding private markets to your institutional investment portfolio can seem as intimidating and complicated as building a racecar. A fund-of-funds approach is simpler—the benefits of alts without the hassle. More like that showroom-floor example. You might call it turnkey.
The benefits of private markets vs. the hassles of private markets
Investing in private markets has obvious upsides, including potential higher returns, access to a broader opportunity set, and greater diversification. We’ve all heard the list.
But private-markets investing is just as well known for its complications. How do you choose the right manager and the right fund? Can you even get access to the top opportunities? Do you have enough scale? Which vintage year should you choose? Do you know how to ladder returns? Can you afford the illiquidity burden? What do you do with the cash distributions? It's a lot. But the upside is so compelling.
The question is: How can an institutional investor get the benefits from a robust alts program without all the complexity and hassle?
The answer may be a fund-of-funds approach.
Private markets: How do you know what to invest in?
Today, private markets assets under management total more than $13.1 trillion (as of June 30, 2023 – McKinsey). And from 2000 to 2023, the number of funds grew from 1551 to more than 12,500 (Cambridge Associates). The real-world impact of all that expansion? Investors need expertise, scale, and global resources to access the right opportunities.
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Identify – Investors need the skills and capabilities to cull through the thousands of potential opportunities to find the best-fit opportunities available.
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Evaluate – Once the right opportunities are found, investors need to determine the quality of the opportunity and how it may fit in with their total portfolio.
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Access – Just finding the right opportunity is not enough. Significant buying power is often required to access top-performing funds.
Investors can attempt to do all this on their own. Or, by working with a top-tier fund-of-funds provider, all these issues can be addressed for them.
In addition, manager selection is crucial to fund performance. Investors sometimes incorrectly assume that the performance-spread in the alts space is similar to traditional equity and fixed income managers. The annual internal rate of return (IRR) between top and bottom quartile private-markets funds has historically been as much as 25.24%*. That’s why we believe the best fund-of-funds providers specialize in manager research, to help capture superior returns and minimize downside risk.
Fund-of-funds: Simplifying the alts investment process
Can you imagine what it might take to build a meaningful alts program in-house? Such an approach requires hiring the necessary investment professionals, performing your own due diligence, selecting managers, building ongoing internal monitoring and reporting systems, legal expenses, cash management, and more.
We believe a fund-of-funds is a superior approach for many investors. A fund-of-funds is a professionally managed pooled investment vehicle where all the investment functions are managed by a third-party firm, including manager selection, portfolio construction, ongoing monitoring, operational due diligence, legal reviews, reporting, and more. All the benefits of a private-assets program are still provided, but all the burden of building and maintaining the program is taken off the investor. And a fund-of-funds approach allows investors to access these benefits with relatively small commitment amounts.
Let’s look at some specific comparisons:
Redemptions – Redemption rights in private markets refer to contractual provisions that allow investors to request the return of their investment. In a typical vintage fund, an investor’s capital is returned as the Fund Manager sells underlying assets, the timing of which can’t be predicted in advance. . Even with an evergreen fund, it may take as long as seven years during a defined lock-up period, before the investor can exercise redemption rights. With the right fund-of-funds, that number can shrink to 0-2 years.
Rebalancing – Rebalancing is hard to do with vintage funds, because once an investor makes the investment, they’re locked in and along for the ride, unless they want to sell their interest in the fund on the secondaries market, and usually at a discount to fair value. With an evergreen fund of funds, an investor can request quarterly redemptions for rebalancing purposes, making it easier to keep their total portfolio aligned with their desired position.
Speed of exposure – Achieving meaningful exposure to an opportunity can take as long as five years with a vintage fund. A fund-of-funds may reduce that j-curve significantly through smart portfolio construction and through utilizing secondaries to acquire existing assets that are desired.
Commitment pacing – With a typical vintage fund, an annual commitment pacing plan is required to define investor size and pace commitments to reach target allocations to private markets. These pacing plans can become very complicated. With a fund-of-funds approach, commitment pacing is minimized..
Capital calls - A capital call, also known as a drawdown, is the act of collecting cash from limited partners whenever the need arises. With both vintage and evergreen funds, these calls can be burdensome and hard to predict. A fund-of-funds approach puts capital calls on a predictable, quarterly schedule.
The diversification benefit
As we mentioned earlier, there is a significant dispersion between the top and bottom-performing private market strategies. A fund-of-funds approach, which incorporates intentionally different strategies—results in a smoother return pattern for investors. Utilizing a fund of funds—especially one with a disciplined portfolio construction process—can effectively manage downside risk.
In the chart below, it’s easy to see how a single fund provides one slice of exposure within an asset class—in this case private credit. Compare that to a fund of funds, where a single solution can provide diverse exposure across regions and subsectors, still using skilled and highly vetted specialist managers within each assignment.
The bottom line
When it comes to entering the alts space, the typical conversation we have with investors is a blunt one: You want the benefits that come with private markets. But the stress and the administrative burdens that come with entrée into alts—it can all be overwhelming. You want to win the race. But are you in a position to build that race car from scratch? A fund-of-funds approach may be a drastically simpler solution, and can provide the alts benefits without the alts hassle. In a word: turnkey.
Take a seat, turn the key, and go.
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