Updated: Aug 21, 2019
There are three main levels of access to invest in private equity.
Which level is ‘right’ depends, as discussed in the last post, on the individual investors' expertise and needs.
1. Fund of funds or fund of funds programme
This is the pure play outsourcing solution. Investing with one or more fund of funds providers for one or more investment strategies. The FoF manager(s) takes care of all investments, portfolio construction, and all operational and management aspects.
2. Fund investments
Investing in one or more direct private equity funds. The investor must consider things like portfolio construction and how to manage the programme. Through multiple fund investment the investor can build an own in-house FoF programme.
3. Direct or co-investments
Investing in one or more direct or co-investments. The investor must consider a great number of things including: valuation, management team, strategy, market, product market fit.
Additional considerations include portfolio construction and how to manage the programme. Through several direct or co-investments the investor can build a well-diversified portfolio equivalent to having invested in a fund.
Figure 1: Three levels of access to invest in private equity
Source: PE Compass
The ‘right’ answer depends a great deal on the four areas discussed in the last post, and each individual investors’ critical assessment thereof.
Risk and diversification are critical considerations
One single direct investment is, compared with a fund of a FoF investment, high risk with very low diversification.
If an investor is not comfortable with this, more direct or co-investments could be made to build a portfolio thus increasing diversification and offsetting risk.
Or, if this is not an option, it may be preferable to invest in a FoF or make one or more fund investments. Both offer immediate greater diversification and lower risk.
Importantly, diversification or portfolio construction is not just about adding ‘more’. Having three funds that essentially have the same strategy in the same region or three direct investments that do the same thing in the same market might be diversification by number but in reality simply increases concentration risk and has nothing to do with portfolio construction.
The three levels can be mixed
Investors may have the expertise and be quite comfortable with certain strategies or geographies and invest direct into one or more funds and possibly direct and co-investments.
Conversely for more specialized or niche strategies and / or regions, for example venture capital and / or emerging markets, the investor may choose to invest via several funds or a fund of funds.
Importantly, the levels of access, investor expertise and needs, risk and diversification while important are only a starting point. Investors must also consider returns, portfolio construction, performance management, and operational management.
These, along with a more detailed look at risk, how much to invest and why invest in private equity will be covered in future posts.