Two Flavors of Private Equity: Direct Investing Versus Fund of Funds

For some investors, deciding to invest in private equity is only the first step. They still need to determine the right approach.

March 22, 2023 - Demand for alternative assets continues to grow, and private equity (PE) is one of the fastest- growing asset classes within alternatives. Between 2012 and 2021, assets under management among private equity firms tripled from $1.5 trillion to more than $4.5 trillion. Preqin, a firm that specializes in PE research, estimates that growth over the next five years will slow somewhat because of inflation, macroeconomic uncertainty, and a shift to lower-risk assets among some investors. But even the slower growth rate is pretty impressive: an annualized 15.4%, which would push the industry to approximately $7.6 trillion in assets by 2027.¹ Moreover, while some of this slower growth has come from a bumpy economy — which may affect the performance of the companies that PE firms invest in — the overall asset class is expected to continue drawing new capital as investors look for alternative investment options outside of the publicly traded markets.

To capitalize on this demand, securities companies are rolling out private equity options for investors. But there are key differences among the offerings. Broadly, investors have two main options: invest in a direct PE fund or in a fund of funds. The two strategies are materially different. Clients who may be considering PE for their portfolios should understand these differences so that they can make an informed decision. Here’s a breakdown of each.

Direct Private Equity

In the most common approach, a private equity firm launches a fund in which it will serve as a general partner (GP). Investors put their capital into that fund, becoming limited partners (LPs). Most LPs are institutional investors like pension funds, insurers, sovereign wealth funds, or high- net-worth individuals. Using LP-committed capital from the fund, the GP buys equity stakes in companies and assembles them into a portfolio that it will own and manage. Over time, the GP’s goal is to improve the financial and/or operational performance of the companies in the portfolio and then sell them, ideally for a gain.

Most GPs are generalists that buy businesses across a range of industries, but the past ten years have seen a growing trend of specialization as GPs seek to differentiate themselves. For example, a GP may only focus on healthcare companies or on turnarounds for distressed businesses. After a predefined commitment period—typically seven to ten years—the PE firm gradually sells off the companies in the portfolio and returns the capital—ideally with gains—to the LPs.

LPs can be a “primary” LP, buying a stake in a new fund directly from the firm. They can also be a “secondary” LP, buying stakes in an existing fund from another LP that wants to reduce its holding. (Additionally, LPs already in a fund can become a co-investor, investing directly in a specific deal alongside the PE fund.)

This direct approach offers some advantages for investors, starting with transparency. Because PE firms have direct oversight and knowledge about the portfolio companies owned by the fund, that information can be shared with the LPs through periodic reports. In addition, fund managers have significant control over decisions regarding the underlying businesses in a portfolio. PE deals typically give fund managers operational control and authority to make the changes they think will best lead to performance improvements. Last is fees—PE fees are typically 2% of committed capital (even if it’s not invested) and 20% of the fund’s profits. The remaining 80% of profits go to the LPs. This may not seem like an advantage, but as we’ll see in a minute, these fees are lower than for the other approach.

In terms of taxes, private equity funds are structured as “pass-throughs,” meaning that capital gains and losses are passed from the firm to the investor, reported on a K-1 form, and taxed at the individual’s rate.

Funds of funds

The second principal way to invest in PE is through a fund of funds — a structure that invests across a collection of PE funds. Fund of funds investors are still considered to be LPs—with the same opportunities in terms of primary, secondary, or co-investing—but they are one degree removed from the other LPs investing directly in a fund. Moreover, most fund of funds invest in PE firms rather than specific companies or deals, and they generally cover a broad range of strategies (e.g., early-stage venture, growth equity, leveraged buyouts, and distressed companies).

For some investors, the fund of funds approach offers advantages. One is diversification. Rather than concentrating capital—and risk—in a single private equity fund, an LP can spread that across multiple private equity funds. In addition, some investors, particularly individual retail investors, may not be able to reach the minimum investment threshold to participate in a new PE fund, but a fund of funds investment typically has lower minimums, thereby increasing access to the asset class. It is important to note that some unique direct PE strategies also have lower minimum investment requirements. Lastly, fund of funds investments are taxed the same as ordinary investments, with capital gains paid out to investors and reported on a 1099.

However, there are downsides to this approach. Perhaps the biggest is fees. Because fund of funds have an additional layer of management oversight, they have an additional layer of management fees as well—typically 0.5% to 1.0% of assets and 5% to 10% of gains; these are on top of the 2% and 20% that the PE firm itself charges. That additional layer of fees could change the risk/reward calculation for some investors.

Additionally, because fund of funds advisors are one layer removed and do not have direct control over the underlying investments, some challenges may arise:

• Reporting and access to information are more complicated. Given they are investing in multiple PE funds, with many companies to report on, there may be less detail available about the underlying portfolio companies. As a result, investors may have less transparency on the companies across the portfolio.
• It can be tougher for advisors to monitor the consistency of the various strategies. Verifying that the manager has experience investing in high- quality and multiple PE funds is key.

As with most investment decisions, there is no best answer that applies to everyone. If your clients are considering private equity as an asset class, they should understand the tradeoffs and advantages of each option. Only at that point can they make the best decision for their unique needs.

¹Dylan Thomas, “Private Equity Set for Slower Asset Growth, Fundraising—Preqin,” S&P Global Market Intelligence, Oct. 6, 2022.

Represents CNL’s view of the current market environment as of the date appearing in this material only. There can be no assurance that any CNL investment will achieve its objectives or avoid substantial losses. Diversification does not guarantee a profit nor protect against losses.

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