Investing in Private Equities through a Fund of Funds


Over the last ten years, private equity has increasingly become a significant portion of most institutional portfolios. The private equity class is defined as investments in private companies or partnerships that invest in them. During the period from 1996 through year-end 2005, investors committed nearly US$1.6 trillion to private equity funds. Despite a drop in private equity commitments following the bursting of the technology bubble in 2000, investors averaged more than US$166 billion in annual commitments to the asset class in 2003-20051 . Furthermore, in 2005, investors committed more than US$267 billion to the asset class, moving closer to the record amount of US$304 billion raised during the height of the technology bubble in 2000. Additionally, global commitments to the private equity asset class continue to increase, as private equity allocations are expected to reach record levels in all markets in 2007. Markets that have historically had smaller allocations to private equity, such as continental Europe and Japan, are showing the largest expected increases2. Respondents from these markets that have traditionally had a lower appetite for private equity investments have indicated that their preferred route for private equity exposure will be through funds of funds2.

The percentage of institutional investors in North America with an allocation to private equity declined slightly from 70% in 2003 to 57% in 2005, with their average allocation remaining constant at about 8% of assets2. Progressive university endowments such as those of Yale, Harvard and Stanford allocate as much as 10-20% of their endowment portfolios to private equity3 4 . As investors consider the private equity asset class, including investing through funds of funds, it is important to understand the nature of the industry and the important characteristics of a diversified private equity portfolio.

The Attraction of Private Equity

There are two primary reasons for financial investors to invest in private equity. First, private equity returns have historically outperformed those of public equities. As shown in Figure 1 below, data from Zephyr and Venture Economics indicate that private equity has delivered more than a 16% annualised return from 1996-2005, outperforming public equities by more than 600 basis points per year, depending on the index comparison. Prior studies show similar superior performance by the private equity asset class.

Figure 1: Annualised 10-Year Returns

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Source: Venture Economics VentureXpert database/Zephyr StyleADVISOR;
performance through 31 Dec 2005.

Secondly, private equity has been shown to have modest correlation5 to public equities, indicating it can be an excellent diversifier when added to a portfolio of stocks and bonds. Based on these two characteristics, adding private equity to a diversified portfolio is becoming commonplace. A Fort Washington analysis on the impact of private equity on a diversified portfolio of stocks and bonds confirms the conclusions of Nobel Prize-winning Modern Portfolio Theory that adding an alternative risky asset class to a diversified portfolio can actually increase expected return and reduce risk (as measured by standard deviation6 ). Based on Zephyr and Venture Economics data from 1996-2005, as shown in Table 1 below, adding 5% and 10% exposures to private equity to a portfolio originally allocated between 60% S&P 500 Index and 40% Lehman Brothers Government/Corporate Bond Index increases expected return and reduces risk.

Table 1: Risk/Return of Asset Classes and Example Portfolios from 1996-2005

  Annualised Return Annualised Std. Dev6 Correlation5 Sharpe Ratio7
S&P 500 Index 9.1% 17.5% 1.00 0.31
Lehman Gov’t/Credit Index 6.2% 4.3% 0.41 0.57
Private Equity Pooled Average 16.5% 15.9% 0.80 0.69
Portfolio 1 (60% S&P 500 Index + 40% LB G/C) 8.3% 13.1% 1.00 0.35
Portfolio 2 (55% S&P 500 Index + 40% LB G/C + 5% PE) 8.7% 12.7% 0.99 0.39
Portfolio 3 (50% S&P 500 Index + 40% LB G/C + 10% PE) 9.0% 12.3% 0.99 0.43

Figure 2 below shows how adding private equity to the three portfolios above moves them closer to the efficient frontier, meaning that the portfolio provides a better risk/return tradeoff. A similar 2001 study for Salomon Smith Barney by professors Paul Gompers and Josh Lerner of the Harvard Business School found that, historically, adding private equity to a portfolio shifts the entire efficient frontier toward higher return with lower risk. The chart demonstrates why private equity has become an increasingly popular and significant asset class for institutional portfolios because it has been found to increase expected return while reducing risk.

Figure 2: Efficient Frontier – Return vs Risk8

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Source: Venture Economics VentureXpert database/Zephyr StyleADVISOR

Building and Managing the Private Equity Portfolio

The decision to allocate to private equity is the first step. However, there are important considerations in building a private equity portfolio, selecting beneficial partnerships, and managing relationships with the general partners. The most widely diversified private equity investment vehicle is the private equity fund of funds. A fund of funds aggregates capital from multiple investors and makes commitments to a number of private equity limited partnerships, sometimes investing a small portion of the fund in direct co-investments in attractive private companies along with underlying fund general partners to enhance returns, adjust allocations, and effectively reduce fees.

A fund of funds is advantageous for both investors with small private equity allocations and for investors with large private equity investment allocations. Although funds of funds add an additional level of fees, the fees can be far less than the costs of managing a private equity portfolio in-house. In addition, using a competent professional manager brings the necessary expertise, discussed below, to effectively gain access to select and manage private equity fund relationships. Because funds of funds are such an efficient private equity investment vehicle, commitments to funds of funds have increased nearly 10-fold to more than US$13.9 billion from 1996 to 20059. Investors in private equity funds of funds include public and corporate pension plans, endowments/foundations, insurance companies/banks and family offices and high net worth individuals. We discuss below the benefits to investors of using an effective manager and a fund of funds vehicle to create a diversified private equity portfolio.


Investors in the private equity asset class exchange the lack of liquidity for a historically higher return premium over public equity investors. However, there are elements of risk dependent on variables such as economic cycles, capital markets and industry sectors, some of which we believe may be eliminated by investing in a diversified portfolio. As graphically depicted in Figure 3 below, we believe it is important that a private equity portfolio diversify across investment style, fund manager, investment stage, sector, geography and time (vintage year) to realise the full potential of the asset class while reducing the risks associated with any one of these risk dimensions.

Figure 3

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For investors allocating smaller amounts to the asset class, it is difficult to create a diversified portfolio across these dimensions because many quality private equity partnerships require a US$5 to US$10 million minimum investment, if they can be accessed at all since many leading funds are closed to new investors. Thus, building a well-diversified portfolio of 15-25 funds could require US$100 million or more. Using a fund of funds manager, with one or more pooled vehicles to commit to partnerships, provides leverage to smaller investment allocations. For larger investment amounts, a fund of funds allows for an efficient single allocation to a manager with the expertise, resources and relationships to build a diversified portfolio by making smaller allocations to select partnerships that may have limited access.

Manager Selection

Much more so than in public equities, manager selection matters a great deal in the realised return on investing in private equity. This selection could mean the difference between achieving exceptional returns and performing below expectations for the asset class. As shown in Figure 4 below, the spread between the median performance and the top quartile performance for private equity funds is much more significant for private equity fund managers than for public equity or public bond managers. We believe this is partly attributable to the private equity market being less efficient than public markets. This inefficiency is partly due to the significant lack of information being available on private companies and manager performance. In addition, private equity managers are able to invest for long-term value creation versus managers in public companies who must be concerned with, and are compensated based on, quarterly performance.

Figure 4: Spread Between Top Quartile and Median Returns – Trailing 10-Year Period7

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Source: eVestment Alliance LLC, Venture Economics as of 31 Dec 2005

The Best Funds Drive Returns

The principal reason we believe top managers perform so much better than average managers is that investing in private companies requires difficult-to-acquire skills, expertise and experience. It also includes a high involvement by the investor in identifying, managing and exiting private company investments. When the fund of funds manager identifies those funds with managers who have demonstrated these unique skillsets, it is important that these fund commitments make up sizeable enough positions to impact the portfolio. Many of these funds are in high demand and have small allocations to any one limited partner. A fund of funds must be sized appropriately such that 15-25 fund commitments can drive returns in the portfolio. A multi-billion dollar portfolio requires many more fund commitments which tends to drive returns toward the median vs the top quartile. This could dilute the expected outperformance of private equity over public equities.

Relationships with Leading General Partners

Given the importance of manager selection, the fund of funds manager must be effective at developing relationships with leading general partners and must be adept at identifying and assessing leading and emerging fund general partners. A long-term commitment to the private equity asset class and a developed reputation in the business is paramount to developing strong and credible relationships with leading general partners. Fund general partners like to develop relationships with limited partners who they can count on to reinvest in future funds, who know the business, do not require a lot of hand-holding on private equity investments, and who can potentially add value in terms of enhancing the network of the general partner. The network and history created between leading general partners and limited partners often leads to an invitation-only opportunity to invest in other leading funds. The fund of funds manager can, therefore, provide access to this exclusive network for investors in its funds of funds.

Identifying Leading and Emerging General Partners

It is critical to apply consistent criteria to all fund investment opportunities, including re-investments in general partners with whom there is already a relationship. The key criteria in evaluating private equity fund general partners includes: portfolio fit, industry and sector expertise, focus and reputation, track record, strategy, integrity and commitment, team rapport, deal flow, and acceptable contract terms.

As many leading general partners see a transition in management in the evolution of their firms, the fund of funds manager must be diligent in recognising when a leading fund may have lost its edge. It is easy for an investor to rely on the reputation of the general partner to select fund investments. However, it takes expertise and experience to assess funds that can be the next generation of leading funds. In developing a new fund relationship, a fund of funds manager’s approach to due diligence should leverage existing industry relationships. In addition, due diligence may include several face-to-face meetings with the partners, extensive review of the track record and investment strategy, review of existing and potential investments and extensive reference checks. Most of all, there must be a general comfort level with the strength of the team, personal incentives and motivations of the partners, their operating philosophy, and specific areas of expertise and, finally, how the strategy fits with the rest of the portfolio.

In building a private equity portfolio, it is important to establish a core portfolio around leading general partners with a proven expertise – whether it is a particular sector focus, strategy or style. Built around the core portfolio are more focused and emerging funds that may have the ability to target a particular niche and more strictly adhere to their investment strategy. For more tactical allocation and the opportunity to fine-tune allocations and enhance returns, many funds of funds will make co-investments directly in private companies along with the general partners, using a small portion of the fund. In all cases, it is important to systematically apply principled criteria and a disciplined due diligence process.

Actively Managing the Portfolio

Once fund investments are made, many private equity investors take a passive approach, waiting to see what the general partners can deliver. However, there are a number of areas in which the fund of funds manager can continue to add value to the portfolio, such as:

  1. holding general partners accountable to their strategies;
  2. supporting portfolio companies through co-investment and connections between other general partners, underlying companies, and limited partners;
  3. advising general partners, including serving on advisory boards, on potential conflicts and decisions which help develop the firm’s investing capacity; and
  4. effectively managing cash and public securities in the portfolio prior to and post distribution.

Monitoring and Reporting

Monitoring investments in a diversified private equity portfolio can be complex. There are quarterly and annual reports and partnership tax returns for each partnership as well as quarterly and annual conference calls and meetings with the general partners. A strong fund of funds manager constantly reviews reports, attends meetings and conference calls and effectively aggregates and communicates such information to investors via quarterly reports and meetings with its investors. The fund of funds also consolidates and simplifies monitoring and administration of capital calls and distributions. Additionally, questions about the portfolio, individual funds or companies can be directed to a single point of contact.


Private equity is an alternative asset class that should be strongly considered for long-term investors who seek to outperform public equities and add portfolio diversification. Using an experienced, effective manager through a fund of funds vehicle is an efficient way to achieve needed diversification, leveraging the necessary expertise to build, manage and monitor the private equity portfolio.


About Fort Washington Capital Partners Group

Fort Washington Capital Partners Group (FW Capital) is the institutional private equity division of Fort Washington Investment Advisors Inc (FortWashington), a registered investment advisor under the Investment Advisers Act of 1940 as amended (the Act). FW Capital manages and/or advises for approximately US$1.1 billion in commitments for private sector and government institutions and high-net-worth individuals utilising, among other things, private equity funds of funds, direct co-investments funds and customised investment programmes. FW Capital, and its affiliates, have invested in more than 107 underlying funds and 33 direct co-investments. FW Capital’s private equity management currently includes five national private equity funds of funds, two co-investment funds and four customised programmes.

For more information, contact Fort Washington Capital Partners Group at 1 513 361 7600 or visit us on the web at

About Fort Washington Investment Advisors Inc

Fort Washington Investment Advisors Inc (Fort Washington), founded 16 May 1990, is the money management and primary investment arm of The Western and Southern Life Insurance Company (Western-Southern). Fort Washington is a registered investment advisor under the Investment Advisers Act of 1940 as amended (“the Act”), registration granted September 1990, and is a wholly-owned subsidiary of Western-Southern, an A++rated (ratings determined by A.M. Best and are subject to change) insurance company founded in 1888, and part of the Western & Southern Financial Group® (W&SFG). Certain employees of Western-Southern’s Finance Department began managing investments for Western-Southern, and its affiliates, in 1984, developing expertise in fixed income, public equity and private equity. Western-Southern formally established Fort Washington in 1990, and subsequently transferred certain members of the Finance Department personnel to the newly-formed entity.

About Western & Southern Financial Group®

Western & Southern Financial Group (W&SFG) is a Cincinnati-based diversified family of financial services companies with assets owned and under management in excess of US$39 billion. A Fortune 500 company, W&SFG has received A.M. Best’s highest rating of A++ Superior for financial strength, is one of the ten highest rated life insurance groups in the world based on Standard & Poor’s ratings, and is consistently recognised by Moody’s and Fitch for financial strength and sound management. With a heritage dating to 1888, the group’s affiliates include The Western and Southern Life Insurance Company, Western-Southern Life Assurance Company, Capital Analysts Incorporated10 11 , Columbus Life Insurance Company, Eagle Realty Group LLC, Fort Washington Investment Advisors, Inc10, Fort Washington Savings Company12, IFS Financial Services Inc, Integrated Investment Services Inc, Integrity Life Insurance Company, The Lafayette Life Insurance Company, National Integrity Life Insurance Company, Todd Investment Advisors Inc10, Touchstone Advisors Inc10 and Touchstone Securities Inc11. For more information, visit W&SFG is the title sponsor of the Western & Southern Financial Group Masters and Women’s Open tennis tournaments.

Note: The opinions expressed herein are those of Fort Washington Capital Partners Group as of the date(s) indicated, and should not be relied upon in making any investment decisions with respect to private equity or fund of funds products. Please consult your investment professional before pursuing any alternative investment strategy.


1 Venture Economics VentureXpert database, 2006.

2 2005-2006 Russell Survey on Alternative Investing. Russell Investment Group: 2005.

3 The Directory of Alternative Investment Programs. Dow Jones: 2005 edition.

4 Thompson Financial’s Nelson MarketPlace, 2006.

5 Correlation is a statistical measure of the tendency of two assets to move together ranging between 1.0 and -1.0. A correlation closer to 1.0 denotes two assets moving in tandem; correlation closer to zero denotes less likelihood for the assets’ movements to be related; correlation closer to -1.0 denotes a tendency for two assets to move inversely. The lower the correlation between two assets, the better diversified a portfolio.

6 Standard deviation is a statistical measure generally regarded as a measure of risk. The higher the standard deviation, the great the distribution of possible returns around the expected return.

7Sharpe ratio is a measure of the reward to volatility; ratio of portfolio excess return to standard deviation.

8Calculated using Zephyr Allocation Advisor based on 01/01/1996-12/31/2005 returns data from Zephyr and Venture Economics using quarterly returns from each asset class. The sample portfolios start with a 60/40 model portfolio and add private equity to the equity portion as listed in Table 1.

9 Private Equity Fund-of-Funds State of the Market, 2006 Edition. Dow Jones: 2006

10 A registered investment advisor.

11 A registered broker-dealer and member NASD/SIPC.

12 Member FDIC.
Ratings refer to the financial strength of the insurance company and not to the safety, stability or performance of any investment product.