Are funds of funds a valuable form of intermediation?
Robert Harris, of the University of Virginia, Darden School of Business, and three other distinguished scholars looked at this question in a Darden Business School Working Paper, and they decided that, at least with regard specifically to the role of FOFs in the venture capital space, the answer is “yes.”
Specifically, FOFs in venture capital perform at least on a par with direct venture fund investing, and in a manner superior to the public markets, net of fees.
But with PE FOFs in the buyout space, the situation is a bit more ambiguous. Still netting fees, these funds do outperform public markets but they “underperform direct fund investment funds in buyout.”
Let’s focus on the success case. How do FOFs in VC produce superior performance? Harris et al suggest that they do so in the manner advertised, so to speak: by identifying and accessing superior performing underlying funds. This is in addition to their diversification risk-management value.
Previous Literature
Harris’s co-authors in this paper make up a distinguished group: Tim Jenkinson and Rüdiger Stucke, both of the University of Oxford, Said Business School, and Steven N. Kaplan, of the University of Chicago, Booth School of Business and National Bureau of Economic Research.
This distinguished quartet was of course aware that it was wading into an area much traversed by other scholars, and their review of the literature on the subject of intermediation that preceded their own work is itself quite valuable. As they note, the usual explanations for successful intermediation generally turn on either (a) transactions costs or (b) information advantages.
In private equity, the creation of the direct funds themselves is one level of intermediation. The limited partners invest with the general partner rather than directly investing in operating companies themselves. The GPs offer “expertise, effort and networks.” That simply means, again, they offer both informational and transactional value in return for their presence and their fees.
So why does this level of intermediation itself require intermediation? The LPs have made an investment that is highly illiquid, risky, and difficult to scale. They have committed themselves to high monitoring costs (and have incurred highly search costs even before settling on a GP.) This is not for the faint of heart.
Lots of Layers
Thus, room exists for the funds of funds. Indeed, room exists for more than one layer of FOFs. Most private equity FOFs are “primary,” that is, they make capital commitment to direct funds when those funds are raising their capital. But there are also secondary FOFs that “provide liquidity to LPs by purchasing their existing interests in one or more direct funds.” They are intermediating the intermediators of intermediators.
Harris et al, in their empirical work focus on the primary rather than the secondary FOFs, thus leaving one of those layers of intermediation out of account.
At any rate: every layer of intermediation has its own costs. Nobody at any of these layers is working for free. The Harris paper cites a Dow Jones report than a median management fee of 1% obtains among FoFs. If one thinks this high, the good news is that about three-quarters scale down that fee in the later years of the fund.
Why Review This Now?
Yes, the Harris paper is more than a year old. It can hardly be considered the discussion of a stale issue, though. In early 2017 one encounters frequently the charge that Wall Street is expanding at the expense of Main Street, that the price of financial intermediation is on the rise, that there is no added value attaching to its rise, and thus that the increase (to an all-time high in 2016, according to New York University economist Thomas Philippon) represents dysfunction.
It doesn’t. At least not necessarily. So long as every layer of intermediary is required to add its own value, the new layers will definitionally not be redundant ones, and the old layers that are redundant will fall off of their own accord. Indeed, many technological developments of our time, especially the growth of block chains, seem sure to induce such falling-off. The problem is that in the meanwhile some of these layers become rent seekers, and the regulatory system may be sure as to encourage rent seeking.
The role of PE funds of funds is a special case of this broader dynamic.