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When introducing their clients to the world of private equity, financial advisors like to point out how top institutional investors use the asset class to turbocharge portfolio returns, inevitably offering up Yale University’s endowment fund as proof. Indeed, the late, great David Swensen gained a cult-like following for piloting the Yale Endowment to decades of peer-beating performance by making heavy use of non-traditional investments, most prominently private equity.
Investors and advisors have sought to emulate Yale’s incredible success ever since. It’s a fine idea. I see just two problems with it: (1) you’re not Yale; and (2) your financial advisor is not David Swensen.
One obvious challenge to investing like Yale is the size and influence the institution wields. Unlike Yale, you don’t have billions of dollars. You may be wealthy – you may even be fortunate enough to have tens of millions of dollars – but sadly, it is not enough. The best private equity funds – and you DO want the best – often require minimum investments of $5 million or more. And as a sophisticated, Yale-like investor, you’re going to want to diversify across multiple private equity funds over multiple “vintage” years. But as someone that doesn’t have Yale’s infinite time horizon and who values liquidity, you’ll prudently limit your private equity allocation to something that feels reasonable, perhaps 10-30% of your overall wealth. Now do the math. Unless you have a portfolio that totals into the hundreds of millions of dollars, investing like Yale is a tough nut to crack.
Enter the private equity fund of funds (FoF). A FoF pools money from dozens of investors, amassing a scale that can meet the high minimum investment requirements of elite private equity funds. Further, the FoF is run by an expert in the industry, one with the connections and analytical horsepower to build a diversified portfolio of such investments. In theory, a FoF is the panacea for private equity investors, offering a solution for individuals aiming to invest like Yale. Sadly, in practice, most FoF often fall short.
First, let’s start with fees. The manager of the FoF obviously deserves to get paid. This creates three layers of fees for most investors: (1) the underlying private equity funds, (2) the FoF, and (3) your financial advisor’s fee. Some ambitious financial advisors have taken out the middleman by creating their own private equity FoF. This can be a smart idea, assuming the financial advisor has the expertise for such an endeavor (few do). Unfortunately for you, the benefit of eliminating a fee layer is typically offset by the financial advisor charging a higher advisory fee. Worse, most financial advisors collect this higher fee regardless of whether the performance of their FoF is good or bad. That’s called lack of alignment. It is the rare financial advisor/FoF manager that is willing to replace a secure annual management fee with a profits-based incentive fee that only kicks in after first earning a substantial return for their investors.
Yale’s size also provides advantages that go beyond its unique access to private investment opportunities and its ability to negotiate desirable fee alignment. Don’t forget David Swensen. He had the intellect and budget to build one of the most formidable private markets teams in the industry. Their meticulous selection process often led to smaller, lesser-known private equity managers with demonstrated expertise in a single industry or sector. This willingness to invest with lesser-known private equity managers and sector specialists proved prescient. Financial advisors and FoF managers looking to emulate Yale’s success would do well to focus on these hard-to-diligence opportunities.
As an individual investor, you do have one key advantage over the Yale Endowment. The virtues of size can cut both ways. At over $40 billion, Yale has become way too big to limit its private equity portfolio to just a select handful of best ideas. Likewise, some private equity FoF have become bloated, forcing them to over diversify and target larger underlying funds. If you’re looking for outsized returns, these types of FoF are likely to disappoint.
Bottom line: Can individual investors invest like Yale? In truth, probably not. But we all can learn from the experience of Yale and Swensen, and there are ways to target higher portfolio returns. To that end, a thoughtfully structured and fee-aligned private equity fund of funds might be a great solution for individuals seeking long-term portfolio growth.
