Why Funds of Funds?

Abstract

Private equity funds of funds (FOFs) have become big business. Today, FOFs form 14% of new money raised. I test six explanations for the rise of FOFs. First, I find that FOFs do not generally deliver superior returns. They do, however, do well enough for the limited partners (LPs) that hire them. Second, FOFs allow small LPs to scale upward, to invest in more funds. However, I find that they do not contribute to diversification. What they really do is to provide smaller LPs avenues to lower the cost of fund management. Third, FOFs allow large LPs to scale downward, to invest vast amounts over a short duration. However, the mechanism is imperfect because LPs can either use many FOFs and risk coordination problems among them or few FOFs and risk getting held up. Fourth, FOFs are used by LPs with weaker governance structures. Fifth, there is some evidence that LPs use FOFs to learn to invest in new areas, but the support is weak. Last, the use of FOFs is partly due to cyclical booms.Venture capital, private equity, agency, economies of scale, outsourcing