The Risk Profile of Private Equity Funds of Funds

Abstract

Private equity fund of funds (FoF) investments are now contributing more than 10% of the capital to private equity, i.e., venture capital and buyout. However, their risk profile is not well understood due to the opaque and illiquid market, and limited access to performance figures. FoFs need to understand their own risk profile, if they are to convince potential investors of their lower risk. Research on direct investments shows significant variability of returns with a significant probability of a total loss and extreme profits while research on funds shows that they are less risky because they invest in up to 20 direct investments. This article examines the risk profile of fund of funds. It illustrates that FoFs significantly reduce risk due to diversification. A framework that constructs the risk profile of FoFs using fund performance data is presented. Results show that the risk associated with a FoF investment is significantly smaller than that for a fund investment