Opening 401(k)s to Private Equity: Fund of Funds vs. Buyout Performance Review

The recent executive order encouraging a re-examination of 401(k) regulations for private investments raises a number of questions. For example:

• If such a change were to go into effect, what might the impact of retail investment into private equity and alternative spaces have on the market?

• What sort of vehicles might be affected?

• How has retail access affected markets in the past?

To answer these questions, we pulled fundraising and performance data from our Cobalt fund of fund and buyout styles and charted relative values over the past 20 years to examine how they compare to one another.

The reason we chose to analyze fund of funds vs. buyout is that a new flood of retail 401(k) investment would likely go into the fund of funds space. The reason is that many 401(k) portfolios invest in diversified index funds, and fund of funds represents one of the more diversified genres of private equity investing.

Key Takeaways

On a historical basis, we see that fund of funds has had consistent investment over the sample period while buyout has grown rapidly.

If fund of funds were to surge in popularity like buyout, what might happen to its performance? Using buyout as a reference, its performance exhibits strong stability for most of the sample, but volatility increased in 2015 as fundraising began to sharply tick up.

Many macro factors could cause this, including the 2020s volatility that impacted fund returns. But it stands to reason that while higher commitment levels in a market should stabilize returns, a sudden influx combined with crowding effects could lead to return volatility.

By contrast, fund of funds returns have also been quite steady, with only funds raised in 2020 showing lower returns. This could be due to diversification benefits or smaller size allowing for more alpha-seeking opportunities. It also offers comparable returns to buyout’s stable return rate.

Combined, these factors show a likely similarity in how they respond to macro events (and almost certainly much of the fund of funds space holds buyout). However, while buyout’s volatility was not fully passed onto fund of funds’ performance, should there be a rush of investment into the space the same risks of crowding and demand inflation could spike return volatility.

Looking Ahead

While the data for 2022 and 2023 look alarming, those lower fundraising values should be discounted as they reflect incomplete data capture from funds not yet closed. Regardless, as we look ahead to possible investment expansion, we may see a continuation of the early 2020s’ volatility as crowding could increase deal competition and decrease alpha opportunities.

Additionally, other segments may see knock-on increases in their interest, such as the underlying investment genres of buyout, venture, or secondaries if funds expand their commitments to allow new capital investment.

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