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Private Equity Fund of Funds 2020

David B. Perkins, CAIA Thomas P. Riegert, CFA Fund of Funds It is well known that private equity investing is dominated by institutional investors. Yet, with relatively attractive historical returns, the broader community of investment professionals has not embraced private equity, as there are several natural barriers to entry for new private equity investors that well-established institutional investors have readily overcome.

barriers to entry

High Minimum Investments Liquidity Minimum investments to a typical private equity fund can be Investors such as family offices, pension funds, life $5 million to $10 million, with some of the larger funds companies, foundations and endowments have longtime requiring commitments of $25 million or more. This charac- horizons to their investment strategies and limited need for teristic excludes many investors with smaller investment liquidity in the run. Many non-institutional investors portfolios and; therefore, lends itself to investors with large new to private equity aren’t used to locking up their capital for pools of capital. This is particularly important, considering such long periods, and those who seek liquidity before port- investors typically invest in multiple private equity funds over folio companies are exited face a limited and restricted market an annual commitment strategy for diversification purposes. of potential buyers.

Legal Structure Since most private equity funds do not register with the SEC, they require their LPs to be accredited investors, qualified purchasers, or both. As a result, many potential investors are excluded from participating in private equity funds.

private equity fund of funds / hatteras investment partners 2 Access The average private equity fund has less than 50 LPs. As a result, private equity managers with strong historical Private equity managers are accustomed to soliciting capital performance have their pick of LPs, and often limit commitments from large investors, allowing them to focus access to their funds to existing investors (i.e., they are their efforts and optimize their time spent fund-raising. “capacity constrained”). Additionally, since private equity is a skill-based , the dispersion of returns between the average fund and the top quartile performers can be significant.

manager dispersion increases as illiquidity grows

50%

40

30

20

Top Decile 10 2nd Quartile 0 Median 3rd Quartile –10 Bottom Decile Return Differential Versus Median (%) –20

–30 Long-Only Long-Only Private Equities Funds Equity

Source: Morningstar, Lipper Tass, Preqin. Note: Past performance is not indicative of future results. Should the study have been conducted over a different time period, the results may have been different. There can be no assurance that an allocation to illiquid investments would yield higher real returns.

private equity fund of funds / hatteras investment partners 3 In addition, top performing managers have historically LPs they accept, as the demand to be in top performing shown top quartile results from year to year. As a result, funds is high among investors. high quality funds have the ability to be selective of the

manager selection is critical performance often continues across vintages

35% Nearly 60% of 24% top quartile managers remain top quartile 28% above median

2nd quartile 13%

3rd quartile 19% bottom Nearly 60% of quartile 22% bottom quartile 23% managers remain below median 36%

Source: Steven N. Kaplan, Robert S. Harris, Tim Jenkinson, Rudiger Stucker, “Has Persistence Persisted in Private Equity? Evidence from and Funds” (February 2014). Darden Business School Paper: 2304808. Vintages are only through 2008 since more recent vintages may still be investing and have few realizations.

private equity fund of funds / hatteras investment partners 4 Private equity fund of funds emerged in the late 1970s and enable investors to hold multiple private equity investment funds in a single vehicle. Private equity fund of funds are typically held by high net worth investors and smaller to mid-size institutions, pensions, and endowments who want to have exposure to many different funds in one vehicle.

While endowments and public pension funds maintain the capital toward multiple underlying funds, managers and appropriate internal staffing and resources, time horizon, and or companies. This structure often has lower investment capital requirements necessary to make private equity fund minimums, thus potentially providing greater access investments, fund of funds have gained increasing acceptance to smaller, non-institutional investors who do not have and influence over the past 40 years. A fund of funds is a the resources to identify, evaluate, and select suitable professionally managed investment vehicle that allocates private equity.

private equity fund of funds structure

Investors

private equity fund of funds Fund of Funds

Private Equity Fund Private Equity Fund Private Equity Fund Private Equity Fund Investee Funds

Portfolio Company 1 Portfolio Company 1 Portfolio Company 1 Portfolio Company 1 Underlying Portfolio Company 2 Portfolio Company 2 Portfolio Company 2 Portfolio Company 2 Portfolio Portfolio Company 3 Portfolio Company 3 Portfolio Company 3 Portfolio Company 3 Investment Companies Portfolio Company 4 Portfolio Company 4 Portfolio Company 4 Portfolio Company 4

Co-Investments Co-Investments Co-Investments

Source: Hatteras Investment Partners

private equity fund of funds / hatteras investment partners 5 how fund of funds help address these barriers

As mentioned in the prior section, private equity fund of funds have provided access to the asset class through a single investment vehicle. As important, they have also helped address many of the natural barriers to entry prohibiting private equity investments in the past, by providing the following benefits.

Outsourced Research and Analysis Private equity fund of funds are able to make 10 to 20+ com- mitments per fund. Thus, they can more efficiently allocate Private equity fund of funds typically have large teams and capital to specialists. For example, a private equity fund of dedicated resources focused exclusively on private equity, funds manager may be more willing to allocate capital to a unlike many investors who allocate to a number of different small, sector focused buyout manager (e.g., healthcare only) asset classes. than a larger institution that may not be willing to make such Private equity tends to represent a limited portion of a typical a targeted investment, particularly if the larger institution investor’s portfolio, there often is an imbalance between the makes a limited number of private equity commitments per amount of work required to successfully invest in private year. Yet, we have seen that manager skill is very important to equity and the resources available to the investor. Therefore, private equity returns. A fund of funds manager who has a outsourcing private equity investing to fund of funds provides broad mandate and identifies a highly niche manager may investors with an efficient channel to access a labor-intensive, have more flexibility allocating to that manager than an insti- yet potentially lucrative, asset class, without having to increase tutional investor with limited due diligence resources who investment resources. relies on allocations to generalist private equity managers as Access a means to create diversification of investments. 4 As discussed earlier, it’s widely recognized that significant Weidig and Mathonet found that private equity fund of funds performance dispersion exists between top and lower quartile have no demonstrated probability of a total loss, versus a 30% managers. High quality funds are typically capacity con- probability of a total loss from an average direct venture cap- strained, and many are closed to new investors or highly selec- ital investment. While performance can never be guaranteed tive of the LPs they accept. A well-established fund of funds for any investment, evidence suggests that fund of funds may serve as a way for lesser-known LPs to access top-per- provide investors with a lower risk means to access private forming private equity funds. In addition, data suggests that equity investments. fund of funds, on average, are skilled at selecting top per- Administration forming private equity funds, which further highlights their ability to provide smart access for new investors to the private Investing in fund of funds can limit administrative burdens equity industry. Therefore, developing relationships with top and relationship management for the investor. For example, performing GPs is essential, as GPs are more likely to offer LPs fund of funds streamline the investment decision-making who have previously invested with them and with whom they process for the investor. Funds handle the due diligence pro- have a trusting relationship, the opportunity to invest when cess, manager selection and have a vested interest to invest they raise their next funds, referred to as re-upping. with the best performing funds. Another example of reduced administrative burden is that the GP is responsible for all Diversification cash calls and distributions. By choosing one or two fund of With a single commitment to a fund of funds, investors can funds, the investor can efficiently address a portion of the access a portfolio of private equity funds, potentially providing overall portfolio, achieve appropriate diversification, and far greater diversification than an investment directly into an move on to other decisions that may impact a larger portion individual private equity fund. In addition, many are diversi- of the investments. fied across strategy, geography, and some by .

private equity fund of funds / hatteras investment partners 6 private equity fund of funds

Sample Investors

•Small Foundation with $45,000,000 wants to invest in private equity but does not have the experience or money to compensate a professional private equity team. • $400,000,000 whose third-generation members are all qualified purchasers but do not have private equity exposure to Lower Middle Market turned to a fund of funds to gain exposure. • $100,000,000 institution with a 15% private equity target allocation and wants to avoid the J-curve by investing through a seasoned private equity secondary fund of funds. • Midwest RIA with $2.1 Billion in AUM enhances investment policy to include private equity; wants to avoid the cash drag associated with the early years of a private equity program.

4 Weidig, Tom and Pierre-Yves Mathonet, The Risk Profiles of Private Equity: Private equity is a risky asset, but private equity investments are not necessarily so, January 2004

private equity fund of funds / hatteras investment partners 7 1 Handbook of Alternative Investments, Second Edition; Anson, Mark J.P. 2006 ii Guynn, Jessica (June 17, 2008). “LinkedIn networks way to $53-million investment.” The Los Angeles Times. http://www.latimes.com/ business/ la-fi-linkedin18-2008jun18,0,6631759.story. Retrieved April 11, 2012 http://finance.yahoo.com/q?s=LNKD. Retrieved April 11, 2012 Weidig, Tom and Pierre-Yves Mathonet, The Risk Profiles of Private Equity: Private equity is a risky asset, but private equity investments are not necessarily so, January 2004

Please carefully consider the investment objectives, risks, and charges and expenses of the Funds before investing. Please read the Prospectus carefully before investing as it contains important information on the investment objectives, composition, fees, charges and expenses, risks, suitability, and tax obligations of investing in the Funds. Copies of the Prospectus and performance data current to the most recent month-end may be obtained online at hatterasfunds.com or by contacting Hatteras at 866.388.6292. Past performance does not guarantee future results. Safe Harbor and Forward-Looking Statements Disclosure: The opinions expressed are subject to change without notice. This material has been prepared or is distributed solely for informational purposes and is not a solicitation or an offer to buy any or instrument or to participate in any trading strategy. The opinions discussed are solely those of Hatteras and may contain certain forward-looking statements about the factors that may affect the performance of the illustrative examples in the future. These statements are based on Hatteras’ predictions and expectations concerning certain future events and their expected impact, such as performance of the economy as a whole and of specific industry sectors, changes in the levels of interest rates, the impact of developing world events, and other factors that may influence the future performance of the illustrative examples. Hatteras believes these forward-looking statements to be reasonable, although they are inherently uncertain and difficult to predict. Actual events may cause adjustments in portfolio management strategies from those currently expected to be employed. It is intended solely for the use of the person to whom it is given and may not be reproduced or distributed to any other person. The information and statistics in this report are from sources believed to be reliable, but are not warranted by Hatteras to be accurate or complete. Private equity funds are speculative investments and are not suitable for all investors, nor do they represent a complete investment program. Private equity funds invest substantially all of its assets in investments that are generally not registered as investment companies under the 1940 Act and, therefore, do not have the benefit of various protections provided under the 1940 Act with respect to an investment in such privateequity investments. Investments in private equity funds involve a high degree of risk, including the complete loss of capital. Private equity funds provide limited liquidity. General Risks, Special Risks and Investment-Related Risks of the private equity funds include, but are not limited to, Limited Liquidity, Reporting Requirements, Non-Listed Status of Units, Non-Diversified Status, Legal, Tax and Regulatory Risks, Underlying Portfolio Funds Not Registered, Portfolio Funds Generally Non-Diversified, Valuation of Portfolio Funds, Multiple Levels of Fees and Expenses, Portfolio Fund Managers Invest Independently, Portfolio Fund Operations Not Transparent, Concentration of Investments, Instruments, Distressed Investments, Valuation of Illiquid Securities and Derivative Positions, Unspecified Investments, Leverage, Risks of Failures, and Limited Selectivity of Investments. The success of a private equity fund is highly dependent on the financial and managerial expertise of its principals and key personnel of the fund’s investment managers. Although the investment managers for the fund expect to receive detailed information from each private equity investment on a regular basis regarding its valuation, investment performance, and strategy, in most cases the investment managers have little or no means of independently verifying this information. The underlying private equity investments are not required to provide transpar- ency with respect to their respective investments. By investing in the private equity investments indirectly through fund of funds, investors will be subject to a dual layer of fees, both at the fund and the underlying private equity fund levels. Hatteras Investment Partners are offered by Hatteras Capital Distributors, LLC, member of FINRA/ SIPC.

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