As with other parts of the private equity industry, the fund-of-funds market has been transformed in the last few years. Attracted by the stellar returns of buyout funds, there has been a boom in fund-of-funds launches. There has also been increasing specialism in fund-of-funds offerings and an attempt by managers to reach new pools of investors.
But the fallout from the credit problems in the LBO market is presenting challenges for fund-of-funds that have not been around long enough to build up a track record and have bought into buyout funds at a time when returns could be about to decline.
Managers of long-established fund-of-funds point out that in the 1990s there were only a small number of such funds. By 2005, a study by Almeida Capital listed 134 and the number is thought to have grown significantly since then thanks to strong investor demand. Among the new funds this year have been
Sam Robinson, a director at
Robinson adds that a few years ago the leading fund-of-funds would carefully consider which buyout funds were planning to come to market. “We’d make sure that before the marketing document was released we’d asked for the allocation we were after. Today, that proactive approach has become almost standard and that’s why we’re seeing a scramble for the best funds.”
The way fund-of-funds investment takes place has not changed significantly, he believes. “Everyone does the same kind of analysis. Yes, there may be more data available but fund selection is still very much about the individuals involved because that’s the best way to forecast future performance.”
Robinson says there has not been that much actual innovation because the big players can raise virtually what they want and so have no need to innovate. But he notes SVG and Partners Group have moved into the niche area of structured finance. SVG’s Diamond II fund raised €500m last year through a collateralised fund obligation (CFO) of private equity funds, comprised of investment grade bonds and preferred equity shares.
In May 2007 SVG Diamond III closed at €700m, which will be focused mainly on large and mid-market buyouts in Europe and the US and will have an over-commitment facility of up to 140%, allowing a target investment capacity of €980m.
George Anson, managing director at
There has also been an increasing geographical specialism offered by managers with more Asia-Pacific fund-of-funds and some focusing on emerging markets, distressed fund-of-funds and emerging managers.
He adds that plain vanilla products have been complemented by the increased use of leverage, such as structured products that use an underlying asset to enhance returns. “By definition, that trend makes fund-of-funds managers more active in how they manage assets and cash position,” says Anson.
John Gripton, head of investment management at asset managers
This means having mechanisms in place so that the draw-down of cash from investors takes place as late as possible. It may also mean having a borrowing facility in place so that the fund-of-funds does not need to keep going back to an investor for cash every week or two weeks, he says.
Another development has been using different fund-of-funds vehicles to reach investors, says David Currie, chief executive at
When it comes to new entrants to the fund-of-funds market, there are differing attitudes among the more established players. George Anson of HarbourVest believes the market is relatively easy to access, at least when things are going well. “When the market is buoyant, it’s fairly easy to set up a fund-of-funds, but the difficulty is keeping going in the long run and we’re already seeing some consolidation among funds.”
He says most new fund-of-funds tend to focus on a new geographical area or investment stage, such as European lower mid-market. “New entrants look for a gap in the market and focus on accessing that,” says Anson.
Anson adds that he expects to see more financial groups establishing de facto fund-of-funds but possibly under another name. For example, in July German insurance group
“They’ve hired Jonny Maxwell to build their third-party mandate business,” says Anson. “It’s a great brand, with some track record and someone good at fundraising. Although they’re not a new entrant as such, they will provide more competition as they’ll be targeting some of our customers.”
But others argue that there are significant barriers to entry in the fund-of-funds market, particularly the relatively long period it can take to establish a track record and the time needed to cultivate contacts in buyout houses. “Funds like us have established a network of managers, with whom we’ve invested over many cycles,” says John Gripton. “It can be tough for new entrants to gain access to these funds.”
Tycho Sneyers, a partner at Swiss-based
Sneyers adds, however, that the bulk of assets are still being raised by the same players and that the new entrants tend to be looking at Asia. “Our experience in Europe is that our competitors are largely the same as they’ve always been,” he says.
Gillian Brown manages one of the new players,
“We are very driven by fund selection, so we’ll have a fairly concentrated portfolio,” she says. “We are return-focused, rather than attempting to offer an over-diversified portfolio.”
Although the fund is a new entrant to the market, Gillian Brown has a long track record in buyout investment and was formerly head of the private equity funds team at Hermes Private Equity. Her contacts and experience could give the fund a head start in securing allocations in buyout funds.
“It’s definitely a very competitive market, raising funds from investors and that’s why it’s important as a new fund to target investors who are newer to private equity,” she says. On the challenge of getting into popular buyout funds, she says that it depends on how the fund-of-funds is regarded by the GP. “You need to be seen as a sensible investor,” she says.
While the fund-of-funds sector is still a competitive market, competition has thinned out a little, believes David Currie of Standard Life. The challenge for new entrants in achieving a track record links in with the difficulty in gaining credibility with the consultants active in the sector.
“Many institutions that are new to private equity use actuarial consultants to advise them and it can be hard for new players to get on the lists of these consultants,” says Currie.
The recent credit squeeze in the LBO market could also be a challenge for new entrants as it will probably hit their performance, believes SVG’s Sam Robinson. He points to the dot-com boom as the last time the market attracted large numbers of new players. “You’ll always get people entering a very successful sector, who perhaps don’t know that much about it,” he says, adding that any new fund-of-fund launching in the past two years may find it hard to do well.
Robinson says: “Partly because of the current debt squeeze, it will be hard for funds launched in the last two years to establish a good track record, as returns will be affected. And without a track record it will be hard for them to fundraise again.”
Gillian Brown of Mithras Capital disputes the idea that newer fund-of-funds will inevitably fail. “The current credit squeeze means that we will continue to focus a lot on due diligence when it comes to selecting funds. We’ll be looking at funds that take a measured and sensible approach to their investments.”
As for the wider implications of the market volatility on fund-of-funds, managers say they are reasonably relaxed. They say a correction in the market was inevitable given the unsustainable level of activity but that the consequences would clearly be more serious if the correction is prolonged and becomes a depression.
According to LGT’s Tycho Sneyers, there will be a slowdown in the buyout market, which is already seeing a reduction in acquisition multiples. At the end of August US home improvement retailer Home Depot, for example, had to reduce the price sought for its construction supply business. “I think we’ll also see buyers having to put in more equity, which will mark a return to the past when deals contained more equity and prices were lower,” says Sneyers.
John Gripton says he accepts returns from buyout funds will fall but that in the past three years returns from the European and US markets have been so good as to be unsustainable. “It’s been clear that the level of returns was not sustainable year-on-year and we’ve been saying that to clients for some time,” he says. “But this market is still one that can generate 15% to 20% IRR per annum over a 20-year period.”
He predicts that by the end of the year deal flow will begin to pick up again and he contrasts the current environment with that of the dot.com crash: “It’s not like 2000 when there were lots of inexperienced companies receiving cash from investors drawn to a bull market. The current market involves LBO firms that have been around for up to 20 years, who have lived through different cycles.”
According to one manager, the last two to three years have seen “ridiculously high” returns from the buyout market. IRR returns have reached 30% or more a year, he says: “Long-term returns for a very good manager have been 20% per annum net. Will we go back to that level or something lower? I suspect it will be lower but not by much.”
David Currie says: “We’ve been in a period of super returns, thanks to market conditions. I think we’ll see a return to more normal returns, although they’ll still be attractive.”
The buyout market is more competitive than it was and there are more intermediaries, he says, but on the other hand managers are getting better and can now recruit high-quality people. Sam Robinson says: “I think we’ll see more sophisticated improvements post-acquisition that will add value to investments. Although private equity houses have bought at high prices in the last year or two, many have factored in the likelihood of a falling market. While they may not be able to sell at the same multiples they bought at, other factors will enable them to make a decent return.”
Box-out – Anyone for venture?
With some evidence that the cycle of easy credit for LBOs is over, are fund-of-funds looking more closely at venture capital funds? After all, research has suggested a renewal of investor interest in venture capital in particular in the UK.
Last year, venture-backed companies in the UK raised £1.4bn, up 27% on 2005. The increase is attributed to factors such as a growing perception among VC firms that the industry is finally bouncing back after the dot.com crash and the fact that there was significant new fundraising by venture houses in 2005, which was put to use in 2006.
And it’s not just in Europe that venture capital is becoming more buoyant. In markets such as China, venture capital is growing even more quickly, at three times the rate of the UK.
There have been significant developments in European venture in the last few years. John Gripton of Capital Dynamics, says: “Nobody disputes the quality of European technology, but it hasn’t always been good at exploiting it.” But, he says, there is now a growing body of experience among European fund managers and repeat entrepreneurs, who have seen more than one company through the venture process.
The fundamentals of the European VC industry are very good, believes Gripton, particularly now that funds recognise the importance of being able to sell outside the European market. “We have a dedicated VC fund for Europe, although we’ve invested cautiously. But if returns improve I can see us increasing that.”
Others, however, seem closed to the idea of investing in venture. Mithras Capital’s fund-of-funds manager Gillian Brown says that venture capital will not feature. “It’s not part of our strategy and a lot of investors are still a little nervous about venture capital.”
LGT’s Tycho Sneyers said the fund has continued investing in European VC, even through the downturn. “And that’s turned out to be a very good investment decision because there have been some excellent investments made by European venture funds,” he says, adding that more capital is going to European VC houses.
“In some situations it pays to be somewhat counter-cyclical,” he says, adding that it is still very important to be with the best managers. “You need to be selective because there are only a handful of European VC’s with the required experience and track record.” Among the VC funds LGT has invested in are Benchmark Capital (now called Balderton) and Index Ventures.
HarbourVest has restricted its VC investment mainly to the US, says George Anson: “We’ve always invested in venture in the US, but only in a handful of firms outside.” He notes that in the mid-1990s US venture capital was probably the best-performing asset class in the world and then there was the dot.com crash, after which it became the worst-performing investment.
Before the dot-com collapse, HarbourVest raised a US$3bn US venture fund and a US$1.1bn buyout fund. “The US$3bn was one of the easiest fundraisings ever because people had made so much money out of venture capital in the mid-1990s, while the buyout fundraising was one of the hardest. Since then both have performed positively, but the buyout fund much better.”
But he argues that there is always a “herd mentality” that attracts investors to the asset class that has been performing best, even though return profiles are cyclical.
Many fund-of-funds managers, however, are sceptical about the attractions of venture capital. “Thanks to rising valuations in the buyout market and a perception that prices in the VC market are cheap, I’ve been asked a lot in the last two years whether we’re putting more into VC,” says Sam Robinson of SVG Capital.
But the problem, he says, is the huge gap between the best and worst-performing venture funds compared with the buyout market. “In buyouts you’re investing in an existing company but in VC you’re taking a new company to market and you’re not sure if someone else in another part of the world has the same idea but a better product.”
Top down, venture capital looks attractive, believes Robinson, but less-so in reality. “I wouldn’t say the leading fund-of-funds are looking at venture capital more, if anything it’s less because there’s a lot of effort involved to make a relatively small investment in venture capital.”
It is not just the risk attached to venture capital investments that is problematic for fund-of-funds, says Standard Life Investments’ David Currie, but also structural issues. These include the fact that venture capital funds tend to be less predictable than buyout funds and holding periods are longer.
Currie says: “Venture funds sometimes get all their money from one or two investments and the rest fail or don’t perform that well. To a large extent buyouts, on the other hand, offer a more consistent performance, cash flow and timing of exits, which makes them more straightforward to manage.”
More venture?
With some evidence that the cycle of easy credit for LBOs is over, are fund-of-funds looking more closely at venture capital funds? After all, research has suggested a renewal of investor interest in venture capital in particular in the UK.
Last year, venture-backed companies in the UK raised £1.4bn, up 27% on 2005. The increase is attributed to factors such as a growing perception among VC firms that the industry is finally bouncing back after the dot-com crash and the face that there was significant new fundraising by venture houses in 2005, which was put to use in 2006.
And it’s not just in Europe that venture capital is becoming more buoyant. In markets such as China, venture capital is growing even more quickly, at three times the rate of the UK.
There have been significant developments in European venture in the last few years. John Gripton of Capital Dynamics, says: “Nobody disputes the quality of European technology, but it hasn’t always been good at exploiting it.” But, he says, there is now a growing body of experience among European fund managers and repeat entrepreneurs, who have seen more than one company through the venture process.
The fundamentals of the European VC industry are very good, believes Gripton, particularly now that funds recognise the importance of being able to sell outside the European market. “We have a dedicated VC fund for Europe, although we’ve invested cautiously. But if returns improve I can see us increasing that.”
Others, however, seem closed to the idea of investing in venture. Mithras Capital’s fund-of-funds manager Gillian Brown says that venture capital will not feature: “It’s not part of our strategy and a lot of investors are still a little nervous about venture capital.”
LGT’s Tycho Sneyers said the fund has continued investing in European VC, even through the downturn. “And that’s turned out to be a very good investment decision because there have been some excellent investments made by European venture funds,” he says, adding that more capital is going to European VC houses.
“In some situations it pays to be somewhat counter cyclical,” he says, adding that it is still very important to be with the best managers. “You need to be selective because there are only a handful of European VC’s with the required experience and track record.” Among the VC funds LGT has invested in are Benchmark Capital (now called Balderton) and Index Ventures.
HarbourVest has restricted its VC investment mainly to the US, says George Anson: “We’ve always invested in venture in the US, but only in a handful of firms outside.” He notes that in the mid-1990s US venture capital was probably the best-performing asset class in the world and then there was the dot-com crash, after which it became the worst performing investment.
Before the dot-com collapse, HarbourVest raised a US$3bn US venture fund and a US$1.1bn buyout fund. “The US$3bn was one of the easiest fundraisings ever because people had made so much money out of venture capital in the mid-1990s, while the buyout fundraising was one of the hardest. Since then both have performed positively, but the buyout fund much better.”
But he argues that there is always a “herd mentality” that attracts investors to the asset class that has been performing best, even though return profiles are cyclical.
Many fund-of-funds managers, however, are sceptical about the attractions of venture capital. “Thanks to rising valuations in the buyout market and a perception that prices in the VC market are cheap, I’ve been asked a lot in the last two years whether we’re putting more into VC,” says Sam Robinson of SVG Capital.
But the problem, he says, is the huge gap between the best and worst performing venture funds compared with the buyout market. “In buyouts you’re investing in an existing company but in VC you’re taking a new company to market and you’re not sure if someone else in another part of the world has the same idea but a better product.”
Top down, venture capital looks attractive, believes Robinson, but less so in reality. “I wouldn’t say the leading fund-of-funds are looking at venture capital more, if anything it’s less because there’s a lot of effort involved to make a relatively small investment in venture capital.”
It is not just the risk attached to venture capital investments that is problematic for fund-of-funds, says Standard Life Investments’ David Currie, but also structural issues. These include the fact that venture capital funds tend to be less predictable than buyout funds and holding periods are longer.
Currie says: “Venture funds sometimes get all their money from one or two investments and the rest fail or don’t perform that well. To a large extent buyouts, on the other hand, offer a more consistent performance, cash flow and timing of exits, which makes them more straightforward to manage.
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