A Growing Class of Middlemen –

As private equity becomes less of a mystery to mainstream investors, more and more limited partners are allocating capital to the asset class. Among the limiteds showing interest are a number of smaller institutions and endowments without prior exposure to the marketplace. For these uninitiated investors-to whom admission to top-tier, high-vintage-year funds may be out reach-one of the easiest ways to merge into the crowding, relationship-oriented world of alternative assets is through funds of funds.

In addition to serving as an entryway for newcomers, funds of funds can also serve as a sheet anchor for returning institutional investors that haven’t been able to reach the desired performance with their past efforts. Part of this comes from access, but much of it also is a result of having sufficient resources to pore over the 350-plus funds in the market. Small institutions, with a staff of four or five, just can’t always perform the due diligence to truly succeed.

“There is an explosion of demand, primarily from new investors coming into the private equity asset class, many of them first-time investors,” observes Marc Sacks, a senior managing director at Chicago-based fund-of-funds manager Mesirow Financial. “They’re looking to funds of funds to provide professional selection, as well as put together a portfolio that is appropriately diversified.”

The capital influx to the fund-of-funds market is being noticed up and down the industry’s spectrum. Indeed, some larger fund-of-funds managers, such as Adams Street Partners and HarbourVest Partners, are having to cap their funds with plenty of LP interest still buzzing around, says one FoF manager.

The fund manager went on to note that demand for his own large-cap FoF, which is currently in the market seeking capital, has been brisk. “Our own fundraising was filled up in record time. It was about a month between the time we sent out our PPM and had our first closing,” the manager said.

Calls placed to Adams Street and HarbourVest, meanwhile, were not returned by press time.

A cross-section of the FoF market’s most recent decade makes it plain to see that LPs are increasingly seeking out assistance when it comes to placing their private equity commitments. In 1994, approximately $1.06 billion in fund-of-funds capital was raised, according to Thomson Financial (publisher of Buyouts). Fast forward to 2004, when the amount of fund-of-funds capital raised increased more than 10x to about $11.9 billion, and the market’s growth becomes evident-not to mention the $22.3 billion and $15.5 billion raised in 2000 and 2001, respectively. And according to recent data compiled by Buyouts, 2005 has already seen more than $9.2 billion of fund of funds raised through Q2 (see accompanying list of select 2005 FoFs).

What’s in the Suitcase?

Like every niche in the private equity market, more capital means more competition. Those in the FoF game have no doubt that the proliferation of funds of funds has heightened the contest among the asset managers. The past explosion of fund-of-funds investing, however, differs from today’s rush. “Five years ago it was fine just to be a fund of funds and provide limited partners with access-now you have to prove your value,” says Catharine Burkett, head of the FoF operations at Baltimore, Md.-based Camden Partners Holdings LLC. “[Limited Partners] are paying fee-on-fee to go into a fund of fund, so it is more important that there be some character, theme or strategy that makes you different from the person down the hall.”

Indeed, the approach is key. Fund-of-fund managers promote everything from fund size and geographic focus to levels of diversification between vintage years and asset classes (venture, buyout, special situations, etc.). Other managers take more specialized approaches to set themselves aside from the pack. Parish Capital, a Chapel Hill, N.C.-based fund-of-funds manager, for instance, chooses to target emerging managers exclusively, confident that its due diligence process will vet out the funds destined to surface as “top tier funds in this decade,” according to the firm’s website. Meanwhile, Wilton, Conn.-headquartered Commonfund chooses to differentiate itself through its LP makeup, offering top placement in its products exclusively to mission-based public benefit nonprofits, such as smaller colleges and universities and healthcare organizations.

Mesirow, meanwhile, prides itself on limiting its number of investments while maintaining a focus on diversity. “It’s a real problem for the bulge-bracket fund-of-fund managers who are still trying to plow $1 billion into venture and buyout funds per year,” Sacks says. “Where some of the larger guys might invest in 25 or 35 funds per year, we seek to invest in about 10 or 12 funds per year. Not having pressure to invest money is a key predictor of success. You can have the experience, you can have the access, but if you’ve got too much money pressuring you to invest, most folks at the margin will make marginal decisions.”

And while no investment pro will admit to making rushed decisions to meet their investment quotas, one FoF pro told Buyouts, “It happens all the time. It happens in periods like the one we’re in now, when there begins to be some froth in the market, everybody jumps in and they don’t necessarily look where they are going. Mistakes are made in periods like this, but you can also get lucky.”

The Return Factor

Regardless of how fund of funds choose to go about differentiation, one thing they all have in common is the promise of access: to top-performing general partners, to large-cap funds with minimum-investment requirements too tall for smaller LPs, to high-roman-numeral funds with deep existing loyalties, and so on.

While the hope among FoF managers (and their LPs) is that through the access will come strong returns, some data suggest that FoFs are underperforming the LP community.

A 2004 study entitled Smart Institutions, Foolish Choices?: The Limited Partner Performance Puzzle, conducted by Harvard Business School professors Josh Lerner and Wan Wong, and Antoinette Schoar of MIT’s Sloan School of Management, agrees that fund of funds have earned their seat at the table, calling them an “increasingly important LP” in today’s private equity arena, but goes on to say that funds selected by investment advisors and fund of funds tend to “lag sharply” behind other LP groups. (See page 39 for interview with Lerner.)

The study, which took into account a sample of 7,587 investments by 417 LPs in 1,398 U.S. private equity funds with vintage years between 1991 and 2001, observed that investments made by funds of funds show an average IRR of -1.8%, while funds selected by endowments, public pensions and insurance companies came in lower than 5.5 percent. (Endowments boasted the highest mean IRRs, clocking in at 20.47 percent.)

FoF managers maintain that such statistics are not a result of poor fund placement, but rather the diversified nature of their product. Because funds of funds could potentially represent an LP’s entire allocation to private equity, it behooves them not only to find the top performers, but to invest judiciously across asset classes, industry sectors and vintage years, as well.

That said, some fund-of-fund managers do agree that, in their arena, there is an inherent conundrum between diversity and returns. Abbott Capital Managing Director Charles van Horne, however, maintains there is also a herd mentality in the private equity community that fund of funds intrinsically protect themselves against by keeping to investment strategies that are defined by cautious diversification.

“Two or three years ago, the big theme in the market was that the big buyout groups couldn’t possibly invest all the capital they’ve raised-that they will invariably end up just sucking down the [management] fees and the limited partners are going to get sub-standard returns,” he says. “But if you missed the large buyout segment over the last two or three years, you would have missed out on the bulk of returns in the asset class, because the larger funds ended up being the ones in position to take advantage of the opening of the capital markets. To me, that really highlights the need for core diversification.”

Mesirow’s Sacks adds, “You have to be able to identify top-tier managers and get into them; that is absolutely necessary, but it’s not sufficient… In addition to strong access, you have to overlay a thoughtful strategy of diversification. One doesn’t work without the other. Without good managers, the diversification doesn’t matter because you’ll just have a diversified portfolio of mediocre performers. But without the portfolio diversification, you may have more beta, or more volatility, than you want.”

So in an age when many endowments and pension funds are reducing the numbers of GP relationships they foster, fund of funds continue committing capital to as many as 10 to 30 private equity funds per year. In today’s breakneck fundraising environment, fund-of-funds managers say there is no shortage of viable vehicles in which to invest. “There’s never trouble signing LP agreements,” says the FoF manager whose firm is currently fundraising. “The issue is, are you doing it in a measured way?”