As the fund of funds industry struggles to raise fresh capital, it is changing in an effort to capture the imagination of institutional investors that are increasingly sophisticated and confident as they make more investment decisions on their own.
At the same time, new investors are committing less money to funds of funds. So, while established investors, like pension funds, “graduate” by making more of their own primary investments, the fund of funds industry is capturing a smaller slice of the private equity fundraising pie.
“The truth is that the industry is going to go through a period of consolidation. It’s already happening,” said Brooks Zug, senior managing director and co-founder of
The weaker climate for funds of funds is of keen interest to general partners, who are seeing the industry as a smaller source of capital than it used to be. At the same time, limited partners could gain sway in negotiating better terms and lower fees for the funds of funds that they do invest in.
One big investor that has gradually curtailed commitments to funds of funds is the
To be sure, an important factor in making successful primary fund decisions is the capacity to do the necessary legwork. A decade ago, said Sinks, the state invested in funds of funds because “Oregon’s staff was smaller and we did not have the resources to perform due diligence on small-to moderate-sized funds.”
Smaller Piece Of The Pie
Since the financial crisis, funds of funds have had more difficulty in raising new money than the global private equity industry at large, according to Preqin, the alternative investment data provider.
The portion of money raised by funds of funds shrank to 7 percent of the total raised by private equity firms last year, the first time that the share has dropped below 10 percent in at least five years. Moreover, the $13.3 billion that funds of funds raised in 2010 represents a mere 22 percent of the $59.5 billion that the industry raised in 2007, its peak year of 2007.
Fund sizes and the total number of fund closings have also shrunk, according to Preqin. The number of funds-of-funds closings was 60 in 2010 versus 176 in the peak year of 2007. The average funds-of-funds size was $259 million in the first quarter of 2011, down from $374 million in the peak year of 2007.
The drop in fundraising is leading to a greater concentration of money at the top of the fund-of-funds pyramid. According to Preqin, the top 10 firms captured 74 percent of all new money raised by funds of funds in 2010, compared to just 63 percent by the top 10 firms in 2001. Industry experts said this increasing concentration is due in part to the fact that new investors are less inclined to take risks with firms that haven’t yet established a long track record.
HarbourVest’s Zug said increased concentration will likely make life harder for newer funds of funds: “Players without a long track record, who may have been able to raise money in frothy times, will now have more difficulty.”
Michael Granoff, co-founder of
In part due to an extra layer of fees, the performance at fund of funds has not always been stellar. Research by Buyouts shows that many funds of funds deliver mediocre profits (39 funds of funds surveyed with vintages between 1985 and 2003), with average and median return multiples of 1.1x when we last looked at performance in mid-2009 (Buyouts, November 16, 2009). The median IRR for the 27 funds of funds that were surveyed was 9.1 percent.
Another challenge for funds of funds is that LPs have become more sophisticated as the industry has evolved, said Bondurant French, chief executive and founder of
French, whose firm pioneered funds of funds and today manages $22 billion, said the main factor that LPs consider when deciding to invest in funds of funds is scale. “Our clients are likely to be newer to the asset class… But as you move up in size as an LP, you’re more likely to have your own staffs to do investments, and the bigger you get… the more likely you are to want to further reduce your private equity costs by doing direct investments.”
Zug of HarbourVest agreed. “Many LPs are becoming more sophisticated. They are making more of their decisions themselves, and they want more flexibility in the product offerings.”
Funds-of-funds firms have answered clients’ calls for more flexibility by creating a more diverse line-up of strategies and investment vehicles, especially “a la carte” funds, such as secondary funds, co-investment funds and Asia-focused funds.
HarbourVest, for instance, launched a dedicated secondary fund in 1991, a co-investment fund in 2004 and an Asia-focused private equity fund in 2007. Pomona Capital also has an extensive line-up of secondary and co-investment offerings, as does Adams Street.
Such specialized funds, said Zug, are one of the reasons that some firms have been able to increase assets and keep long-time clients, even as more of those clients make direct investments to primary funds. By diversifying into niche funds, even LPs that have grown more sophisticated, but which lack expertise in a particular strategy, can invest in areas that help diversify a portfolio.
Although additional diversification makes funds of funds less likely to deliver the 3x-plus returns that some top-performing primary funds sometimes offer, the extra diversification does gives investors an extra level of protection during times of upheaval, like the financial crisis, when funds of funds performed well compared with some private equity funds.
Another advantage of funds of funds is that they are better prepared to take smaller “bite sizes” than many large private equity funds. And, there is the due diligence that funds of funds perform.
But the promise of access by funds of funds to top-performing private equity shops “is not what it once was,” according to Pomona’s Granoff. “In a capital constrained environment, the access argument clearly is not what it was five years ago. And that removes one of the value pillars of the fund of funds industry,” he said.
Obviously, as mentioned earlier, funds of funds carry extra fees (frequently, a 1 percent management fee, while some funds tack on an additional carry charge if returns reach a certain level). By definition, these fees lessen returns available to investors. Ultimately, said French, “funds of funds have to add enough performance to justify their fees.”