Challenges or opportunities?

In the February 2004 article Fund of Funds are Here To Stay, Jesse Reyes, managing director Reyes Analytics, outlined the history of the explosive growth of the private equity fund-of-funds vehicle. That article discussed the basic reasons why fund-of-funds are so prevalent and the reasons that investors would choose the fund-of-funds vehicle over direct investment in funds. Here Reyes takes a look at further developments in the fund-of-funds space over the last year, updating some of the observations in the last article given the current fund raising and performance environment and discussing some of the ongoing and new challenges.

The private equity industry continues to be among the favourite of the alternative investment options available to institutional investors. Commitments to venture funds and buyout funds have finally stabilized over the last quarters to levels that are consistent with levels seen in the mid 1990s. While it is a more competitive environment for funds on the fund raising trail, institutional investors have not abandoned the industry, they are simply more cautious in their allocations and their mix of venture and buyout groups. This portends that the industry will continue to be self-selecting over the next several quarters with the best funds having little trouble raising money while the rest struggle to find new investors or convince old investors to re-up.

Among one of the factors that have made this cycle a critical crossroads for funds that are out seeking new capital is the fact that some LPs have decreased or eliminated VC allocations. Others only want top-quartile or even top decile players. The rest are moving some of their allocations to buyout funds.

Pension funds also have a critical actuarial timeline they need to meet in the next 12-15 years so have substantial expectations. Private equity may not meet these expectations by itself given the current returns profile of the industry so they are looking for other ways of increasing the overall return to their portfolios.

Hence the interest and explosion in hedge funds and other absolute returns vehicles. Institutional investors are drawn like moths to a flame to vehicles that will help increase overall returns albeit at increased risk levels. This will continue to provide considerable competition to private equity programmes at key institutional programmes.

It is likely that hedge funds and their kin will be subject to some sort of event which will draw intense scrutiny on these type of vehicles. Not to say that private equity is immune from making mistakes, but in any event private equity will receive shrapnel from this scrutiny, not only because they have similar structures, but many private equity groups are starting or investigating starting hedge vehicles.

In the US, SEC oversight of the private equity industry is a real threat to the relatively isolated environment that the industry has enjoyed over the last forty years.

Disclosure and transparency will continue to be a factor – can you say Freedom of Information Act? As a result there is an increased bifurcation between the funds that don’t care about disclosure and those that do. On the other hand are the LPs who are scared that their particular vulnerability to disclosure will lock them out of funds they desperately want to invest in or keep.

Fair value valuations are coming to the global industry. In reality they’ve been here for a while but will have profound implications for the industry as they are adopted and become mainstream standard industry practice.

What does this mean for Fund of Funds? What this means is they are both beneficiary as well as malificiary of the more competitive, fragmented and increasingly confusing, fund raising environment. What these changes also mean is that there will likely be a new form of vehicle for private equity investment to evolve into over the next few years. These type of changes are the catalyst for finding opportunistic ways to take advantage of new inefficiencies. The fund-of-fund vehicle was formed as a result of profound changes in the industry some twenty years ago when institutional investors found it was not as easy to invest in private equity as it first appeared.

The February 2004 EVCJ article outlined several reasons that investors choose this vehicle. In summary:

§ Lack of manager selection expertise on the part of the limited partner

§ Lack of resources on the part of the limited partner for administration and investment management

§ Access to otherwise inaccessible funds

§ Scaling up and leveraging small investments

§ Lower risk in new markets

§ Diversification

§ Optimisation of the Manager Risk Coefficient (MRC)

For more discussion on these topics please refer to the aforementioned article in EVCJ’s end of year review February 2004, page 28.

What is important to take away is that the fund-of-funds vehicle grew out of specific needs that have not abated and in some ways have increased.

As a result everyone wanted to start a fund-of-funds – first the largest independents, then the investment banks, then the consultants. The reason for this is pretty easy to see – a simple private equity investment advisor with a discretionary mandate has a client only for as long as the client is happy. However, getting an investor into a fund-of-funds means they have a client for 10 years. One anecdote is that a few years ago a large foreign bank investor wanted introductions to several private equity advisors in the US who would manage their US$50m investment. They called several months later to say that no-one wanted to manage the money, but everyone had room for them in their fund-of-funds.

It’s hard to find any pure consultant nowadays who hasn’t tried the fund-of-funds or advisory business – after all if one is going to make investment recommendations, why not create a vehicle to make it easy to execute or implement those recommendations. This is not an indictment of the industry, but an indication of just how much the world has changed in a decade. Just remember that fixed fees for 10 years are pretty seductive.

Funds-of-funds continue to grow

After a brief haitus in 2003 where the number of fund-of-funds raised globally was only 22 funds for a total of little over US$4bn, a figure that was the lowest in over seven years, 2004 has seen commitments to funds increase as 37 funds have raised a little over US$6.2bn as of September 30, 2004 – see figure 1.

For the first time, capital under management by fund-of-funds vehicles has now topped US$100bn globally – see figure 2. Whether this will continue will depend on how critical limited partners view the perceived value of these investment types. There are no generic formulas anymore for what type of investments these funds make. Some continue to invest purely in other funds for typical fees and carry, while others have diversified by adding secondary investments in LP interests and direct portfolio company investments. This type of investing does complicate the job of the LP in deciding how much to allocate to a fund-of-funds so that the investment doesn’t duplicate current portfolio composition. Some of the more comprehensive portfolio management packages for the private equity industry have spent quite a bit of time developing the capacity to drill down to individual company investments even through a fund-of-funds. This indicates that portfolio composition is being monitored by institutional investors who are not taking portfolio composition for granted.

Firms managing fund-of-funds have become larger. The average firm size managing these vehicles is over US$550m – see figure 3. Although this figure has shown signs of peaking over the last couple of years as the industry has slowed down its commitment pace, there is no reason to believe that fund-of-funds will have a downsizing. While there has been a consolidation of sorts with the mergers of groups such as Frank Russell and Pantheon, this will only increase the size of the average firm through consolidation. That LPs are committing relatively more to fund-of-funds is evident in figure 4 where the US$6.2bn raised so far in 2004 is over 9% of the total committed capital for the year which means 2004 is one of the top 4 calendar years based on this measure.

Darwin hasn’t excluded fund-of-funds.

Until the late 1990s it seemed that fund-of-funds were a sure-fire bet for any pension fund that needed to accomplish any of the aforementioned factors. The explosion in the number of fund-of-funds managers in that same time period however meant that all of a sudden, it might be necessary to do more due diligence and use some manager selection criteria in investing in this part of the private equity market.

It is no longer a foregone conclusion that an investor can simply pick a fund-of-funds and get the results they expect. Fund-of-funds are not generic investment vehicles. They take different approaches at developing their investment style just like any other investment manager. Some continue to invest only in other funds. Many have added direct investment in portfolio companies and in secondary LP interests. Some have gone the securitization route.

So the challenges for picking a fund-of-funds are just as difficult and some would say more difficult than investing directly in funds. Why? While there have been a fair number of studies by the information players in the industry as to the structure and the history of these vehicles, there hasn’t been a comprehensive performance review of the fund-of-funds sector. For the most part, investors have relied on the generalized private equity benchmarks published by Venture Economics or Cambridge Associates and made comparisons to the overall averages based on portfolio life cycles.

Some investors feel the fund-of-funds industry has evolved to the point that more generalized benchmarks are probably apropos in addition to private equity specific benchmarks. The CFA Institute/GIPS performance guidelines, for example, indicate that the more generalized a investment manager is in their strategy, the more appropriate a time-weighted return is versus an IRR. So this is a rationale that investors in fund-of-funds might be well served using public market indices as well as private equity benchmarks in evaluating performance.

What do recent performance results mean for fund-of-funds?

Obviously, one rationale for investing in fund-of-funds is that is optimizes the return to private equity portfolios relative to the cost of investing those portfolios. At least in the US, the primary reason for investing in fund-of-funds has been access to elite groups. Given the number of fund-of-funds vehicles that have been raised, it is hard to rationalize that all these funds provide the access required for superior performance.

Based on the most recent statistics published by Venture Economics, the returns to the private equity industry are slightly above 14% in the US and 9.4% in Europe (figure 5). At these levels, pension funds are looking for other ways to make up the actuarial shortfall they must be feeling as these private equity investments were made with a substantially higher expected rate of return.

Without access to the best funds in the industry, a typical fund-of-funds manager would be hard pressed to meet the performance criteria for investment, so the other factors cited at the beginning of the article have to be reason enough to make fund-of-funds investments.

For some LPs that will have to be enough, but in the end, performance will have to be high enough to meet performance expectations or the fund-of-funds industry will suffer a contraction. The jury is still out as to whether the explosion in the number and size of the fund-of-fund’s portion of the private equity industry will ultimately pay off.

Jesse Reyes is principal of Reyes Analytics, a private equity research consultancy based in Summit, NJ. Reyes was formerly vice president, global research of Thomson Venture Economics. He can be reached at