Cocktail Investors Return To The Party

Feeder funds, last seen in the buyout market in large numbers in 2000, are back.


recently raised a feeder fund, channeling more than $700 million from wealthy investors into Kohlberg Kravis Roberts & Co.’s 2006 buyout fund. Deutsche Bank has arranged feeder funds targeting a number of funds for The Carlyle Group, according to sources, and Goldman Sachs, meantime, is said to have raised a large feeder fund for Thomas H. Lee Partners’s sixth fund, which has a $9 billion target and has closed on $7.5 billion so far. Each firm declined comment.

Earlier, UBS raised a $500 million feeder fund for The Blackstone Group’s fifth fund, closed in 2006, and $550 million for Carlyle Group’s fourth fund, closed in 2005, according to regulatory filings. Other firms that reportedly have used feeder funds to fill their coffers include Apollo Advisors, MatlinPatterson Global Advisors, Quadrangle Group and Silver Lake.

Altogether, Buyouts has identified seven feeder funds raised since 2005, accounting for some $1.9 billion altogether. While details about feeder funds are extremely scarce, it is safe to say that the volume of feeder fund activity, part of the $198 billion raised by U.S. buyout firms last year, is growing.

In fact, bankers say that most buyout firms raising funds of $2 billion or more at least consider taking money from feeder funds. On a number of occasions, feeder funds themselves have grown to more than $1 billion in size, gathering dollars from hundreds of investors that pay fees to get access to the big-name funds. Sometimes these investors pledge as little as $250,000, and get access to a fund with a $25 million minimum requirement.

Why are feeder funds so popular right now? Perhaps the biggest reason is that they give wealthy investors and smaller institutions a chance to diversify their portfolios of stocks and bonds into higher-risk assets managed by names they trust. At the same time, they have the virtue of giving investors a chance to hand-pick their own LBO funds—a privilege denied them in co-mingled funds of funds. For general partners, feeder funds represent an easy way to raise capital for their ballooning war chests, as well as a means of diversifying their investor base.

If there’s a dark side to the trend it lies in the instability of the capital source. In past cycles, wealthy investors gained a reputation for leaving the buyout market as fast they got in. In fact, investors in feeder funds are sometimes referred to as “cocktail investors,” because they often hear about investment opportunities, and brag about ones they’ve found, while chatting with colleagues and friends at cocktail parties.

“There is clearly a component of panache of getting access to certain individual managers,” said Paul Weisenfeld, COO of Citi Global Wealth Management Alternatives Investments.

Who’s Creating Them?

Citigroup, JPMorgan, Merrill Lynch and UBS are among the most established players in the feeder-fund market. But every major investment bank is active on some level. Any one investment bank is likely to be selling one to three feeder fund products at a time, and to be placing perhaps four or five in a year, bankers said. A good guess is that a few dozen feeder funds are raised each year altogether.

Citigroup typically will only have two or three private equity offerings available at any one time. This is because it takes time to educate investors about a fund. “It’s incredibly difficult to make five, ten or fifteen funds available at any given time,” said Weisenfeld. “It may take years to educate a client on private equity and the last thing you want to do with a high net worth client is say, ‘You have to move now,’ after they made their first allocation.”

While banks typically target brand-name firms with feeder funds, not all do. Morgan Stanley, which has been ramping up its activity, recently placed $150 million through a feeder fund with CDH China Holdings, a growth capital firm based in Beijing. Morgan Stanley declined comment.

Each bank maintains its own requirements on who can invest in a feeder fund. At Morgan Stanley, for example, feeder fund investors need more than $5 million in net investable assets—which basically means liquid assets—to satisfy the Securities and Exchange Commission’s qualified purchaser rule. In addition, their assets must total at least 10 times the minimum commitment of the feeder fund, said one person familiar with the matter.

Speaking more broadly, the minimum commitment to a feeder fund is rarely lower than $250,000, and typically is in the range of $250,000 to $500,000. In some feeder fund products, clients are able to co-invest with general partners. Investors typically pay a management fee of 1 percent to 1.25 percent on feeder funds, and may also have to pay an upfront placement fee. It is not entirely unheard of for feeders to charge a carry, said Weisenfeld.

Feeder funds typically range in size from $100 million to more than $1 billion, with $200 million being a sweet spot. The smallest are $50 million in size, since anything below that costs too much to administer to be lucrative. As a general rule, feeder funds account for about 10 percent of the size of the funds they back, and GPs usually limit taking money from just one feeder fund, said bankers. The smallest funds targeted by feeder funds for commitments are probably around $1 billion, though $2 billion is a more common floor, said bankers. Indeed, one fund manager who closed a $1.2 billion fund recently had never even heard of them.

I think it’s a natural product of what’s happening in the marketplace. Funds are getting larger. There’s more appetite for the asset class.

—Marco Masotti

Within a feeder fund, wealthy investors vastly outnumber any participating institutions, but institutions often make bigger commitments. Feeder funds typically take at least 50 investors but no more than 499, since with more than 500 investors, the feeder fund would no longer qualify as a private placement.

One new twist in feeder funds today is the use of a feature called “warehousing.” Similar to the way in which they underwrite an IPO, banks commit to a buyout fund in advance on its own balance sheet, then syndicate the fund out later, said sources. While banks don’t want to keep the warehoused commitment on their balance sheet for long, warehousing helps feeder-fund sponsors manage their relationship with investors. When marketing a fund, “you can market contemporaneously, or you can do it afterwards,” said Weisenfeld.

Growth Ahead

For now, there doesn’t appear to be anything stopping the feeder-fund trend.

One of the biggest factors behind their growth is the desire by fast-growing buyout firms to find capital anywhere they can. “I think it’s a natural product of what’s happening in the marketplace. Funds are getting larger. There’s more appetite for the asset class,” said Marco Masotti, a partner with Paul, Weiss, Rifkind, Wharton & Garrison. Masotti recently worked with a GP raising a $2.5 billion fund, which in turn had a $100 million feeder.

Another reason for their popularity are improvements in the technology underlying their administration, said one banker. Part of the annual management fees charged to the investors goes to offset the cost of sundry accounting, reporting and tax issues, which can be “a huge back office headache.” In the past several years, said the banker, the process of forming and managing feeder funds has become more efficient.

On the demand side, feeder funds help individual investors build out their portfolios of alternative investments. They get exposure to private equity, and, for those who have been in the asset class long term, they get to build a multi-year, multi-geography portfolio of LBO funds.

Because of the low minimum commitments, wealthy investors can also build a whole portfolio of buyout funds using feeder funds, said Weisenfeld. They can choose among LBO firms that give their portfolios exposure to technology or software investments, for example. The feeder funds also allow them to diversify over time, across several vintage years.

One banker said he thinks that wealthy investors, like many smaller endowments and institutions, found themselves underallocated to alternatives in the early 2000s. They are now pushing the needle back. “I think the driving force behind the growth in feeder funds is more of a search for the right balance in portfolios for investors more than it is a sign of cyclicality or the market being at a peak,” he said.

Sign Of Market Peak?

But others in the industry do warn that the avalanche of feeder fund activity is a sign that the buyout market is peaking. The last time the rich moved in large numbers into private equity was in late 1999 and 2000. They quickly retreated with the start of the bear market that followed.

Bankers also caution that the feeder fund market is glutted with clients who don’t understand private equity but, having read about Blackstone or Carlyle in the newspaper, want to be able to boast about their LP status.

“What you typically find is that when private equity gets hot, there’s a certain class of high-net-worth investors that pour into the asset class,” said one investment banker who has been creating feeder funds in the late 1990s. “When people load into feeder funds, that’s the top of the market. You can actually chart it. The last time a peak hit was in late 1999 and early 2000. By summer of 2000, the floor of the high-net-worth volume had fallen out.”

The investment banker said a correction in the public equity market is usually enough to send wealthy investors running.