Coping with change

Managers of fund-of-funds (FoFs) are under no illusions that this year will be a tough one, with a slump in fund raising by buyout houses and far harder conditions facing traditional private equity investors like pension funds and insurance companies.

“Anyone trying to raise money in this environment faces a difficult task because there’s not much money around and many institutions find themselves over-committed,” says Sam Robinson, a director at SVG Advisers. He adds that SVG would love to raise money for another fund, but knows that now would be a challenging time.

Nevertheless, says Robinson, the level of over-commitment is more of an issue for institutions that were directly investing in private equity funds, rather than those more likely to enter the market via FoFs. “The average county council pension fund was probably less aggressive in its investment strategy and may have money still to invest,” he says.

Overall, while there are obvious challenges facing the private equity industry, Robinson argues that compared with other asset classes, it doesn’t come out too badly. The ‘denominator effect’, which is hitting investors’ asset allocations, is clearly important, he acknowledges.

“We’ll have to wait until the end-of-year numbers are out to see if that eases, but there are still arguments favouring private equity FoF fund raising, such as the fact a lot of institutions were invested in hedge funds and have had problems there. They’ve also had a tough time in property and the public markets. In a way, private equity can be seen as the least bad investment option.”


George Anson, managing director of HarbourVest, says that everyone recognises that fund raising will take longer and be more difficult but that there is not a noticeable lack of interest from clients. “It’s about the wherewithal – the spirit is willing but the balance sheet is weak,” he jokes.

The news is not all bad. Anson says he was recently making a presentation to pension fund trustees and pointed out they had done very well out of the sale of two life science companies made by two different venture funds in which HarbourVest was invested, making a return of 10x money. “That sort of investment is a counter cyclical play and it was great to be able to tell these investors that they’d actually done very well in that part of their portfolio,” says Anson.

Robinson notes that there is still demand from clients for certain products outside the larger LBO area: “There’s demand for mid-market funds, VC and Asia products as many institutions are still underweight in Asia.”

Another area where there continues to be substantial demand is secondaries, according to Vincent Gombault, head of fund-of-funds at AXA Private Equity.

Gombault says that many in the market think the secondary market is ripe for investment, with some funds-of-funds snapping up what they believe are bargains: “But mistakes are being made. The market has been overheating for some time, so values are likely to fall further. Taking a conservative approach to investment opportunities and deploying capital with caution is the way forward. We’ve been extremely disciplined about our investing and don’t believe values are at their optimum. Prospects are good, but timing is the key.

“Of course, some investors will apply pressure on fund managers to utilise capital. It’s important that investors trust fund-of-funds to continually research the market for opportunities. In turn, managers must earn their confidence by demonstrating that they have the experience and market knowledge to wait for the most apposite time to invest.”

Good relations

Despite the interest in these other markets, it will be a very tough year, and the number one priority is maintaining relationships with existing clients, says Anson. This means communicating with them about what is going on and trying to do as good a job as possible, in the hope that the next time there is a fund raising the clients will be there to invest. What this means in practice is, for example, helping clients understand what is likely to happen with their private equity valuations.

John Gripton, a managing director at Capital Dynamics, says that fund raising has slowed significantly both for private equity managers and for FoFs, as a result of the denominator effect. “Clients are trying to assess the effect on year-end private equity valuations, knowing about what’s happened to quoted equities, which make up the bulk of portfolios, but not the valuations of private equity.”

When these valuations are known, he says, it may ease the pressure on investors because it is quite possible private equity will not represent such a high proportion of portfolios after valuation adjustments.

There is currently a greater focus on monitoring the existing funds and understanding how portfolio companies are doing, he says. “There is a greater need for communication between us and our clients and also with our GPs, not necessarily formal communication but just talking more to each other and passing on important information.”

Anson says that HarbourVest has been trying to help its clients understand the likely impact of valuation changes. It has developed a formula, based on various factors, to enable clients to get a more detailed estimate of the impact on their private equity investments.

He says: “Our formula is based on taking the relevant stock index sector movements (telecoms, consumer, etc.) and weighting it according to our own funds’ sector diversification then aggregating that to arrive at a best guess at year-end valuations.

“The reason for doing this, for example, is that our underlying private equity funds are very underweight in banking and insurance whereas the indices are not. We then take into account year-end public company values and closing foreign exchange rates.”


Bruno Raschle, managing director of Swiss fund-of-funds Adveq, says: “Last September we went through a stress testing of the investments held by our clients and shared with them the estimates of what the numbers on their 2009 end-of-year balance sheet would look like under various scenarios.”

Raschle believes, in the context of asset allocation models, a new “language” will need to be developed so that private equity managers and institutional investors can communicate more clearly with each other and understand the role of private equity on a risk-adjusted basis in clients’ portfolios.

He says: “Private equity has been treated as an ‘alternative’ for far too long. It has reached a stage where it does fulfil a role in a portfolio of assets on a risk-adjusted basis. The reporting and sharing of information between managers and investors must therefore follow this new dynamic.”

As well as more transparency, investors are likely to continue putting pressure on fees, both of GPs and FoFs. Anson says that the pendulum has swung back in terms of the relationship between FoFs and GPs. “Terms are more negotiable, as are transaction fees, management fees and fund sizes. All these elements are on the table for discussion and GPs are listening.”

Gripton says that over time there has been a move from a straight management fee to a management fee plus incentive fee linked to carried interest. “That means a significant part of our fee is linked to the uplift in value and this trend has also been reflected in the fees we pay GPs.” Management fees charged tend to cover day-to-day running costs, while the larger part of the overall fee is linked to performance, he says.

Filling the information gap

FoF managers argue that there is still a genuine role for them in a bear market.

According to Gripton at Capital Dynamics, the fact that in private equity there is a big gap between the top and lower quartiles means that research into the best funds is crucial: “It’s a labour-intensive activity and you get economies of scale with a FoF, so I think FoFs or advisers will be essential for many investors going forward because there will be significant changes in the private equity world, as people leave the market and we enter another cycle. It’s going to be even more important to understand the internal dynamics of private equity managers. In addition, problems accessing top managers will persist due to the flight to excellence as well as consolidation.”

SVG’s Sam Robinson agrees: “A few years ago many institutions thought they could stop investing in FoFs and invest directly in funds but a number of those investors will now have found they haven’t done that well and that maintaining an experienced investment team is expensive. I would hope that we’ve selected managers that have done better and I’d say that, unless you have a portfolio of more than £100m, it makes sense to use a fund-of-funds.”