Eastern Expansion

Although European fund-of-funds investors might be happy just to take some exposure to a European fund, the escalating needs for investment portfolio diversification and generating enhanced yields continue to shift a large part of market emphasis towards to the Asia Pacific and South Asia regions.

“There’s a lot more money around this year in China than there was last year. Some funds that had representative offices in Beijing and Shanghai now have a full presence,” says Constant Tang, executive director of Latitude Capital Group in Hong Kong.

Although Asia may be an unknown concept for many funds, as each quarter passes valuations are being boosted because of healthy liquidity flowing in the growth markets, adding more pressure on investors to take a stake. Some might define that as hype.

Fund-of-funds players such as Adams Street Partners, AXA Private Equity, Hamilton Lane and The barriers to debuting as a private equity investor may well be cultural in many cases but the long-term investment perspective is just too long-dated for some institutions keen to generate shorter-term yields on their capital.

Investing in a mezzanine fund-of-funds could be the compromise, offering some investors access to private equity and also guaranteeing early liquidity.

“It is something that if you can provide early liquidity for investors, it is always a positive. However, investors do need to be aware that private equity is long-term,” says Philipp Gysler, a partner and head of private alternative investment strategies at Partners Group in Baar-Zug, Switzerland.

“Early, stable distributions are important for many of our investors,” says Jeremy Golding, managing director and founder of Golding Capital Partners in Munich. “Our 2005 mezzanine fund-of-funds has already paid out its initial distribution of about 2.5% earlier than expected within seven months of final closing.” The fund closed at €200m in June 2005.

“The early distributions were attractive from a cash-planning perspective. A typical buyout J-curve would still have been unpalatable for many of our clients,” says Golding.

“Many investors new to the asset class were simply not in a position to bear the three-to-five-year drought of the typical J-curve, which was the driver behind structuring a mezzanine fund-of-funds with its earlier returns,” he explains.

Golding Capital Partners has partnered with VCM Capital Management closing their second mezzanine fund-of-funds – VCM Golding Mezzanine II ¬- significantly above target at €238m in August.

Golding is going it alone now having developed and structured a third-generation product, combining buyout and mezzanine fund-of-funds. The main innovation is a guaranteed 5% coupon from the day of signing for five years.

“This is unique in that it provides investors with exposure to buyouts, but without any J-curve at all. And a €35m warehousing facility has enabled us to kick-start the investment process before the fund was even launched,” says Golding.

Golding Capital Partners operates in a double niche in a sense because its investor base is made up almost exclusively of German institutional investors.

Regulatory and supervisory constraints are a major burden for German institutional investors, such as the regional savings banks, insurance companies and pension funds. Golding Capital Partners focuses on solving the problems of these sophisticated investors, who have to fulfil a whole range of complex regulatory, tax, legal and supervisory issues. Investments through the funds-of-funds are made on a global basis.

“We have structured several funds as Luxembourg SICAVs which provide significant advantages from a tax and regulatory perspective. They have also in the meantime become more widely recognised by German institutions,” says Golding.

Partners Group all appear to be at home in Asia, but is the taste of east just too exotic for other managers?

The near double-digit economic growth rates in India and China make it clear to some more experienced private equity players in the region. It’s not whether to have an allocation, it’s about how much to allocate.

“Everyone’s looking into Asia and everyone’s looking into venture again. We are increasingly hearing in Continental Europe that chief investment officers are beginning to ask for private equity and hedge fund investments from their teams,” says André Jaeggi, managing director at Adveq in Zurich.

“We clearly see a need for additional niche exposure. The fund-of-funds culture is changing to the degree that it needs a more specialist approach, whether that is the regions or the investment stage that it focuses on. Gaining access to smaller or specialised funds is easier if you take a specialist approach yourself,” he says.

While the investor base for many European fund-of-funds has generally been sourced from institutional investors and banks in the region itself, interest is emerging from much further away. This new-wave investment flow has been stimulated by demand from the large pension funds in locations like Sydney and Hong Kong.

“Over the last two years we have seen increased interest from investors based in Asia and Australia. We have investors in all the Asian countries,” says Tycho Sneyers a partner at LGT Capital Partners in Pfäffikon, Switzerland. “Asia is definitely less mature than Europe, which is less mature than the US.”

“There’s clearly investor demand for the Asia Pacific region,” says Sneyers. “We’re interested in that area but we would be cautious and would also advise our investors they need to be cautious.”

“I’m a bit surprised about where the money is going to with everyone looking at Asia. Asia has possibly attracted more people because there is more of a listed equity experience in those emerging markets,” says Petteri Änkilä, Amanda Capital’s CEO in Helsinki.

One development in the Asia Pacific region this year was the announcement by Portfolio Advisors and UOB they were setting up a joint venture to launch a new SG$200m (€99.8m) Asian fund-of-funds. This is the first time that a Singapore-based institution is launching such an Asia-focused fund-of-funds.

Taking an investment approach on a regional level, new entrants will typically pick one fund for the US, one for Europe and eventually one for Asia. However, investors are making it clear from the outset that they do not want a one-fits-all global fund-of-funds approach, fund managers agree.

In Europe

Europe-originated fund-of-funds business has the potential to grow at healthy annual rates thanks to very different investor stories. There are new investors raising debut allocations for the private equity asset class and although more experienced investors are starting to manage some of their investment processes in-house, they are still using the fund-of-funds route to top up their private equity exposure.

“Certain investors are becoming more experienced and are using fund-of-funds to cater for their satellite investments,” says Sneyers. “It’s a continual cycle with new people coming in and experienced investors doing some of their own investments and using fund-of-funds for niche products.”

Fund-of-funds managers across Europe are developing relationships with first-time investors that may have little or no experience and what experience of private equity they do have has largely been limited to their home markets. In some European countries that translates into a rudimentary exposure to the private equity world.

“While smaller investors look to fund-of-fund managers to provide a general solution, more sophisticated investors like to get exposure through fund-of-funds managers to fill specific allocations which might be venture capital and small-cap buyouts,” says Philipp Geysler, a partner and head of private alternative investment strategies at Partners Group in Baar-Zug, Switzerland.

Managers are experiencing as much as 20%to 30% growth rates in the volume of assets they have under management, they say, as the market continues to remain buoyant through the remainder of 2006. They are also keen to describe the market as “healthy” rather than “hyped”.

“The business reason for fund-of-funds has been increasing of late both in the US and Europe,” says Michael Granoff, president and CEO of Pomona Capital in New York.

“People who want to commit to private equity have to pinpoint which funds are the best funds to target and how to get into them. There is a very powerful flight to quality. On the buyout side it is clearly true that for the best buyout groups access is limited,” says Granoff. “Also, can you get enough capacity to get a meaningful impact on your business?”

This flight to quality obviously means that some managers are unsuccessful in securing allocations in the best buyout funds, but that inability could be a big warning sign for the managers themselves and for their investors.

“You have to ask the question that if you can’t play with the best players then should you be in private equity at all,” says Granoff. The key to success would seem to be maintaining multi-level relationships with a cross-section of buyout groups, he says.

Managers advise their investors to delve deeper into the investment process and analyse the details of the access versus capacity equation. Sure enough, if a fund can allocate around 25% of its money into one of the best buyout funds, where has the rest been invested? Another piece of investor advice is to be aware of bedfellows: who else is investing in the fund? Is their presence good news?

Fund raising in 2005 and 2006 is generally considered exceptional in terms of the volumes raised, but the concentration of activity in those two years is part of the fund raising cycle. That said, every manager has a different approach to raising funds either ranging from specific funds to rolling fund raising.

For example, LGT Capital Partners typically raises new funds every 12-to-18 months and manages US$6bn in private equity. Adveq currently manages around US$2.5bn of fund-of-funds.

Pomona Capital is working on its fifth fund-of-funds, with a target of US$300m, with first closing having achieved US$200m and the final closing expected in a few months.

For SVG Capital, the bite sizes have generally increased largely because of growth in business. In its second fund-of-funds, which totalled €285m, the commitment level was on average €20m, doubling to €40m for the third fund. The third fund, a joint venture with Schroders, Schroders Private Equity Fund of Funds III, closed at €422m in April.

Generally, managers say that the amounts of funds raised should be more on the conservative side to maintain a steady flow of repeat-investor plays and to avoid over-saturation of vintage year investments.

When it comes to the investment stage that fund-of-funds managers focus on, they continue to share a hope, albeit vague in certain circles, that European venture capital is going to shine through and start to emulate the successes of the American model.

The Skype deal has demonstrated that it is possible to make great returns in Europe but are there enough quality venture funds in the region to justify a dedicated fund-of-funds vehicle? After all, there are specific mid-market buyout funds, emerging market funds and even mezzanine fund-of-funds.

Mention Mowbray Capital’s attempt to raise a European venture fund-of-funds last year and the marketplace agrees that it was too soon after the losses of the European venture bubble burst. Consequently, this meant the Mowbray fund never made it beyond the roadshow.

Apparently, it was a non-starter for UK pension funds and the Mowbray fund was being marketed to investors mainly in the Scandinavian and Benelux countries.

“The problem with European venture is that you just don’t have as large a pool of fund managers as you do in the US. In Europe, there are probably about five to 10 managers with a proven track record,” says Gysler.

“I wouldn’t call it off. I think the players in Europe are becoming much better and are developing more international contacts. I think we’ll see more venture activity in Europe,” says Gysler.

“In Europe investors are starting to see more return and portfolios are coming into money. Those portfolios have become more visible after managers have gone through a great learning curve,” he adds.

Knowing that mid-market buyouts are a steady part of the business is fine, however, there is the sense that if European venture just had a good clear run, then a dedicated fund-of-funds would be possible.

Nevertheless, it just goes to show that negative headlines in national newspapers and other media about the over-heated venture-backed market a few years ago are still vivid in many an investor memory.

“The overall attitude of most institutional investors in Europe towards European venture capital is negative,” says Sneyers. “We believe that if you have access to the top five venture capital managers in Europe you will get the returns. The big problem is gaining the access. You don’t want to venture too far down the list of venture capital managers.”

One of the reasons that places European venture at a distinct disadvantage to the America success story is that the European exchanges are not like NASDAQ. So, bypassing the European market and going straight to the golden goose on the other side of the Atlantic might seem like a great idea but only if a fund-of-funds manager can secure sufficient allocations. No surprise then when most managers say access to US venture is very restricted.

“It is very work intensive to build relationships in US venture if you do not already have them in place,” says Gysler. “The same can be said for the small-cap buyouts market in Europe.”

“While there is less activity in Europe there is even less money which makes for less competition compared with the US,” he says.

A first-time European institutional investor – say an insurance company or pension fund – may be disinclined to invest exclusively in a European or US buyout fund-of-funds because they might be able to generate the same returns in asset classes they are more familiar with such as the public equity markets.

Increasingly, fund-of-funds are offering a mixed approach combining primaries with a mixture of secondaries, direct investments and mezzanine.

Golding Capital Partners has developed a track record in raising funds from German institutional investors and offering them quick returns in the first two joint venture mezzanine funds it has established with VCM. Golding is in the process of launching a third-generation mezzanine fund that will offer a fixed coupon. (See sidebar Overcoming the J-curve.)

With primary funds there are no assets for the first five or six years but on the secondary fund side there is more leverage in the funds and this is one area where innovation could be applied.

“There isn’t really that much innovation on the fund-of-funds side. SVG has a corporate structure that is more innovative whereas most use LPs. We take the view that many investors will not have invested in private equity before and therefore do not understand it completely,” says Sam Robinson, a director of SVG Capital’s fund advisory business in London.

“There’s more innovation on the GP side with examples like the KKR and Apollo vehicles. It remains to be seen whether that approach will become a trend,” he says.

Other fund-of-funds like Helsinki-based Amanda Capital are finding new investment targets in countries that other managers may be reluctant to invest in. Amanda III Eastern Private Equity LP invests in companies in Russia, Ukraine and Eastern Europe.

There are still barriers in place for a true free flow of investment. Various legal changes in the different European jurisdictions can sometimes offer a boost to private equity investment. Recent legislation in France has made it easier for insurance companies there to invest in private equity, but it favours the home market because a French investment structure is required.

Accounting differences and reporting requirements right across the region still dog the free flow of investment, and to some extent, limit the investor base for some funds. For example, in countries like Denmark and Iceland, an investor has to file returns at the investee company level.

The current growth in European fund-of-funds is further boosted by heightened bank interest in that part of the private equity universe. There is a sense that many banks will move away over the next couple of years as they change their investment strategies.

“Banks tend to invest in funds to build relationships with GPs so that GPs may give them transaction work,” says Robinson.

The European fund-of-funds asset class has only been around for 20 years so it is difficult to generalise about it. In the last four years performance has been very good and as a result there are more and more institutions saying they want more private equity.

“You might find that in three or four years the professionalism will still be there but the level of demand has dropped off,” says Robinson. “If the market continues to expand, people may think about investing themselves but they may get burned. This could be a time when the market dips. I think many people are going down a fund-of-funds route because they have been burned in the past.”

Overcoming J-curve concerns

The barriers to debuting as a private equity investor may well be cultural in many cases but the long-term investment perspective is just too long dated for some institutions keen to generate shorter-term yields on their capital.

Investing in a mezzanine fund-of-funds could be the investment compromise, offering some investors access to private equity and also guaranteeing early liquidity.

“It is something that if you can provide early liquidity for investors, it is always a positive. However, investors do need to be aware that private equity is long-term,” said Philipp Gysler, a partner and head Private Alternative Investment Strategies at Partners Group in Baar-Zug, Switzerland.

“Early, stable distributions are important for many of our investors,” says Jeremy Golding, managing director and founder of Golding Capital Partners in Munich. “ Our 2005 mezzanine fund-of-funds has already paid out its initial distribution of about 2.5 per cent earlier than expected within seven months of final closing.” The fund closed at €200 million in June 2005.

“The early distributions were attractive from a cash-planning perspective. A typical buyout J curve would still have been unpalatable for many of our clients,” said Golding.

“Many investors new to the asset class were simply not in a position to bear the three-to-five-year drought of the typical J-curve, which was the driver behind structuring a mezzanine fund-of funds with its earlier returns,” he explained.

Golding Capital Partners has partnered with VCM Capital Management closing their second mezzanine fund-of-funds – VCM Golding Mezzanine II – significantly above target at €238m in August.

Golding is going it alone now having developed and structured a third-generation product, combining buyout and mezzanine fund-of-funds. The main innovation is a guaranteed five per cent coupon from the day of signing for five years.

“This is unique in that it provides investors with exposure to buyouts, but without any J-curve at all. And a €35m warehousing facility has enabled us to kick-start the investment process before the fund was even launched,” said Golding.

Golding Capital Partners operates in a double niche in sense because its investor base is made up almost exclusively of German institutional investors.

Regulatory and supervisory constraints are a major burden for German institutional investors, such as the regional savings banks, insurance companies and pension funds. Golding Capital Partners focuses on solving the problems of these sophisticated investors, who have to fulfil a whole range of complex regulatory, tax, legal and supervisory issues. Investments through the funds-of-funds are made on a global basis.

“We have structured several funds as Luxembourg SICAVs which provide significant advantages from a tax and regulatory perspective. They have also in the meantime become more widely recognised by German institutions,” said Golding.