FoFs Coping With Capacity And Access Constraints

After an extended stretch of enthusiastic fundraising, private equity funds of funds—flush with cash—are now looking to stay ahead of the curve as to where to invest their new found capital. What they are finding is that limited partner demands and varying levels of general partner access have influenced how they set their allocations. That, in turn, has led to more specialized funds, such as vehicles exclusively targeting the middle market or funds of funds designed to expose investors to international markets.

Unlike other types of limited partners, such as the government pensions or university endowments, funds of funds must answer to their own limited partners. For many, that means allocations are largely dictated by the demands of the institutional investors that make up the investor base.

If investors are clamoring for exposure to energy, marketwatchers can rest assured a fund of funds catering to that niche will soon materialize. Case in point, earlier this month Robeco corralled $200 million for its debut Robeco Sustainable Private Equity fund of funds, which is designed to target energy funds located throughout North America, Western Europe and other emerging markets.

Meanwhile, funds of funds increasingly find themselves competing for access to top-tier GPs. That too impacts where funds of funds can allocate capital. Not all new investors in private equity can get Texas Pacific Group to return their calls. To gain access to TPG’s latest fund, they would need to go through a fund of funds, one that would ostensibly have a long track record in the industry and the necessary contacts to gain access.

The FoF Money Flow

For the most part, funds-of-funds capital continues to find its way into the coffers of domestic buyout funds. Brian Murphy, a managing director of funds-of-funds investor Portfolio Advisors, says his firm recommends that LPs new to the asset class allocate 50% of their private equity dollars to buyout funds, 30% to special situation funds and 20% to venture funds. “We view buyouts as a core holding,” says Murphy. “We’re in a range of between 30% and 70 percent. It’s [roughly] half of our portfolio.”

But just investing in LBO funds does not satisfy most institutional investors. Within the LBO space, most will have specific goals in mind. These investors more and more are seeking to work with fund-of-funds managers to spread their commitments around to varying segments throughout the asset class.

David Schwartz

, a partner with Debevoise & Plimpton, describes that the larger and more established funds of funds are able to offer a range of vehicles that appeal to these different demands. Often these allocations are not necessarily sector specific, but are more often designed to focus on the various market-sizes within the space or will have a geographic focus.

“The institutional investor understands its entire portfolio and is making many of those allocation decisions internally, or they’re going to a fund of funds and making decisions with them and putting money in two or three [separate] products,” Schwartz says.

If there is a hot area within funds of funds investing today, there has been a heavy leaning toward foreign markets. Portfolio Advisors, for one, reports that its allocations to foreign-based or -focused funds is now more than 30%, whereas in past years its foreign allocation was approximately 20 percent.

Fund-of-funds experts say that Western Europe’s buyout market is the most developed outside of the United States, to the point that it closely resembles that of the U.S. So to truly diversify and add risk to the portfolio, many investors are using funds of funds to gain exposure to relatively new private equity markets in India, China, or Eastern Europe.

“It’s a truly global buyout market,” Piper Jaffray President Danny Zouber cites. “There are so many opportunities that weren’t around in the past.”

The Issue(s) of Access and Capacity

When it comes to justifying the role of funds of funds, most managers have trumpeted their access to top general partners. However, when GPs such as Blackstone Group and TPG raise $15 billion-plus funds, it signals that access may not be the selling point it once was. This is magnified as groups such as Kohlberg, Kravis, Roberts & Co. and Apollo Management test the public market waters, making themselves accessible to nearly any Tom, Dick, or Harry with a bankroll.

The question that many funds of funds may be facing today is not necessarily access in and of itself, but rather how much access they actually have.

“People discuss access but they never discuss capacity,” says Pomona Capital CEO Michael Granoff. “It’s one thing to say, ‘I have access to this fund,’ but do you have access that moves the needle? Capacity is tight on both the buyout and venture side and it’s something that we think about a lot.”

Piper Jaffray’s Zouber confirms that the current fundraising climate leaves plenty of room for funds of funds. His worry, though, is if there’s a reversal in fund sizes during the the next fundraising cycle, it could make finding access more difficult. “If the buyout funds in the future come back to [what were] normal sizes, then we could swing back to cycles where access becomes more of an issue.” he says.

On the venture side, the picture is vastly different, as many firms have returned to the market with smaller fund sizes and there are still ongoing qualms regarding Freedom of Information Act (FOIA) scrutiny. The fund-of-funds world took a punch to the gut when Menlo Park, Calif.-based venture firm Sequoia Capital Partners froze funds of funds out of its latest vehicle, and there have been other instances in which venture firms have been making similar excisions from their investor bases.

Reportedly, Sequoia’s move against the industry stems from the firm’s annoyance with having its name tied to funds of funds touting its access to top GPs. Also, there were reportedly issues regarding funds of funds receiving access to certain information, and the non-alignment of fees between the funds of funds and Sequoia also played a role.

While the situation on the surface appears grim, industry insiders say that the move by Sequoia is a rare one that will not impact the larger private equity world or undermine the overall position of funds of funds.

“It’s a very, very small percentage of investors in private equity that are invested in those funds anyway,” says Portfolio Advisors’s Murphy. “Unless you started investing in [those funds] in the 80’s or early 90’s, you’re not in there.”

Moreover, Ashton Newhall, a general partner with Montagu Newhall, insists that the role of the fund of funds as an investor is too large for GPs to turn their back on the industry wholesale. “There’s a loyalty to this capital source especially considering how significant it is for many general partners.”

Flexibility Counts

Despite all the pressures that can influence fund-of-funds allocations, whether it’s LP directed or stems from GP capacity issues, in most instances fund-of-funds managers will keep their allocation mix flexible. They’ll often issue the caveat that access to a top-quartile GP, regardless of segment, trumps a predetermined allocation strategy.

“We would rather do the A-level buyout fund than the B-level venture fund,” says Granoff. “We’re not going to force the allocation for top-down purposes.”

But that doesn’t mean FoF investors will forgo a set strategy. Newhall warns, “If you take a spray-and-pray approach to partnership investing, when people wake up 10 years from now it’s not going to be a pretty picture.”