The fund-of-funds (FoFs) market has witnessed a boom in recent years and can be ivided into two categories. The veterans of the business such as HarbourVest and Pantheon operate as limited partnerships and raise funds like a traditional private equity firm. Then there are the multi-product asset managers and investment banks that entered the market in the mid 1990s, exploiting the private equity ambitions of their existing client base by launching specialist FoFs. But with the private equity market contracting and ridding itself of those that probably would not have got into the market in less buoyant times, which will survive? Angela Sormani reports
According to EVCA figures FoFs raised €3.4bn in 2002, down from €4.6bn in 2001. But as a percentage of total funds raised, this figure was up from 12.2% in 2001, to 13.1% in 2002 perhaps in part reflecting the difficulties faced by venture groups and the newer and less well performing groups, which in itself could go some way to sustaining FoFs fund raising activity as institutions sought safety in the diversity offered by the FoFs product.
While the FoFs model is indispensable for many inexperienced institutional investors to gain access to the asset class, fund raising remains tough. According to AltAssets Research of the 120 or so FoFs in Europe and the US, around 35 are fund raising. With the number of FoFs managers growing over ten-fold over the past two decades, Chris Davison, head of research at AltAssets, predicts a major shakeout over the next few years with as many as 40% of present managers struggling in the tough fund raising market.
But Davison stresses the research does not sound the death knell for FoFs. “There will always be a need for fund-of-funds products, the market is just undergoing an overdue correction and that correction will take a long time because it is dictated by the fund raising cycle.”
Anthony Romanello, director of investor services Venture Economics, does not think the shakeout will be that great, especially considering the fluid nature of the market.
“While some firms will die off, others will sprout up,” he says. He cites the emergence in the US of a new class of FoFs managers such as GM Pension, Toronto Dominion Bank and MIT Endowment. These organisations, historically passive LPs, were each able to raise maiden FoFs vehicles from third-party investors based on the strength of their relationships with level-one GPs, good track records and decades of experience in the asset class.
And a similar situation is emerging in Europe. There is consolidation, but there are new FoFs groups cropping up all the time. A recent example is Keyhaven Capital, currently in the market raising a €150m vehicle to invest in European primary funds. Founder Sasha van de Water and her team set up the new venture following her departure from AXA Private Equity last year.
For those that have the connections and the reputation, fund raising is not a problem says Romanello. “Many private equity FoFs managers are financial giants with fantastic distribution networks that are only just beginning to tap the vast middle and small pension markets globally.” As an example, he points to Pantheon, which is in the process of raising its fifth US fund and just attracted money from a whole host of middle-market tax-exempts worldwide including the Lutheran Church and a major Canadian university.
“FoFs are important,” says Romanello. “They represent 15% to 20% of a typical fund’s LP roster in the US, a little less in Europe. Even in this current market downturn, Pantheon and HarbourVest, for example, which have been in the market for decades and have vintage-diversified portfolios, are still earning long-term returns superior to public equities.” Unfortunately, he says, it is the non-brand names stuck with recent vintages and weak stables of GP relationships that are most vulnerable in the current climate and that’s where that shakeout is likely.
Survival of the fittest
“Those funds that will go out of business will do because they don’t have critical mass,” says George Anson, managing director at HarbourVest. “What is the minimum amount of capital you need to run a global FoFs? My guess is €1bn if you want to be able to offer globally diversified longevity and for the clients to feel you’re going to be around. You wonder how the small groups will survive.”
Jan Faber of Henderson Private Capital is of a different opinion. The big end is not traditionally where all the money has been made, he says. There is definitely a role to play for the smaller players with a differentiated angle. In addition to the mega generalist FoFs groups, he predicts the emergence of groups with niche strategies. “A $50m to $100m FoFs programme focusing on a specific niche could be more than sufficient if the strategy is very specialised. A limited number of the larger FoFs will survive due to a shortage of opportunities to differentiate themselves.”
Differentiation is key in the FoFs market, according to Faber. A FoFs can use product design as a unique selling point. For example, Henderson Private Capital has set up
a vehicle for its German investors, which is a co-investment pool and invests alongside other funds in the actual portfolio company, rather than in the fund itself. This reduces the tax risks for German investors. The reason not many people do this is the administrative burden but Henderson does because it is added value for its investors, says Faber.
Not surprisingly, listed FoFs have been receiving bad press of late because of their heavy discounts to NAV. Conversely this does mean listed vehicles are a cheap way to access the asset class. The problem here being, however, that thanks to the depressed share prices, while there is a stock of ready buyers, sellers are hard to come by.
There have been some major successes such Pantheon and Schroder’s offerings, but few have launched in the last few years due to market conditions and the inherent liquidity problems, which these managers have worked hard to structure out of the product.
Schroder Ventures International Investment Trust’s (SVIIT) most recent listed vehicle floated on the Dublin stock exchange in June 2002 and will have completed its investment programme by next year. Only when this is complete will it see its share price increase, says Guy Eastman, director at Schroder Ventures. “It’s currently trading at net asset value. We expect that will be the case for the next two to three years.”
He explains the aim of a listed FoFs is to allow pension funds and high net worth individuals to invest in private equity as and when they want to. Minimum subscription
to the fund is €125,000. “Right now, apart from the venture and development capital investment trust sector in the UK, I don’t think there are many ways you can access a focused private equity portfolio like the fund-of-funds that SVIIT raises for as little as €125,000,” says Eastman.
A prime example of the ravages of the public markets on a listed vehicle is Swiss Life’s offering, Private Equity Holding (PEH). Many say PEH’s aggressive over-commitment strategy to venture backfired and so it was forced to downsize.
A listed vehicle is better suited to a diversified portfolio and so a high exposure to venture and long J-curves can mean death for such a product in a down market.
Over the last year PEH has been in negotiations with Swiss Life and other interested parties regarding its long-term refinancing. To prevent the impending threat of illiquidity and to maintain the largest possible value for its shareholders the group decided on a partial sale of the investment portfolio.
Most recently the group announced the sale of part of its investment portfolio representing a fair value as of March 31, 2003, of CHF616m and related unfunded commitments of CHF305m to a private equity fund managed by Credit Suisse First Boston. The proceeds were used to fully repay an outstanding loan of CHF325m to Swiss Life. The group is starting to see the benefits of its restructuring and has posted its first quarterly profit in over two years, up CHF4m compared with a loss of CHF34.8m for the same period last year.
A striking contrast to the turmoil PEH has experienced is the fortune of PIP, Pantheon’s long-standing listed vehicle. PIP’s global FoFs strategy is framed to manage risk through appropriate diversification within the underlying portfolio. Secondary investments have been a major driver of PIP’s performance since its inception in 1987. During down periods, the acquisition of secondary assets drives up net asset value (NAV) and thus helps to maintain shareholder interest.
In the listed arena you are dealing with many more shareholders and for structural reasons you can’t necessarily make distributions when you want to. There are two main issues here. One is efficient cash management; the concept of illiquidity is not one that marries well with the listed arena. The second is making sure investors take a long-term view and understand the implications of the J-curve. When you’re dealing with 30 or so investors in a limited partnership this is easier because most have an understanding of the private equity industry. In a listed structure you’re dealing with more investors and there are restrictions surrounding what information is divulged.
Andrew Lebus of Pantheon explains the rationale behind PIP’s strategy following a restructuring of the vehicle in 2000. Until PIP restructured, its investment performance was 28% per annum and its NAV performance, while still more than satisfactory, was significantly lower at 18%. This inefficiency was caused by holding quantities of cash without having the mechanisms to distribute this cash to investors efficiently in the way that an LP structure can. When the vehicle restructured in 2000, it distributed all of its cash out and introduced participating loan notes (PLNs) with an equal value to the underlying asset value of the ordinary shares, into the company’s capital structure. The PLN programme allows PIP to make capital calls and returns as necessary without having to keep a large amount of cash in the trust, which would drag the NAV performance down.
Lebus says: “The structure enables us to solve this technical difficulty of managing a cash-efficient vehicle which is what investors in private equity want. Other listed vehicles are trying to deal with this issue through a geared structure which we think is higher risk.” He adds that it is much easier to keep investors in an LP structure happy as the majority have a greater understanding of private equity than those in a listed vehicle might. The only way you can keep investors in a listed vehicle happy is by delivering good news frequently enough to outweigh the bad. This will translate into shareholders being more confident and wanting to keep hold of their shares and subsequently increasing the value of the share price.
Listed vehicles can be a relatively safe way for investors to enter the asset class but you have to find a way of marrying private equity with a listed vehicle. Lebus says: “PIP has made this work through an efficient capital structure and risk management through diversification, combined with a strong secondaries component which can boost NAV performance even during the ‘down’ phases of the market cycle.”
Eastman sees listed vehicles satisfying an increased demand for the asset class among high net worth individuals. But whether the supply is meeting the demand in the FoFs market as a whole, he is not so sure. “There are maybe more players trying to enter the
FoFs market than there is capital,” he says.
Opportunities for investment are plentiful says Christophe Bavière of AGF Private Equity. But the market is saturated by a number of players investing in the same partnerships. “Some of the larger FoFs raised have to be invested in the mega funds. We have a different strategy and the most important aspect of our due diligence and fund selection process is that we are pro-active. We identify teams before they start fund raising and we particularly focus on teams with specific investment strategies, often niche players or local funds in the European private equity market. We believe it is the best way to outperform the market in the long term.”
AGF looks at primary and secondary funds and also direct co-investments. The fact the group co-invests in buyouts is particularly beneficial in the due diligence process, says Bavière. The group is reluctant to invest in a first time fund, but does not rule them out and would rather propose a direct co-investment strategy with the fund. “If we decline to invest in their portfolio companies then it is unlikely we will invest in their second fund!
Co-investments are excellent opportunities not only to improve returns for our investors by providing them direct access to deals but also to improve our due diligence on a buyout firm,” he says.
Another way for a FoFs group to evolve is via the secondary FoFs route. “The skill set you need to be a secondary player is much more similar to the skill set of a FoFs manager than being a private equity fund manager,” says Timothy Spangler of Berwin Leighton Paisner.
Consequently, AGF’s secondary acquisition strategy comes as a natural extension of its primary investment policy. Bavière stresses the firm is reluctant to use a vulture type investment strategy and would rather buy at a fair price low risk quality assets than risky assets with a steep discount.
As the FoFs market grows in sophistication Spangler raises the possibility of a FoFs manager providing added value for its investors by constructing a comprehensive alternative asset product, combining a variety of asset classes together in a single vehicle. For example, long term allocations to private equity and real estate, and exposure to hedge funds and more liquid assets that will allow investors liquidity in the short term.
Pressure to perform
Today most investors are seeking risk reduction and diversification. The challenge for consultants in the current climate is trying to convince institutional investors why private equity at all and how you achieve superior returns. Everyone wants access to the premium funds, but it is tough to get into the top quartile.
Bruno Raschle of Adveq says: “Access is important, however that’s not enough. You must have access to the premium funds with 100% of your capital and many FoFs do not, they are just too large. There are hundreds of fund managers and only a few are outperforming the private equity index.”
There is something to be said about a good reputation in the FoFs market. A market review by McKinsey in 2002 revealed that good private equity fund managers are able to repeat their success.
In the US buyout market a fund manager who had been in the top quartile with his previous fund has a 45% probability of being in the top quartile with the next fund. In 28% of the cases the fund was in the second best quartile.
“The biggest question mark over the whole of the FoFs market is performance,” says Jan Faber. How can you calculate performance in a FoFs vehicle? There is a lack of tangible proof whether many FoF managers have done a good job and it is only possible to get a real idea of returns after a six to eight year period. “Many FoFs are coming back to market to fund raise every one or two years so how do you know they’ve done a good job if funds are unrealised?” asks Faber. “The risk here is that managers can get away with bad performance for a long time. Consultants need to be able to differentiate between the good and the bad.”
According to Venture Economics to December 31, 2001 US-domiciled top-quartile FoFs have a net IRR of 24.4% per annum, while the pooled average (standard measure)
is 18.7% annually. Anthony Romanello says: “As in private equity generally and unlike the public markets, there is a great degree of dispersion between top and median performing funds. Manager-selection risk is high but outsized returns, relative to the public markets, accrue to those LPs who select well.”
Fees are also a major issue. FoFs try to position themselves at the pressure point to be able to capture as much of the added value they are providing, says Timothy Spangler.
FoFs are performing a role not dissimilar to what GPs are doing with regards to the underlying portfolio companies and so believe that they deserve a piece of the carried interest. “It is a commercial question,” he says. “LPs need to assess whether the level of added value they are receiving back from FoFs is worth the fees being charged.”
Investing via the FoFs route is viewed by some as the shallow end of the pool, adds Spangler. “For those who are making their first allocation to private equity there is some sort of expectation that you will eventually be able and willing to invest into individual GPs once you’ve familiarised yourself with the asset class.” But this is probably not the view many FoFs want promulgated.
“FoFs don’t want to compete for investments in portfolio companies; they simply want to be the outward-looking face to the ultimate investors,” says Spangler. Most FoFs have a reputation among the GP community as good investors. And unless something in the economics between the two changes, for example more direct fee competition between them, the relationship between FoFs and GPs should remain mutually beneficial.
But there is still more to be done to raise the profile of private equity among the institutional investor community, concludes Anson. “More than ever FoFs providers like ourselves need to inform the market, consultants, intermediaries and service providers. It is true there are more investors out there who need to know. Service providers have a great influence on who the institutions talk to. You can’t stand still and expect the market to come to you, you have to go out there.”