Fund-of-funds: are the smart guys selling up?

The development of the fund-of-funds FoFs market is like a time-delayed mirror of the underlying funds. Just as the GPs have had to deal with succession issues, as well as the growth of the secondaries market, so FoFs will face similar challenges in the years ahead.

Stefan Hepp, CEO of SCM Strategic Capital Management, says: “In some of the older firms, there are people wanting to retire, and this means owners have one of three options: they can either sell to a trade buyer, maybe float on the public markets, or sell on to the employees. The first will see the quickest return of cash, but there is no reason why someone like HarbourVest, for example, could not issue an IPO.”

The sale of FoFs is likely to become increasingly common in the coming years, and Hepp is sure the thought of selling to a bank has crossed the minds of many fund-of-funds in the past. Indeed, there is one large and very well known firm that is reportedly up for sale, with a UK hedge fund manager leading the race.

Some believe buying a FoF could be a risky investment over the long-term. The argument goes that as investors become more and more aware of what private equity actually is and how it works, FoFs will become obsolete. There are a few people who do subscribe to this belief. But there is and always will be an endless supply of investors out there with money to spend, and either little idea of how to spend it and/or a lack of time, resources or inclination to invest directly. It’s these two reasons for choosing FoFs over direct investment that is leading to the emergence of two different types of FoFs and what HarbourVest’s managing director, George Anson describes, as a bar-bell approach.

On the one side are the generalists, on the other, the specialists for those investors who know what they want but either can’t get access to the best funds or don’t want to spend the money setting up an in-house team. “About 80% of fund-of-funds are generalists,” says Anson. “You don’t see anyone in the middle. I think there is room for both and the reason is that not every one client is the same. We have a US fund-of-funds and an international fund-of-funds, which mainly invests in Europe, and there are a number of clients interested in both. You then have US investors who have their own US programme but haven’t got access to European funds and so come to us and the reverse for European investors.”

The products offered by FoF managers are ultimately driven by the investors; it’s basic supply and demand. If investors want to invest in a specific sector or stage or region, then FoFs will spring up to meet that demand. “For me it is proof that the European market is maturing,” says Christophe Bavière, CEO at AGF Private Equity. “There are certainly many specialist fund-of-funds in the market now, but to do this you need a very deep know-how. At the end of the day, it is the investor that is making the choice.”

Shakeout delayed According to Almeida Capital’s FoF review in March 2003, there are 120 firms managing FoFs worth $130bn worldwide, with Europe home to 49 FoF managers, up from 10 in 1993. For the last 18 months various observers have been predicting the great shakeout. Almeida Capital, for example, stated that around 40% of FoFs will struggle to survive over the medium term. “The number of fund-of-funds managers has grown more than ten-fold over the past two decades,” according to the report. “The market was flooded in 2002 by more than half of the fund-of-funds population looking to raise new capital. Their relative lack of success, however, gave a clear signal that the industry is now well past its peak and on the cusp of a major consolidation.”

Over a year on, nothing much has happened. Richard Sachar, chief executive of Almeida Capital, says: “There is a shake-out on its way, it’s just that it hasn’t worked its way through the system. The market has picked up this year and investors are looking to private equity more, but those that were struggling last year because of a lack of differentiated products or an inability to raise new capital will continue to struggle.”

There is a sense that a shake-out is inevitable. Germany in particular has room for a consolidation of the market due to the particularly high numbers of FoFs that emerged during the boom. The merger of Sal Oppenheim and CAM Private Equity in November 2003 is a start.

Bruno Raschle, managing director and founder of Zurich-based FoF Adveq, says: “The rise in the attractiveness of the capital markets was just delaying the shake-out by two or three years so when it does come, it will be more brutal and take a lot longer.”

A shakeout was never going to be quick. Anson says: “No-one puts up a white flag. These things take time, they tend to die a slow, lingering death.” And as long as managers have their fees coming in, they aren’t going to shut up shop. What may happen is that many may never raise another fund and just continue to invest their fund and collect the fees until the FoF is either acquired or the fees stop coming in and they close down.

Timothy Spangler, a partner at Berwin Leighton Paisner, is sceptical over whether the market actually does have too many funds: “Big shakeouts are always being talked about. Consolidation occurs in two ways. One is via acquisition, but this is very difficult. The other is by attrition, but this is also a very slow process. The shakeout may happen in five years or so, but now is too early. By definition of course there can’t be too many FoFs if people keep investing in them. Are there too many Starbucks? Of course there are, but they are all full of people so really there can’t be. You can only say there are too many when there are lots which keep launching but not closing.”

Fund raising

The fund raising environment is difficult for everyone at the moment, but it is better than it has been. Anson at Harbourvest says: “If one is bad and 10 is great, we are at six and that’s the first time I’d say we’ve been beyond a five in years. Fund raising is always hard but I don’t see a diminishment of appetite.”

AGF’s Bavière says: “Pension funds, at least in continental Europe, are still cautious about private equity, but a lot of people are starting to acknowledge it as a growing asset class because of the impact it has had on the European economy. I am not saying that everyone is enthusiastic but I am sensing that things are getting better. People are more open, or at least less reluctant to the idea.” AGF is confident about the fund raising environment and recently appointed an extra fund manager, Martin Mabille, at the beginning of July.

Unfortunately for many FoF managers, increased interest by institutional investors will not necessarily make fund raising any easier. As is the pattern in the underlying funds, the big names with the good track records will find it easiest to attract capital. Adveq closed its fourth technology fund, PETP IV, in June on $325m, $25m more than its target. According to Almeida, just 11 European FoFs closed in 2002, eight of which failed to reach their target size, and there are a number of FoFs out there still looking for money.

Standing out from the crowd

Differentiation, or lack of it, is the main reason for the predicted shake-out. With so many FoFs offering essentially the same product it can be difficult for an investor to know which one to choose. For this reason investors will head for the big names such as Pantheon and HarbourVest, or specialised funds because they offer something specific.

The move towards specialisation is, according to Sachar, a natural evolution, but he questions whether this is really what LPs want. The big names of the FoFs world would argue, with justification, that investors come to them because they have a superior track record. “I think that branding is important,” says Anson. “While individuals are important, investors need to know they have stability.”

This is one of the risks attached to specialist funds: they don’t always work and so can’t be guaranteed to be around in five years time, a risk for both the investor and the underlying funds. Eiger Capital I is such an example that launched a technology FoFs in 2001 which failed.

Hamish Mair, director of private equity at Martin Currie, says of specialist funds: “For tightly focused fund-of-funds the institutional investors would need to have a knowledge of the area and would therefore probably know enough not to have to buy a FoF anyway.”

Spangler identifies further perils: “There is a risk of style drift. The investor will think they have this great scope, but if the funds they are in are very specialist and nothing happens in this market then a fund manager may drift away from what the fund was set up for. By being a specialist fund you are entering into an agreement with investors that could find you opportunities in your chosen market. But if you do stay in your chosen market the risk is that you will spend money in poor investments.”

The key is to find a specialist niche. Guy Fraser-Sampson, for example, set up Mowbray Capital in 2003 and in February this year launched the first ever FoF purely dedicated to European VC. “I think European VC is going to be the best performing asset area in private equity,” he says. “You can forget what has happened so far in European venture capital. European VCs make a lot of excuses, like there aren’t any entrepreneurs, but the problem is that VCs here are almost exclusively investment bankers and advisers. In the US, they see it as, what they call, a home-run game. Four or five of their companies will make 80% of the profit. Fifty per cent will fail. In Europe, they are very uncomfortable with a model as binary as that. They try to get the same returns across the whole portfolio. But there are now a small number of European VCs using a US model, and this will take over and revolutionise the market.”

Mowbray only began fund raising this year so it is too early to tell whether the firm will be a success. Specialisation in a particular sector relies on access. Fraser-Sampson previously set up and managed the European operations of VC Horsley Bridge so this will give the firm a head start with regards to contacts, as will his enthusiastic optimism for European VC. But whether investors will take the plunge is anyone’s guess. Spend any time talking to a fund manager at a European VC house and it won’t take long to work out things are difficult;. 2003 was pretty awful and 2004 is proving to be only marginally better.

Another type of differentiation for a FoF is to raise its funds on the stock market but, as Martin Currie found out, this is not without its problems. The Martin Currie European Capital Trust, launched in 2003, was meant to be a successor to the E170m Martin Currie Capital Return Trust plc fund-of-funds. Unfortunately in April this year the firm announced it was postponing the fund raising and aimed to return when market conditions improved. The latest from the firm is autumn, but this is not definite.

On the one hand, Martin Currie’s problems exemplify the problems faced by many FoFs; that is a generally difficult fund raising environment due to investor scepticism and the big names attracting the majority of funds, and on the other they indicate the difficulties faced by those FoFs offering quoted vehicles.

“The problem,” says Brian Wright of Pomona Capital, “is that the public market doesn’t get it. The J-curve, the long holding periods and the uneven cash flows confuse analysts. There are also too few analysts looking at quoted private equity FoFs to give it a high public profile, which means that a lot of them are valued at less than their net asset value.”


Another form of differentiation is offered by the secondaries market, a space Pomona has occupied longer than most. “The secondaries market is superficially attractive,” says Wright. “Intuitively everyone gets it so new players are attracted to the space, but there are significant barriers to entry: you have to find the deals, price the deals in the time frame available and get GP consent.”

The secondaries arena is becoming particularly competitive after years of being dominated by a handful of players such as Pomona, Lexington Partners, Landmark Partners, Coller Capital and Fondinvest. The new entrants, many of whom are FoFs, have gravitated towards the large auctions, and this has made that area especially competitive.

There is a considerable amount of money in the secondaries market at the moment. Lexington raised $2bn last year and Credit Suisse $1.9bn. In March this year AXA Private Equity closed on $300m, while HarbourVest reached $4bn for two funds which will invest in primary and secondary partnerships. In June, Paul Capital Partners VIII reached a first close on $104m, with a final target size of $800m. In August Pantheon reached its $900m target, while Goldman Sachs is imminently expected to launch a plus $1bn secondary fund, GS Vintage III, imminently.

A big reason for the comparative flood of FoFs moving into the secondaries world is the slow fund raising environment. A number of FoFs have money burning a hole in their pockets and see the secondary market as a good investment. According to Venture Economics, secondary funds have achieved average returns of almost 25%, far more than the 10-year 13.4% average of all private equity. As a result, FoFs have stayed in the space and increased their allocations to secondary investment. HarbourVest, which invested just $100m in secondaries in 2001, pumped in some $900m in 2003.

One of the more understated draws of secondaries for FoFs is access to underlying funds. By purchasing a secondary position, not only is a fund getting access to an already-established portfolio of funds with a good track record and a good level of diversification, they will also be put on the list the next time a fund is looking to raise money.

This is currently more of an issue in the US, where access to the top funds is becoming more of a concern as VC funds reduce in size. US venture houses are either cutting the size of existing funds, or raising new but smaller funds. Wright says: “In Europe this is not an issue yet. I can’t think of any invitation-only fund-of-funds. Europe is generally about five years behind the US market in terms of capital raised so perhaps in the future the access issue will become more prominent.” The area most likely to feel this first will be the mid-market funds, due to their smaller capital requirements in comparison to the mega-funds and the popularity of the sector.

Segregated funds

A phenomenon identified by Anthony Romanello, director of investment services at Thomson Venture Economics, is the increasing use of funds for segregated accounts. In January, Finland’s Local Government Pensions Institution (LGPI) mandated Grove Street Advisors to build a E97m VC portfolio in the US. The LGPI is the pension fund for Finnish municipal employees, with over E14bn in assets under management and is one of the largest Nordic private equity investors. The mandate will see Grove Street spend the money over approximately three years with 12 to 15 fund managers, committing up to $15m per fund.

In April, Pantheon was one of three FoFs along with Paul Capital and Grove City appointed by Florida’s state pension fund and handed $100m to invest in biotech VC to encourage companies to set up in the state. Grove Street, is also performing a similar role for AlpInvest as it is for the LGPI.

It is a more common trend in the US where institutional investors, especially pension funds, are more comfortable with private equity. Romanello says: “It’s a simple fact that certain pensions in the US, like Florida and Oregon, for example, had very low weightings to VC, historically, in their private equity portfolios, as low as 0-10% as a recently as the mid-1990s, even after the venture run-up had started in earnest. Consequently, their private investment pools did not benefit, to a large degree, from the fantastic returns of early-to-late 1990s venture vintages.” This contrasts greatly to with Yale University, GM Pension or the University of California Retirement Plan, which had weightings of 35% to 60% to venture and have returned about 30% annually over 25 years.

“The reality is that the average historical institutional weighting to venture is about 30% to 35%, and Florida and Oregon were grossly underweighted, and underperformed many of their institutional peers,” says Romanello. “Many institutions have benefited enormously, like banks, insurance companies, corporate pensions, endowments and foundations, but public pensions, by and large, were late to the gravy train.”

This failure to get out of the starting blocks until it was too late makes access to the top funds very difficult, if not impossible. “This is where established FoF managers like Pantheon, Grove Street and others can help because they have relationships with blue-chip venture firms.” says Romanello. Indeed, one of the stated aims of the partnership between Grove Street and the Finnish pension fund is to build relationships with the underlying funds so they can invest directly when the funds return to the market for fund raising.

But that’s how it is in the US and while there is some evidence of it occurring in Europe, it is uncertain whether it will become a mainstream option for European pension funds. Tycho Snyers of LGT Capital Partners suspects probably not: “You have a lot of large institutions in the US and this is important. In Europe this is not where the market has gone. We have some ourselves, but co-mingled is more popular. It’s not the bread and butter business of European fund-of-funds.”

Almeida’s Richard Sachar believes they may have a future: “Funds for segregated accounts are lower, but because money is proving harder to come by for the co-mingled funds, fund managers are coming back to it.” The UK local authority pension funds are reported to be interested in such an approach. They are suited for those institutional investors that have a knowledge of private equity, as the LGPI has in its investments in Europe.

The division seems clear. Top dogs such as Pantheon and HarbourVest will continue to attract money. For those less well-known players, the key is to either differentiate yourself, merge or face the possibility that the older the fund gets, the more the management fees will fall. The shakeout will take time, and there is a definite possibility that it will not occur at all, at least not in such a dramatic way that the market shrinks significantly in the next five to 10 years. And just because consolidation occurs does not mean new entrants can’t come in and exploit new areas carving out sustainable niches for themselves.