The advent of the fund-of-funds vehicle in the private equity industry in the 1980s and its tremendous growth, particularly over the last five years, indicates it is a more successful or popular vehicle than anyone gave it credit for when it first emerged. As far back as 1989 there was ongoing industry debate as to whether the fund-of-funds/advisory business was a short-term phenomenon primarily boosted by the poor returns to limited partners during the 1980s or whether it was a major structural shift in sources of capital. Jesse Reyes, vice president, director of research Thomson Venture Economics, reports.
Where are we?
Figure 1 shows the global growth in committed capital globally by fund-of-funds vehicles both in number and in capital raised. The industry exploded in the late 1990s just as the rest of the private equity industry went through its fund raising binge. This is, of course, almost a tautology as fund-of-funds are limited partners who pool the capital of their own limited partners and invest that pooled capital into other funds thus fueling the increase in amount of committed capital. This culminated in 2000 where 89 fund-of-funds vehicles raised almost $19bn. While the pace of fund raising has decreased, even 2003 saw interest in fund-of-funds with 19 vehicles raising capital. This does not include any funds dedicated to buying limited interests; so-called secondary funds.
The cumulative impact is that currently about 160 firms manage one or more fund-of-funds and have a combined total of $91bn under management, with the average capital under management of $550m (figure 2). The explosion of fund-of-funds has been dominated by the US, (figure 3), but European fund raising has been robust with almost 20% of the capital coming from the continent.
Where did fund-of-funds come from?
While fund-of-funds advisors and their predecessors can be traced back to the late 1970s and early 1980s, it wasn’t until the downturn in returns to the venture industry in the mid 1980s and the commensurate increase in attractiveness of buyout returns in the same period, that all of a sudden complicated the decisions that limited partners had to make.
The industry has committed a record amount of capital, in particular to venture capital funds, in the late 1970s and early 1980s. By 1987 to 1988 where returns to venture capital funds were in single digits, it became apparent to limited partners that deciding which funds to invest in and committing the right amount of capital was not an easy exercise.
With the dearth of industry information available, private equity consultants found themselves advising clients not only what assets to invest in, but also which fund managers they should pick. It was natural evolution that they become discretionary advisors. Not long after that, advisors started to develop fund-of-funds vehicles.
The attractiveness to the advisor community is easy to see. A client of an advisor with several tens or hundreds of millions to invest can switch advisors at virtually any point, but as a limited partner investor in a fund-of-funds vehicle, the limited partner is locked into paying fees to the advisor for the life of the fund, ostensibly ten years. By the late 1990s it became obvious to advisors that the best way to keep clients was to get them to commit to the resident fund-of-funds vehicle.
And just as it seemed that it was relatively easy in the late 1990s for a person to hang up a shingle as a venture capitalist and raise money, during the 1995 to 2001 time frame, it was not uncommon to see fund-of-funds managers spring up everywhere, from former pension fund and endowment managers, who decided the grass and payout was greener in the private sector, to third parties such as investment banks, consultants and even individuals who found it relatively easy to raise capital for a fund-of-funds vehicle, particularly from high net worth individuals and smaller limited investors.
The net result is that by 2000 there were few independent consultants or intermediary private equity advisors left. A few years ago, an Asian bank contacted this author for information and education on the private equity industry. The bank wanted to be introduced to a private equity advisor that could manage the $25m dollars it wanted to allocate to private equity. After a few weeks of meetings, the banker came back to say that unless he had ten times that amount, no advisor would take his discretionary business, but would instead prefer them to be investors in their “new” fund-of-funds vehicle.
So what is the attractiveness of the vehicle to limited partners, and is there any indication that it has met investor’s expectations? Some of the principal reasons fund-of-funds are attractive include:
§ Lack of resources for administration and investment management. Even 25 years after the prudent man rule was established in the US to allow pension funds to invest in riskier asset classes, ushering in the modern institution private equity fund era, many limited partner private equity staff levels are often inadequate to effectively manage the administration of the investment operation, much less the ability to look at often numbing numbers of offering memorandum for new funds. For many, the burden is too much and outsourcing this function to a third party advisor, on an either discretionary basis or through a fund-of-funds vehicle, is often the only way to effectively manage the workload. During peak distribution periods such as the 1999 to 2000, where distributions were coming in almost faster than the investor could make new commitments, the intermediary is almost a necessity. The fund-of-funds makes the multiple fund distribution process much simpler to manage
§ Lack of manager selection expertise on the part of the limited partner. Due diligence is the most time intensive part of the limited partner private equity decision process. With the due diligence that has to be done to make sure the limited partner gets into the best funds it can, it means fund-of-funds may exist if for no other reason than to manage this due diligence process. For many new limited partners with relatively little experience in the private equity industry, the fund-of-funds vehicle is an easy way to navigate the risky shoals of venture and buyout investing.
§ Access to otherwise inaccessible funds. With the competitive nature of the industry, the fund-of-funds offers the limited partner the ability to get into funds the LP may not be able to get into itself. With so many limited partners programmes opening in 1995 to 2000 and investing in the private equity market, the marque funds may be out of reach for new investors as the competition for inclusion into the newest best funds is fierce. The fund-of-funds vehicle may be the only way in for many, if that vehicle has access itself.
§ Scaling up and leveraging small investments. Fund-of-funds offer scaling of investments for smaller investors A small pension fund, endowment or family investment office may only have a small amount it wants to commit and may not the have the scale to be attractive to larger funds, a fund-of-funds ability to pool client interest allows participation by small players.
§ Lower risk in new markets. LPs choosing to diversify and increase their returns may look to emerging markets. There are individual funds focused in those areas, but again a fund-of-funds strategy may be more efficient and less risky than making fund manager selection decisions outright.
§ Diversification. Ostensibly an investor that invests in the private equity industry through fund-of-funds might not need to invest in funds directly, unless the fund-of-funds is offering something the limited partner cannot do themselves as in access better funds, enter new markets etc. However by its nature, a fund-of-funds vehicle is a diversifying vehicle, probably not an absolute returns vehicle. See The Future of Performance article in Venture Capital Journal, June 2003, which discusses that the private equity industry is probably a dollar cost or investment averaging business. That is investing continually is probably the best method of success rather than trying to time when to get in and out. Since a fund-of-funds vehicle invests across vintage years, the limited partner investor gets not only manager diversification, but just as important, temporal allocation.
Are some investments better suited to fund-of-funds?
In Not All Funds are Created Equal article in Venture Capital Journal, July 2003 I introduced the concept of the MRC (manager risk coefficient), which is a measure of the relative
risk between investment managers in an asset class and the return of that asset class. The chart from that article is shown in figure 4 and augmented it by replicating European private equity data using the same metrics where relevant. The MRC is calculated using the IRR of a sector of the industry since inception and calculating the standard deviation between the returns of each fund in the same sector. This standard deviation is not volatility across time as you would measure for asset allocation, but it is the measure of variance between managers.
What combining this return and risk measure does is demonstrate the riskiness of certain asset classes such as early stage ventures in the US and in Europe. In the US, for example, the return to early stage funds overall has been phenomenal; over 20% annually, but the standard deviation of 68% which means returns between managers is very large and limited partners have extremely careful in manager selection. Contrast this with medium to large US and European buyout funds, which may not have a dominant rate of return, but the risk between managers (standard deviation) is relatively lower.
So how do you normalise these measures to make comparisons within each subsector? A statistical normalisation metric called the coefficient of variation would divide the standard deviation by the arithmetic average. We do almost the same thing by dividing the standard deviation by the pooled average to take cash flow investment into account. We term this the manager risk coefficient or “MRC”. The interpretation is that the higher the MRC the higher the risk relative to the return and the lower the MRC, the lower the risk relative to the return, or it is another measure of “efficiency.” Lower MRCs means more efficient investments.
Now this should not be interpreted as put all your investments into medium and large US and European buyout funds and none into early stage funds. It simply instead indicates sectors with relatively higher MRC need relatively more due diligence to be sure you invest in the right funds. Note that mega buyout funds suffer from the same manager risk as early stage venture funds do; large manager deviation with relatively low returns. So again you have to know who to invest in or risk inferior returns.
So what does all of this have to do with fund-of-funds? In our experience, successful private equity investments require manager selection as paramount. Our advice to limited partner clients is that if they have superior management selection skills, time, energy, resources and access to the best funds, by all means (to use a US colloquialism) ‘swing for the fences’ and look at those sectors with the highest returns regardless of manager risk. Diversify of course, but look to those sectors as absolute return strategies.
Conversely, if a limited partner has no manager selection experience or expertise, adequate resources or has limited access to the best marqe funds, sectors with high MRC values should be avoided or minimised in their portfolio. Instead if a limited partner falls into this category, a fund-of-funds vehicle might be better ways to access these high MRC sectors if desired.
What is the future for fund-of-funds?
The fund-of-funds vehicle is here to stay. Although not all fund-of-funds managers will be around in the next fund raising cycle for the same reasons that many other private equity fund managers won’t be; non-sustainable long term investment performance. But winnowing out the winners from the others is a natural part of investment manager selection.
Limited partners have been funding these vehicles for the reasons mentioned above. If you compare total commitments to private equity funds represented in 1990 to 2002, you can see limited partners are increasingly dissatisfied with their own investment records and are outsourcing this function to fund-of-funds and other intermediaries. Figure 5 indicates that from 1986 to 1994, fund-of-funds represented no more than 3% at most of commitments to buyouts and venture firms. By 2002, that number has grown to 14%.
Some factors that favoured continued growth
While the future of the fund-of-funds industry is secured, there are challenges ahead. However, a few points favour increased interest;
§ Pension funds are going away eventually. The pension fund as we know it in the US, and to some extent in Europe, is eventually going to be replaced by defined contribution plans. Unless legislators think individuals need to make risky venture capital investments, pension assets will become less relevant to the private equity industry over time. The controversy over disclosure in recent months has exacerbated the relationship between traditional public pension funds and their investee funds. As a result funds will have to look for other sources of capital than traditional pension funds. The fund-of-funds vehicle with its inherent pooling of investment interest has to become a prime fund raising target.
§ The industry is getting smaller and leaner. The private equity industry is going through its first real contraction in 25 years and we will continue to see fewer and fewer funds have success in raising funds. For the most part, fund sizes are and will be smaller as managers have found good returns are hard to sustain with mega-sized funds. As a result, limited partners will either have to take smaller slices of the pie in funds they are in or will be locked out of funds altogether. The fund-of-funds may be the only way to access the private equity market in a large way.
§ Getting into good funds will get harder and harder. As the industry contracts, even the good funds will downsize their commitments, forcing all their LPs to put capital into other funds or asset classes and for some access to the best funds may only be possible through existing fund-of-funds structures.
§ Challenges for the fund-of-funds industry. Just because the fund-of-funds industry looks to have a bright future, doesn’t mean there aren’t some bumps in the road.
§ There are too many. The increase in the number of funds over the last few years does lead one to wonder if mutualisation of the private equity industry is in the offing. With the advent of some securitisation in the industry being led by some fund-of-funds vehicles, there may be just too many funds to have sustainable returns that are attractive to new investors.
§ They are too big. In addition, fund-of-funds have to learn the lessons their buyout and venture brethren learned in the 1990s; bigger is better to a point and then bigger is really not better. Larger and larger fund-of-funds vehicles with fewer and fewer places to invest, due to the industry contraction, is a recipe for suboptimal returns.
The fund-of-funds industry grew at a rate that has surprised everyone. With consultants, investment banking groups and others throwing their hat in the ring, the grow was truly unexpected. It is interesting looking at the roster of funds as to how unconventional the backgrounds of many fund managers are. In some ways it resembles becoming a neighborhood realtor; you just have to have the license and a good rolodex to be successful in finding clients. The real trick is in deploying the capital.