Fund-of-funds: Hot property

The proliferation of fund-of-funds managers in Europe, and for that matter the US, is staggering, particularly from the mid 1990s on. Ten years ago fund-of-funds managers were presumed by many to be part of the evolution of the fledging European private equity investing scene now talk even extends to the possibility of the creation of a secondary fund-of-funds market although the talkers concede this is probably still some way off. EVCJ looks at why this fund-of-funds bubble has been created in Europe and what will be the consequences.

Fund-of-funds managers cannot be ignored by general partners on the fund raising trail since they now contribute something in the region of 20 per cent of monies raised for investing in private equity in Europe. However, similar concerns are raised about the quality of some of the new kids on the block as were levelled at the explosion of early stage venture capital and incubator/ accelerator investment groups that entered the private equity field in the late 1990s and 2000. Clearly, for the established fund-of-funds players who have long been advocates of private equity as an asset class, the crowding out of their market niche is likely to be unsettling because, for one thing, if a significant minority of the new players don’t generate acceptable investment returns this will have an impact.

Investment performance is only one part of the picture and one that is not going to fully emerge for the latest round of entrants for another five or six years. Several established fund-of-funds investors report hearing complaints from general partners about the conduct of some of the new entrants interfering in individual investments being the worst sin. Recompense for the general partner in such situations is delayed to the firm’s next fund raising cycle when meddling fund-of-funds managers are not invited to join. The majority of the new entrants to the fund-of-funds scene, however, behave in a professional manner.

Returning to the investment performance of the new breed of fund-of-funds, there is obviously the concern that these firms will not gain entry to the best funds and those that are deploying vast amounts of capital will be forced to deploy them over a greater number of funds in order to get their capital to work now that fund sizes are shrinking back to sensible levels. As Jesse Reyes, vice president of Venture Economics, says: “You can over-diversify a fund-of-funds portfolio pretty quickly.” He goes on to to cite a conversation with a veteran US fund investor, Tom Judge, who, until his retirement, was in charge of private equity investing for AT&T. Judge determined that if he didn’t limit his diversification the end result was that he would be looking at a bond-type level of return over the long term. Investors in fund-of-funds faced with bond-type returns but little liquidity and significantly greater risk will get quickly jaded.

There are so many players in the European fund-of-funds market today that many are already talking about the need for consolidation. Guy Eastman at Schroder Ventures fund-of-funds suggests how this might work: “It will take five to seven years to see the impact on performance of the fund-of-funds explosion. It is important for investors to see how fund-of-funds managers are tied in. Over time, many firms will keep ticking along on their management fee stream, the average managers will move on and the better groups will continue to grow. Firms are unlikely to merge because private equity is a people-driven business and if you merge two groups it will cause problems as egos get in the way of things, like who is going to run the new firm.”

Schroder Ventures fund-of-funds falls into the new entrant category, although part of the team has been running the SVIIT investment trust since its launch in 1996. Eastman, who joined the firm late in 2001 as part of the European investment team, has been investing in private equity funds since 1994, previously with Hermes and Granville. Schroder Ventures fund-of-funds opted for a Dublin stock exchange listing, a decision driven in part by the 30 per cent holding triggering a full offer under London stock exchange listing rules. The structure and listing they have chosen also allows the fund to be self-liquidating, at net asset value, after year five.

The majority of fund-of-funds have been raised on a limited partnership structure, however the issue of fund-of-funds structuring remains a hot topic. Ultimately the vehicles choose themselves once a fund-of-funds manager has determined its aims. For example, in the case of Schroder Ventures’ fund-of-funds it is looking to tap individual investors who can take a minimum of EURO125,000 in the funds, which is called in three separate instalments.

Once a structure is chosen, however, they are not without their problems. The oldest listed private equity vehicle Pantheon International Participations (PIP) which came to the market in 1987 as a global secondary vehicle started buying primary fund-of-funds positions in the mid 1990s. Rolly Crawford at broker Collins Stewart did the original structuring for the PIP vehicle. He notes that the fund was able to buy a number of good assets when there was a move out of private equity during the recession of the early 1990s and these bore fruit in the mid 1990s, at which point the fund diversified into primary fund-of-funds to absorb some of the returned capital and it enabled the fund manager to steer the trust’s diversity to the degree that it could not do by relying on the opportunistic secondary market. But by the late 1990s another problem had been created; the fund was subject to a large cash drag to allow it to meet capital calls from the fund-of-funds investments with the trust. Crawford structured a loan note programme with an equal value to the underlying asset value of the ordinary shares that allows PIP to make capital calls and returns as necessary rather than having to keep a large amount of cash in the trust that drags the overall performance numbers down.

Although, as stated previously, the vehicles choose themselves once a fund-of-funds manager has determined its aims, Crawford muses that some investors in private equity have not even considered using this route when in fact it could present a neat solution. Specifically, there have been a number of private equity fund holdings sold by institutions into the secondary market at a considerable discount that could have considered a listed wrap to these holdings. This would effectively securitise the assets off balance sheet. Many of these sales have been promoted by US regulatory change that requires banks to account for private equity commitments in year one rather than, for ten-year limited partnership structures, at ten per cent of the commitment per year until year ten.

Securitisation of private equity assets is something of a talking point among fund-of-funds managers although the general consensus is that what’s currently in the market will be improved upon in the not too distant future but unfortunately no one is giving any secrets away at this stage. The Princess fund launched three years ago with an insurance guarantee attached at the time saw many in the industry shaking their heads in the belief that guaranteed private equity returns wasn’t really cricket. That sentiment has been washed away by the concern that the price discount it’s currently trading at around 80 per cent means investors have paid for a costly guarantee, which won’t be applicable for another seven years (year ten) and that in fact they might have been better off investing in the bond markets.

The vehicle a fund-of-funds manager chooses is largely determined by where it sees its capital base, which in turn is often dictated by the existing relationships it can leverage. For example, Schroder Ventures, which is launching a fund-of-funds with an attractive retail offering, has already conquered the individual investor market to some extent. Alice Todhunter at Schroder Ventures says: “Approximately 25 per cent of SVIIT is held by retail/high net worth investors. When the fund was launched in 1996 we had just 200 shareholders and now there are 1,500. We have dedicated a lot of time marketing this investment trust to high net worth individuals over the last five or six years.” Eastman, who manages the newly-launched Schroder Ventures fund-of-funds vehicle in Europe, says: “Our fund-of-funds product has a minimum investment level of EURO125,000 and we are calling the money down in three installments. This significantly lowers the barrier to entry to private equity investing for individuals and we are able to give those investors access to 20 to 30 of the best private equity funds in the world, which they otherwise would not be able to get.”

The issue of widening the private equity investor base is a hot topic on both sides of the Atlantic at the moment. Eastman notes: “The source of private equity capital is undergoing a shift. For example, defined benefit pension plans, where a lot of money has come from, are slowly closing to new members.” He envisages the take-up of Schroder Ventures fund-of-funds retail element coming from high earners personal pension planning. Specialist European private equity law firm SJ Berwin is currently looking at the issue of providing access to private equity for individuals not in the high net worth category a portion of the latter have access to traditional private equity limited partnerships already and, as such, are not considered a key area.

“We want to structure a pan-European product that will bring retail investors and insurance companies into private equity especially those who are not currently investing, but who seem to be demonstrating a strong interest in the asset class. There is relatively little available to attract private money, other than from high net worth individuals, to private equity at the moment. We are currently gathering our thinking on this across our European offices,” says Josyane Gold, partner at SJ Berwin. It’s early days and the firm does not expect to have made significant headway on the matter until towards the end of this year.

A mainstream asset class?

“More and more investors are looking to find ways of increasing returns in their overall investments. It’s more difficult to make returns from the stock market so pension fund consultants are increasingly looking at private equity as a mainstream asset class,” says Carol Kennedy at Pantheon Ventures.

But being a mainstream asset class something the more proactive parts of the private equity industry has lobbied long and hard for brings its own set of assumptions. John McCrory of Westport Private Equity sums it up: “If private equity is to become a central part of institutional investors asset allocation then the industry has to move to make itself more institutional-looking.” The investment banks, long used to the beauty parade process, are stealing a march here.

But it’s more complex than that. While it might be assumed that an investor, such as a pension fund, investing in private equity for the first time, having decided on the fund-of-funds route, would choose an established player with a track record, the reverse is often true. The established players are finding it hard to beat off competition from global investment banking brand names, regardless of those banks’ depth of fund-of-funds experience.

As one independent fund-of-funds manager puts it, having been advised by their consultants to make a private equity allocation, choosing a brand name is often the path of least resistance especially if things were to go wrong at a later date. Another describes the UK market as a “bun fight” each time a private equity mandate has been put out to tender in the last year, with as many as 30 or 40 names being put forward and the investment banks willing to pitch for mandates as small as GBP5 million in one case.

It’s easy to postulate as to why the investment banks are jumping into private equity they are fee-driven and fees from M&A and IPO have long since dried up and so it’s not just private equity but the whole asset management business with its attendant fee structure that is proving attractive. Although the fee-driven nature of the investment banks clearly worries some since the idea is for the fund-of-funds manager to be primarily returns-driven and therefore aligned with their investor interests. They are also obviously peeved to be losing business to the investment banks, although this doesn’t appear to disappoint as much as the fact that there is precious little opportunity in a beauty parade situation for a relationship to develop between the institution and the fund-of-funds manager something that was previously a large and important part of this market.

But what should investors be looking for in a fund-of-funds manager, aside from an alignment of interest? (It’s worth mentioning that any self-respecting investment bank will tell you their interests are aligned, if only because some have learned the hard way that this must be the case given the performance on their direct investment portfolios in the past.) Track record of the investment team if the firm doesn’t have one to offer, ability to source the best funds and identify those funds are recurring themes. Linked to the sourcing of funds is the concern regarding over-diversification mentioned earlier. Some believe that those firms or institutions that are attempting to deploy globally over EURO300 million in a year are going face overweighting problems in certain sectors, geographies, or investment stage if they are to get the funds deployed into credible funds. One smaller long time private equity fund-of-funds investor notes that all funds the firm commits to get equal weighting because, “if something is worth doing, it’s equally worth doing to everything else in there.”

McCrory notes: “We’re looking for people who really do build value. The number of groups that can do that is small. What’s desperately needed is talent. There is no longer any co-investment and by and large in the past there were benefits from two groups looking at an investment, although co-investment does bring some problems. On the whole private equity investors lead very isolated lives. The US venture market is co-investing again though.” The issue of management fees is much talked about but doesn’t appear to be the thorn in the side in Europe that it has perhaps been in the US. “We don’t have any major concerns about management fees: some of our funds have taken management fee holidays and cut fees. Intransigence on management fees tends to come from those who cannot raise another fund,” says McCrory.

Why fund-of-funds?

Jesse Reyes says: “There are three main reasons for using a fund-of-funds manager. Firstly, you don’t have the time or know-how to pick funds. Secondly, a fund-of-funds should lower your fund management expenses, and finally, you don’t have access to the best funds. The first two reasons are the main drivers for people investing in fund-of-funds.”

Ivan Vercoutere, partner at LGT Capital Partners, looks at the recent history: “In the late 1990s a lot of institutions thought private equity was an easy place to achieve superior returns. Now that the distributions and returns are not coming through as initially expected, many are realising that it’s not that easy so they have decided to do things differently and a number have ended up going the fund-of-funds route. Some of the small institutions will probably stay with fund-of-funds managers because it’s much more economical and less risky. Others with larger portfolios will initially work closely with fund-of-funds managers and leverage the relationships while building their own private equity resources and portfolios.” Some institutions follow fund-of-funds managers investment patterns, as much as they are able, but try to avoid the fund-of-funds managers fee. “You do get coat tailers at the end of the day if people know that your due diligence procedures are very thorough,” says Carol Kennedy.

Tailor-made mandates, which give the institution more control, appear to be increasing. Ivan Vercoutere says: “There are the investors that have decided to invest in fund- of-funds and those that have decided to have their own mandate that is tailor-made. In both cases the investors will hold beauty parades. Some of the institutions will pick two to three fund-of-funds managers with different skill sets, this is a smart approach and is increasingly being done.” The popularity of fund-of-funds remains not just for the reasons outlined above but because they have traditionally earned their keep the worry is that this might not continue to be true as more and more new fund-of-funds enter the market. “Fund-of-funds are probably earning their one per cent across Europe and the US at the moment, but only just,” says Jesse Reyes.

For the moment though, fund-of-funds are concentrating on the soon to be out end of Q1 2002 figures as many expect further falls in valuations, but the real pain may be some way off suggests McCrory. “A lot of bad news is coming out from the US funds invested in 1998/1999. At the moment valuations are right down but in two year’s time these will be write-offs so I don’t think we’ve had the full implications in terms of perception of the private equity market.”