Fund-of-funds: working to stand

While the past few years have recorded a dip in funds raised for the fund-of-funds industry, the fund-of-funds population has remained stable, despite predictions of a consolidation and shake-out of the industry. And then last year the capital raised for fund-of-funds increased.

While a shake-out has yet to materialise, consolidation has arrived. This has taken the form of large asset management groups and investment banks buying up smaller fund-of-funds to increase their exposure to private equity. Notable deals include Lehman Brothers’ purchase of the Crossroads Group and Frank Russell’s acquisition of Pantheon. And most recently F&C Asset Management’s acquisition of Martin Currie Investment Management’s private equity fund-of-funds business.

Looking at the fund raising success of fund-of-funds of late, the attractiveness of these businesses with their high, by other assets class standards, fixed fee income, to larger fund management groups is underscored. European fund-of-funds raised in 2004 were up by 220% to US$4.2bn, according to research from Almeida Capital. This accounted for over a third of the global total of fund-of-funds, which stood at US$12.1bn. US growth was also impressive, up by 120% in 2004 to US$7.9bn with over 60% of funds headquartered in the US and managing two-thirds of total fund-of-funds assets. Almeida Capital research also reveals the average European fund-of-funds is now the same size as the average US fund-of-funds.

And the market looks set to grow further. Of a survey of 50 LPs actively looking to invest in fund-of-funds, over half plan to increase their allocation, according to Almeida Capital research.

Stefan Hepp of SCM Strategic Capital Management says: “There is definitely an increased interest in fund-of-funds after several years of decline. That interest has been more pronounced in the US. It reflects the increased interest in investing in private equity after the decline of the years 2001/2002. It is also a signal that the group of participants in the industry is increasing again. There is more interest from new investors and a return of some of those who got burnt. One could say the tourists are coming back.”

The main reasons LPs choose to use fund-of-funds products are for diversification, to access top tier VC and LBO funds, as an introduction to the asset class, access to investment expertise and professional resources, or so the arguments go. In reality it’s a combination of all of these factors, so once the introduction to the asset class reason is voided by time, one or all of the others kick in (although more on the diversification issue later), and this is why fund-of-funds continue as a vital component of even large and mature LPs. Track record and experience are still the most important criteria when it comes to selecting a fund-of-funds. But as investors become more experienced in the asset class, so must fund-of-funds providers offer more value-added services.

Tycho Sneyers of LGT Capital says: “Providing diversification, industry expertise and administrative support have long been key benefits investors would expect to get from a fund-of-funds. Over the years, the average investor’s experience in investing and managing private equity funds has significantly grown and such sophisticated investors now feel more comfortable doing things themselves. Therefore, fund-of-funds need to keep evolving their value proposition.”

Fund-of-funds will continue to succeed where they serve a purpose for investors. The best purpose that fund-of-funds serve is outsourcing the selection of funds and monitoring of their activities. This can involve everything from the allocation decision to taking on board a wide range of administration responsibilities from the investor. Timothy Spangler of Berwin Leighton Paisner says: “I see fund-of-funds which are also providing value-added services on top of their investing services. Many seek to provide an investor relations interface with the fund-of-funds’ LPs which they wouldn’t get if they were direct investors in private equity funds. There has to be some added value. For some investors who enter into fund-of-funds it seems to be a way of jump-starting their allocation to the asset class so that they can go it alone the second time around. Most fund-of-funds overcome losing their client base by adding something other than just an outsourcing exercise.”

Subhead] Access all areas

Getting to invest in the best performing funds has become increasingly difficult and access to these funds has become highly sought after and therefore expensive. Alexandre Covello of LGT Capital Partners says: “Investing in private equity is more and more relationship driven and securing access to the top performing primary funds has become a major value proposition that investors are looking for in their fund-of-funds managers. Not only do we provide access to top tier funds through our programmes, we very often help some of our clients get a piece of the allocation in funds in which we are investing.”

Michael Granoff, CEO of Pomona Capital, which closed its fourth primary fund-of-funds, Pomona Partnership Holdings IV on US$250m (€206m) earlier this year, says: “Investors understand that they must invest with the highest quality funds in order to achieve meaningful performance in a world where the spread between top and bottom quartile private equity funds is over 50%. Yet access to the best buyout and venture funds is becoming increasingly difficult. The Pomona approach of deploying modest amounts of capital in a focused strategy is our way of minimising the risk and maximising the return in a complex private equity market.”

Good GP relationships are key to securing access to top performing funds and fund-of-funds have both the infrastructure and the relationships that a single LP, unless a big private equity investor (and even then staffing is more often than not an issue), can hope to replicate. Not only this, a GP wants to invest its fund raising time and effort in an LP sure to be there at the next fund raising, and given that investing in PE is the only business of a fund-of-funds, unlike a pension fund or bank that may have a change of investment strategy imposed on it from higher echelons, fund-of-funds are likely to be there next time around, as well as tending to have more money at their disposal to commit per fund. GPs will also look for LPs who will be beneficial to them as a networking partner and also as a co-investor in certain transactions.

Subhead] Finding a niche

According to Almeida Capital, around 18% of LPs think fund-of-funds managers fulfil more or less the same role, while half think fund-of-funds do manage to differentiate themselves.

Examples of players targeting the less populated sectors of the market include European mezzanine-focused VCM Golding and European venture-focused Mowbray Capital. Whether the opportunities for these funds are out there remains to be seen. Munich-based fund groups Golding Capital Partners and VCM have managed successfully to raise their fund, completing the final closing of Europe’s first dedicated mezzanine fund-of-funds in June this year. The fund closed at €200m, above its original €150m target, after just over 12 months fund raising. The vehicle is the first of its kind to offer European investors access to a diversified portfolio of mezzanine transactions throughout Europe and the US, see EVCJ July/August fund news.

Jeremy Golding says: “In a relatively mature market like the UK, it’s hard to find a niche and differentiate yourself. In comparison, the German market is not only underdeveloped but also extremely complex. The main challenge is understanding the tax, legal and regulatory hurdles of the various investor groups. We offer a clear value proposition in having positioned ourselves as a problem solver for German institutional investors, which is our niche. It’s not just the language that’s important, you also have to understand their mindset and develop innovative structures to solve their problems. To come up with plain vanilla fund-of-funds will not be enough, structuring expertise will become more important.” Golding says there are other projects in the pipeline for the team’s fund-of-funds portfolio.

As would be expected with so many disillusioned European venture investors, venture-focused Mowbray Capital is having a tougher time fund raising. Guy Fraser-Sampson says: “It has been slow. We have a commitment from one pension fund and are hoping for a first close later this year. Interest for the fund is coming exclusively from non-UK Europe, our investors are predominantly from the Nordic area and the Benelux. It is a tragedy that UK pension funds are missing out on the whole private equity opportunity set, but we see them and their consultants as a non-starter.” The team is not marketing the product in the US, at least not at the moment, because Fraser-Sampson feels it is not a product that would attract US investors who typically have a jaundiced view of European venture. This is understandable given that typically LPs seek US venture exposure before any other because the potential returns consistently outperform not just European venture but European and US buyouts too.

Regionally focused fund-of-funds, which might not have appealed in the past, seem to be gaining in popularity, particularly with those investors more familiar with the asset class. Tycho Sneyers of LGT Capital Partners says: “New investors that would have typically invested in a globally diversified fund-of-funds for their private equity allocation are now turning more and more to geographic specialisation, like for instance splitting up the mandate between a US manager and a European manager. More experienced investors will hire a fund-of-funds only where they don’t have the expertise or to fill satellite strategies. As a result, investors and managers have started dividing the market and we are now seeing more and more specialised funds, such as US venture capital fund-of-funds or European mid-market buyout fund-of-funds.”

“There are some good specialist managers out there. I would be more concerned with a globally-focused fund-of-funds with only a few million to put to work and which is spreading itself too thinly compared to a specialist fund,” says Eric Kaas of fund-of-funds manager Partners Group. This brings us back to the issue of diversification raised earlier.

While fund-of-funds do inevitably provide diversification it’s not an automatic pick-a-fund-of-funds-off-the-shelf-and-my-portfolio-diversification-requirement-is-met solution. This is partly because the bulk of fund-of-funds diversify only within the relatively narrow band of US venture and European buyouts, ignoring all the permutations of US expansion, buyouts, mezzanine, distressed and European venture, growth, mezzanine and turnarounds, to list just some.

But there is always huge competition when it comes to top tier funds. For the upper decile in US venture funds, in particular, competition is fierce, says Hellmut Kirchner of VCM. But when it comes to European venture, there is not much competition, which will stand Mowbray Capital in good stead in the long run if the European venture scene picks up. Kirchner says: “To find first class venture funds in Europe is not easy. But I’m positive. We are seeing a number of first class management teams aged between 30 and 35. And you have a number of first class VC fund managers in Germany such as Target, TVM and Wellington.”

He adds: “But our strategy is to provide the best possible returns without accepting compromise, be it in mezzanine, buyouts or venture. Some investors have appetite only for European investments, some only for US investments. It’s important to have a balance. We strive for the best possible vehicles. At the moment we believe European mid-market buyout funds promise the better returns than the mega transactions from mega funds with an auction process.”

Subhead] Paying the price

Investing in a fund-of-funds programme is often much cheaper than the cost of setting up an in-house private equity programme. According to Almeida Capital research, 40% of LPs think fund-of-funds are cost-efficient while only 18% think them expensive. And 30% of respondents believe fund-of-funds managers should be rewarded through a profit share, while 34% disagreed.

Private equity fees vary from firm to firm. While private equity fees can be substantial, they are justified to those having to foot the bill by the labour intensive nature of private equity investing and the high net returns investors should enjoy at the end of their ten-year investment.

Annual management fees are used for general operating purposes; ensuring a firm has adequate means to compensate investment professionals, source investment opportunities and perform comprehensive due diligence on investments. The carried interest should provide the main incentive for the fund managers and aligns their economic interests with those of their investors, such that the bigger the fund’s returns, the greater the profit for the investors and team involved.

Clearly going the fund-of-funds route will dilute an investor’s returns to a certain extent because the fund-of-funds fees are laid over those of the underlying private equity investments. But Fraser-Sampson says: “Investors need to be aware that many fund-of-funds managers significantly reduce the impact of the management fee by recycling (as do many of the underlying buyout and venture managers), so the issue is not as clear cut as you might think. Yes, of course there will always be an element of extra fee, but you have to measure that against what it would cost you to initiate and manage such a programme yourself, and what you might be giving up in terms of not accessing the very best opportunities, which can make a dramatic difference to returns.”

US-based alternative asset manager Piper Jaffray has published research looking at the way the fees of the underlying funds in a fund-of-funds portfolio might impact returns. VC firms typically charge an annual management fee of between 2% and 2.5% on committed capital and LBO firms typically charge between 1.5% and 2.0%. The reason for the difference can largely be attributed to differences in fund size (LBO funds tend to be larger and can afford to charge a lower percentage on a bigger dollar amount) and track record. And there are certain (US) VC firms that experienced almost no resistance when they raised their fees because they had previously generated stellar returns for their investors eg Google and Jamba!

Carried interest fees usually range from between 20% and 30%, with only the most successful funds (not amounting to much more than a handful of funds globally) charging the higher amount. It is rarely that a firm can charge a 30% carry but with access to the best LBO funds being limited, several notable managers in the US have been able to do this recently, according to Piper Jaffray’s research. But in general the fee trend has been downward in recent years.

From these figures, Piper Jaffray runs sensitivity analysis in order to show to its investors how fees can impact the fund-of-funds’ IRR (see tables). A fund-of-funds’ fees can vary from firm to firm. Carried interest of 20% remains the industry standard. But in the fund-of-funds sector it is common to charge a significantly lower carried interest. The carried interest fee can range from 0% to 10% (or higher for specialised funds that are more labour intensive.) In Piper Jaffray’s analysis the net IRR assumes a 2% management fee and 20% carried interest at the VC and LBO fund level. To illustrate, a group of underlying funds with gross IRRs of 30% would yield 22.7% net of their fees. In the instance of a fund-of-funds manager charging a 0.5% management fee and 5% carried interest, the return to the fund-of-funds’ investors would be reduced to 21.1%.

Fraser Sampson says of European fund-of-funds: “Fees are pretty standard at 1%, although some Swiss groups are offering less, but you have to take the rest of the economics into account as well. Smaller, specialist funds, such as Mowbray, can’t run their funds on less than 1% if they’re doing their job properly. It is true that the larger groups will be making a profit on their management fees, sometimes even a big profit, but in general I don’t think fees should act as a deterrent to investing in a fund-of-funds.”

André Jaeggi of Adveq suggests that with the increasing number of funds raised and under an increasing pressure to commit uninvested capital, both fees and carried interest for fund-of-funds managers may come down. He says: “Management fees will come down below 1%. Fees above 1% are a thing of the past. If an investor is willing to pay over 1% for fund-of-funds services he has probably not done his homework.”

He adds: “As management fees come down, the barriers to entry will become higher, and we may also see some of the smaller players disappearing because the fees do not allow them to support the needed resources and infrastructure anymore.”

Subhead] What you get for your money

As far as performance is concerned most fund-of-funds investors expect returns of between 10% and 15% per annum, according to Almeida Capital. Stefan Hepp says: “Performance has mirrored the private equity industry and for many funds launched in 1999/2000 there is not much to write home about. It is natural to expect that the fund-of-funds industry overall won’t do any better than the industry itself.”

Top performance is also hard among fund-of-funds because as soon as you have a diversified product, which is what most of these vehicles have traditionally been, it’s hard to be a top quartile product. But Hepp says it is important to recognise that while the dispersion of returns is not as wide as in the private equity industry at large due to the inherent diversification, it is still substantial.

One way to outperform in the fund-of-funds segment might be to do less in, for example, mid-market buyouts, than anyone else. Hepp says: “If you follow the trend of offering what everyone else wants then you are just following the herd and that has cost some players’ credibility. But it’s a double-edged sword. If you are too contrarian you don’t sell, but the same investors backing you will then turn against you if you don’t perform.”

Alexandre Covello of LGT Capital Partners says one of the main values added from fund-of-funds will be to make sure that capital is faster deployed. “Fund-of-funds have many ways to achieve that. They can use secondary investments for a faster deployment of capital and as an efficient way of mitigating the J-curve. Another tool to rebalance and fine tune a portfolio can be found in publicly listed private equity fund-of-funds.”

The fund-of-funds market looks set to go from strength to strength. There is growing and significant demand from both institutional and retail clients for alternative assets and private equity in particular. Kirchner at VCM says: “I think the fund-of-funds business is burgeoning because more and more sophisticated investors are just starting to realise how difficult it is to get into top quartile funds. It’s a science and an art at the same time and often a fund-of-funds is the only option.”