Even the worst of times can lead to the best of opportunities, and fund of fund managers are no less oblivious to such an ethos than the rest of the private equity world. Just because the world of the mega LBO has come to a halt, fund of funds haven’t been dissuaded from putting their money to work in other parts of the market.
“People are starting to rethink their allocations. For example, we invested US$130m in the secondaries market in the first half of 2007 and in the second half we invested US$1bn in secondaries. Flexibility between investment segments such as primaries versus secondaries, various geographic regions or investment stages offers significant return opportunities,” says Fredy Gantner, executive chairman of Partners Group in Zug, Switzerland.
“If your private equity allocation remains too static then you are going to miss out on opportunities. You can only have a more flexible approach if you have the resources such as outsourced comprehensive asset management services or you are able to manage your own secondaries business,” he says.
Partners Group takes the view that firms need to have a global footprint as well as a regional focus to be able to succeed. “You can’t operate successfully out of three offices, so that’s why we have 10 offices,” says Gantner.
“Asset allocation is going to get more dynamic and fund of funds managers will need to build their portfolios around the globe through primaries, secondaries and direct investments. I think smaller groups with up to 20 fund managers will be squeezed out of the business,” says Gantner.
For those fund of funds managers that disclose the split-out of their private equity allocations, it is not uncommon to see half or more of a portfolio focusing on mid-market deals, about 30% on large buyouts and possibly as much as much as 10% on venture. The big question is whether this kind of allocation split is going to change irrevocably over the next few years.
“We’re really not market timing,” says Sam Robinson, director at SVG Capital’s fund advisory business in London. “The funds we invest in will make investments over the next four to five years; therefore I don’t think we should consider now to be a bad time to commit to a large buyout fund because the next few years may be a very good time to invest. There’s prejudice against the big buyout funds and I think that is a bit short-sighted.”
“Am I concerned about mark-to-market? A little bit. But I’m not really worried about all the recent covenant-light deals because in four-to-five years from now I think value will have been added to many of those deals,” he says.
Hedging on the LBO revival
The investment pace in Q1 this year has held up quite well compared with the first quarter of last year, and there have been investments, good levels of disbursements, realisations and even some capitalisations, according to John Gripton, head of investment management, Europe, at Capital Dynamics. “It seems to me that the market is steadying and picking up.”
But the outlook for the large LBO space is less clear at this stage. “If we don’t see any large deals materialising over the next 12 months then we would be concerned about the flow of returns,” says Gripton.
“You don’t have to pay more or less fees if GPs are investing in one year or in four years. Some 1997 funds had six-year J curves and returned solid double digits to investors,” says Gantner.
“Although there is the issue of management fee drag, I’ve got no problem with people sitting in the wings rather than drawing down money and doing bad deals. I think we’ll see very few mega deals because the bank debt market is not active,” says Jonny Maxwell, global head of private equity fund of funds at Allianz Private Equity Partners in Munich.
Maxwell adds that in the €1bn to €3bn range there is scope for deals including a number of public to privates across Europe assuming sponsors are able to get the debt, which will mean the banks becoming comfortable with these deals again.
“Obviously there are huge opportunities in the buyout space. We like small-cap investment with enterprise values up to €100m, but the small-cap and mid-cap markets might be on the crowded side,” says Gantner.
Partners Group is also among those managers keen to commit to the mega-large buyout funds. “We think the credit market will be coming back. Even if the global economy goes into recession, investing in large buyouts could be a portfolio hedge because prices will be discounted,” says Gantner.
“The market is undoubtedly cyclical. I personally think the next year will be a very good year in terms of investments. From a buying perspective, 2009 and 2010 look like they will offer similar opportunities to 2002 and 2003,” says Peter McKellar, partner and chief investment officer at SL Capital Partners in Edinburgh.
“The private equity market is going to be relatively calmer for the next five years. We have this pregnancy of expectation and people’s pricing expectations take a long time to change,” says Maxwell.
“The next four years will probably throw up some very good opportunities and it will be a time for sensible valuations to return to the market. I think people will look back on 2006 and 2007 as the more curious vintage years in private equity,” he says.
Despite the potential for discounted deals in the near future as some European economies falter, some enter into recession and some listed companies are taken private, appeal for the big buyout phenomenon is not shared by everyone.
“Why would you want to sign up to a large buyout fund?” asks George Anson, who manages HarbourVest Partners (UK), based in London. “The ability to transact is not there and the credit markets are not able to finance the deals. So, the only thing you are signing up to is an arrangement fee. What we’re looking at is spreading our allocation to small and medium-size buyout funds.”
“If you are willing to pay 500bp over Libor you could probably get the senior debt, but no-one wants to pay those kinds of spreads,” says Anson.
Anson says that in the context of banks increasingly pricing their loan activity to risk he would advise fund managers to have some form of contingency to pay back loans just in case their bankers call in outstanding loans.
“The area where we are doing most buying is in our secondaries business,” says Anson. HarbourVest has a 21-strong team in this area and Anson says that 25% of portfolio in secondaries makes sense right now.
Like other fund of funds managers, HarbourVest is fundraising among its existing investors at present but has not disclosed the size of the fund, which will focus on Europe and on Asia Pacific. Its last fund, totalling €3bn, was closed at the end of 2006. The fund of funds manager also has approximately US$375m to allocate from its dedicated mezzanine and distressed debt fund.
Although distressed debt and mezzanine funds, Asia Pacific funds and also cleantech funds are in danger of being overblown, according to some managers, the demand for these diversification plays are evident.
“We’ve seen more fundraising for distressed debt and mezzanine, for which there will always be opportunities. Although there is an element of wait-and-see for these opportunities, the key is to look for managers investing in distressed debt who have generated good returns in periods of sustained economic growth,” says Gripton.
SVG Capital is completing the first closing of its dedicated Asia fund at US$100m with the intention to raise approximately US$200m. The company is also opening a Singapore office in June.
“There are more firms out there of institutional quality than people know – we look at international players and domestic players in Asia. We’ll probably invest our Asia fund in two or three funds in China, two or three funds in India and some pan-Asian funds over the next three years. Some of our investors have come to us and asked for more Asia allocation,” says Robinson.
Gripton says there is definitely more interest in Asia and Capital Dynamics is increasing exposure there but cautiously. “We believe it is the right time to take a position in Asia and we prefer to have Asian nationals involved in the management of the funds wherever they are located,” he says.
Elsewhere, emerging markets are grabbing more attention from fund of funds managers, albeit from a much lower base than allocations in Asia
“We have seen some good opportunities in Latin America and Africa – both regions are becoming more interesting,” says Gripton. “Russia is less clear in terms of political and legal issues.”
Gantner says that 2007 and 2008 will probably be landmark years for emerging markets with good opportunities in Asia and more developing opportunities in Eastern Europe, Latin America and Africa. However, he warns against long-distance investment strategies that some managers still adopt, especially for the more heated markets.
“You cannot sit in London and truly think you can understand China – there are so many tools and skills required to be successful there. Albeit our long-term optimism on China, reality will be bumpy and there will be setbacks on the way,” says Gantner.
Generally, GPs had a lot of influence up to the credit crunch and now the market is reverting to market conditions similar to those in 2001 and 2002. Back then, Cinven and CVC took a year to raise their 2001 and 2002 funds, but they still reached their targets even though it took longer than it would have before.
“I don’t think it has got to the stage where people have started to panic about raising money. There’s bound to be one or two funds that will be smaller than they should be, but I think the big names will be fine. However, I simply don’t know if the market is there to raise US$20bn, for example,” says Robinson.
Although the impasse at the upper end of the LBO space might in theory have stimulated more interest in European venture funds, the lack of US-style entrepreneurial spirit and lack of impressive returns look set to keep this asset class in the allocation margins, managers agree.
“European venture opportunities continue to be limited,” says McKellar. And SL Capital’s 5% allocation to venture is unlikely to change, he adds.
Is there any short-term chance for renewed interest in European venture? “No, but it’s not through want of trying. Culturally, the Germans have a very different view on risk taking than they do in the US. And I don’t think any of the US venture funds are scaling like they did in the technology bubble,” says Anson.
When it comes to spin-out funds, the basic advice from the fund of funds community is that those new funds should be convinced they can raise the funds before they split from their employers.
“People who come out to the market over the next 12 months may have some problems because of their shorter track records and recently-established teams. I don’t think they will be bypassed completely but they do require a lot more time to consider,” says Robinson.
Communication between fund of funds managers and their GPs does not appear to have resulted in any discernable change in recent months and most managers agree that the outlook will be for a steady flow of information. Also, with less time spent on frantic auction processes, there is more time being spent on portfolio performance discussions.
But nuanced changes in communication appear to have filtered through from the GP community. “They are more forthcoming with information like gearing levels, and GPs are generally aware that LPs are more concerned,” says Gantner.
Relationships with their LPs – new and existing – means more time spent on discussing J curves and IRRs, for example. And managers are reporting that there is little evidence of stop-start investing among their LP communities. In fact, there is a growing trend of European local authorities and sovereign wealth funds embracing fresh allocations in new fundraising by fund of funds.
“If you look at current deals with higher equity contributions and increased financing costs, now featuring mezzanine tranches in almost all structures, we foresee levels of returns as we saw in the 1990s that ended up in the mid-to-high teens. Currently, returns on secondaries might generate 20%-plus,” says Gantner.