Like fund-of-funds in other leading markets, Swiss-based funds have become increasingly attractive for institutional investors in the last two years, as returns have been strong and market sentiment highly favourable towards private equity. These factors have helped turn around Switzerland’s listed fund-of-funds market, which had been suffering from falling share prices, as well as benefiting the country’s limited partnership-style fund-of-funds.
However, Swiss funds face significant challenges if they are to continue to remain competitive. These include the increasing globalisation of their investor base and the growing appetite for specialist funds. Proposed changes in Swiss investment law could also affect the domestic regulatory environment.
With Switzerland’s tradition of private banking and investment services there has long been a large pool of capital available. In the 1990s this led to the country’s financial services sector to enter new areas such as private equity, fund-of-funds and hedge funds. André Jaeggi, managing director at leading fund-of-funds Adveq Management, says the fund-of-funds business is a valuable part of the country’s investment services: “Switzerland is second in Europe when it comes to fund-of-funds, after the UK.”
But he highlights the importance of regulatory developments in Switzerland, notably the revision of the Investment Funds Act. In September 2005 the government passed its proposal to revise the law, which will now be discussed in parliament. The broad aim of the amendment, which is expected to come into force sometime in 2006, is to bring Swiss law into line with the relevant European Union directive on collective investment. While the aim of the legal change is to increase the attractiveness of the Swiss financial system, not everyone is persuaded. Jaeggi says one of the new law’s aims will make it easier for UK-style limited partnership private equity funds to be set up in Switzerland. But the legislation is likely to contain some additional requirements. These are expected to include that the LPs of such funds must register with the Swiss Federal Banking Commission, while GPs will need to be structured as corporations.
“These additional requirements have not yet been defined in detail and so how the legal changes will affect the fund-of-funds business is not yet clear,” says Jaeggi. But he notes that many state pension funds in the EU have made it clear that registering in Switzerland is not acceptable and they would require registration in the EU. “There could be a situation, therefore, where Swiss fund-of-funds faced certain disadvantages,” says Jaeggi.
Some other fund-of-funds managers, however, play down the relevance of the proposed law change, arguing the increasingly international perspective of Swiss fund-of-funds makes changes in the domestic regulation less important. “Only 10% of Swiss fund-of-funds investment comes from Switzerland and only 5% of our own investment,” says Urs Wietlisbach, chief markets officer at Partners Group. He adds that it is important Partners Group take account of global legal and regulatory terms.
“We have eight lawyers and tax specialists who, besides structuring products, keep track of the legal and regulatory issues across the world because if we’re dealing with investors in Canada there are different issues to investors in Australia or Singapore,” he says. It is by developing in-depth knowledge of the legal and regulatory issues facing clients that Swiss fund-of-funds are able to offer tailored products. For example, to deal with particular taxation issues facing German investors, Partners Group recently launched a mezzanine product. It was initially seeking €200m but raised €225m and had to turn investors away. A large part of the attraction was that the fund was extremely tax efficient for German investors.
For Tycho Sneyers, partner at LGT Capital Partners, one of the biggest challenges for Swiss fund-of-funds is the need to match an increasingly global investor base and the rapidly growing private equity market in Asia. LGT, for example, has recently opened a New York office and is looking at opening one in Asia. “It’s not easy to talk about the ‘Swiss’ fund-of-funds industry because the leading funds are now global and dealing with clients and investments all over the world,” says Sneyers.
Wietlisbach agrees, noting that if the larger Swiss funds want to compete with other global players like HarbourVest Partners and Adam Street Partners they need to be able to service clients on a global basis and to offer specialised fund-of-funds focusing on different regions. He says smaller Swiss fund-of-funds have not gone down the global route yet but are expected to in coming years. Stefan Hepp, chief executive of Strategic Capital Partners (SCM), an advisory service for institutional investors, says: “Swiss-based fund-of-funds managers have become increasingly global as there is a trend to open offices in the US and Asia.” Hepp places Swiss fund-of-funds ahead of the UK in terms of their importance: “The diversity and experience among Swiss fund-of-funds managers makes them, as a group, by now the second most significant private equity fund-of-funds industry after the US.”
André Jaeggi of Adveq says Swiss managers need to take a global approach almost by definition because the Swiss market itself is so small. He adds that just over a third of Adveq’s investors are from German-speaking Europe but the rest from all over the world.
When it comes to selection Jaeggi says Adveq is still extremely prudent: “We have more than 20 different criteria and our focus when it comes to the funds we invest in is on operational experience much more than financial skills.” The number of good managers has not increased in recent years, he says, but the number of poor managers has doubled. He says: “We’ve looked again recently at the universe of managers and there are perhaps 350 managers focusing on small buyout development capital but how many of these have institutional quality? Perhaps 12 or 15.”
Hepp says investors are increasingly concerned about performance, and demand results from their fund managers as well as a clear focus. Others agree. According to LGT’s Tycho Sneyers, demand for private equity in general has been strong and this has been reflected in strong appetite for fund-of-funds from pension funds and insurance companies. But he adds: “Many of these institutional investors are looking for fund-of-funds that offer specialist access, such as the European small and mid-market buyouts, US venture and so on.”
There is relatively less demand from the institutions for generalist fund-of-funds because they can often carry out that sort of research and investment themselves, says Sneyers: “But in, say, the European mid-market buyout sector there are hundreds of managers and the institutional investors just don’t have the time to go out and meet all those people and understand their propositions.”
Partners Group’s Wietlisbach says institutional investors are getting more and more sophisticated themselves, with bigger in-house teams to carry out research. “That means that they can partially cover the private equity market themselves but they can’t cover all of it and that’s where the fund-of-funds are so attractive,” he says. “It’s not easy for the institutional investors to cover the European small cap market, which would mean visiting managers in the different countries, or the Asian market or US venture. In these kinds of market the fund-of-funds can really add something and clients are willing to pay for that.”
Asia is likely to become an increasingly important market in the future for fund-of-funds. Harold Weiss, managing director at Swiss Re’s asset management, says: “At one of our conferences recently we asked investors about their future plans and they all talked about committing more funds to Asia Pacific in the next two to three years.” The larger Swiss fund-of-funds, like Partners Group and LGT, have also moved into other areas, such as secondaries and co-investment alongside GPs.
Partners Group, for example, has about $4.5bn in primaries and over $1bn in secondaries, and several hundred million in direct investments. Its aim is to provide a full range of investments suiting different clients’ needs, says Wietlisbach.
While fund-of-funds are having to develop more specialist products in order to win clients, the downside is that they are losing the economies of scale that come with the bigger fund sizes. “The fee base can suffer when you don’t have the critical mass that comes with some of the specialist products,” says Harold Weiss. Swiss Re’s approach, he says, is that it invests its own money alongside that of third parties which means there is no ‘cherry picking’ but just one pool of money. “It also means we only raise money from outside investors when we have access to the right manager,” he says.
An important part of the Swiss fund-of-funds sector has been the listed vehicles, of which there are a handful with a combined market capitalisation of around €2bn. These funds were set up in the 1990s, largely because at that time there was a lot of interest in private equity among both institutions and high net worth individuals. But it was hard for most institutions to invest in the asset class, which regulators regarded as illiquid and potentially risky. This was deterring investors, who were often unwilling to carry out the level of work required to win approval for private equity investments from Swiss regulators. As a result a number of listed vehicles were launched, offering liquidity and instant access to a diversified portfolio of investments.
In their early years these listed funds seemed to provide an ideal option for many smaller institutions and high net worth individuals to access the private equity market, and the bullish performance of private equity meant the funds were doing well. But by the early years of this decade sentiment seemed to have changed dramatically. By 2000 new legislation had been brought in that had made it easier to invest in private equity and thus removed much of the original raison d’etre of the listed vehicles. Furthermore, some of the promised benefits of the listed funds did not appear to have materialised.
An important challenge the listed funds faced was around liquidity. One of the advantages the listed fund-of-funds managers promised investors was liquidity but by early 2003 share price discounts to net asset values for some listed funds were hitting 90%, making it very hard for investors to get out of their shareholdings without making significant losses.
But in the last 18 months there has been a significant turnaround in the situation of listed funds. Tycho Sneyers of LGT, which manages listed vehicle Castle Private Equity, says: “Investor sentiment is much more favourable and share prices of listed vehicles are up as are net asset values.” Partners Group’s Wietlisbach says: “On the private client side demand has really picked up again because all the listed funds have had a tremendous rally in the last 18 months. They were all trading below their net asset values and now some are trading above, some around the same and some a little below. As a whole, the share prices of listed vehicles are up 50% to 60% during the period.”
Sneyers says, unlike the popular
perception, listed funds are not focused predominantly on retail investors: “A very big component is institutional investors, who like to use listed vehicles as part of a private equity portfolio for liquidity purposes and to rapidly increase the net asset value of the private equity exposure, so that if they allocate 7% to 8% to private equity 1% to 2% would go into a listed vehicle, which allows them to adjust their exposure and is far more liquid than other private equity investment.” He adds that listed vehicles play a relatively small part in overall private equity investment and are unlikely to ever be significant in terms of total assets but that they do offer some investors a particular benefit.
But there are still sceptics. One manager says despite the recovery in prices listed vehicles are still out of favour among the bulk of investors: “People see them as expensive and that the price generally paid is not necessarily a reflection of the net asset value but of the market sentiment towards private equity generally. If sentiment is favourable towards private equity then there is a premium on listed vehicles’ prices and if it’s not then there’s a discount but the ups and downs tend to be disproportionate to the reality.”
In more general terms, future challenges for the Swiss fund-of-funds market include how succession issues are handled. This is because funds were launched in the 1980s and 1990s and the original founders are often now in their sixties and therefore looking at retirement. What happens to the ownership of some of the fund-of-funds is going to be an increasingly important issue, executives believe, pointing to the example of global fund-of-funds Pantheon, which lost its independence when it was taken over by the Russell Investment Group. Some Swiss fund-of-funds executives would like to avoid this kind of takeover occurring in the Swiss-based funds because they believe clients generally like to see the fund-of-funds groups retain their independence.
In terms of ownership structure, when it comes to the Swiss fund-of-funds, LGT is part of the larger LGT group. But even though it is captive, the parent group has had to give the fund-of-funds business a very long leash, say observers, which means the fund-of-funds managers are fairly independent from the bank and have their own salary scheme that is competitive in private equity terms.
“Often with captives you find a high staff turnover because the parent group’s usual salary scheme can’t match the high pay of many non-captive funds, but LGT seem to have got round that issue,” according to one executive.
Adveq is clearly independent. Founding partner Bruno Raschle “looks like he will keep on working indefinitely and that retirement is not on his agenda,” according to one observer. Partners Group, meanwhile, is one of the “younger” Swiss fund-of-funds, founded in 1996, and is therefore unlikely to face succession issues for a while, as co-founder Urs Wietlisbach is still only 44. It looks, therefore, like most of the leading independent Swiss-based fund-of-funds will continue to operate autonomously for the foreseeable future and as long as they can offer their institutional clients sufficiently specialised funds they are likely to retain their prime role in global fund-of-funds.
The caveat, however, which probably applies across the board in private equity, is the suspicion that the high returns of recent years are creating a bubble. “The danger is that the due diligence begins to suffer when managers are under so much pressure to deploy capital,” says Swiss Re’s Weiss. “We saw a similar process in the late 1990s with venture and there’s a danger that similar patterns are emerging with buyout investment.”