Coping with the private equity boom

In last year's fundraising bonanza, speed of response and a reputation for staying the course helped funds of funds to meet their deployment targets. But their longer-term success will depend on finding time to identify the managers of the future, writes James Taylor.

2006 was by some distance the biggest year of fundraising in the history of private equity. 684 funds raised $432 billion between them, according to data provider Private Equity Intelligence – a 38 percent increase on the previous year. New investors flocked into private equity, attracted by the market-beating returns delivered by the top funds, while existing investors continued to increase their allocations to the asset class.

All this was good news for managers, who enjoyed unprecedented demand for their new funds. But it wasn't such good news for investors, many of whom faced an uphill struggle to get access to the top-performing funds – knowing that without this access, their chances of getting above-market returns would diminish significantly.

So for funds of funds, 2006 was a mixed year. On the one hand, as fundraisers themselves – and as an obvious entry point for investors new to the asset class – they have never had it so good. On the other hand, their appeal to these investors is predicated on their ability to access the topperforming funds – and in 2006, this was more difficult than ever.

No matter how impressive its market insight or contacts book, a fund of funds will only retain its investors if it consistently achieves meaningful allocations to the right funds. And with so many investors clamouring for access, popular general partners had much more freedom to dictate terms than in previous fundraising cycles. So why give allocations to fund of funds ahead of other investor groups?

Longevity is perhaps the most important reason. Most funds of funds have been investing in the asset class for many years, and have built up long-standing connections with the top managers over a number of cycles. Helen Steers of Pantheon Ventures, which opened for business in 1982, says: “We've been around for a very long time, and we have very well-established relationships. We've been meeting these people on a continuous basis for many years, so our process builds on existing information and relationships.”

Most funds of funds were also active a few years ago, when it was much harder for general partners to raise funds. Those investors who stayed loyal through the difficult times are far more likely to be rewarded with a place at the front of the queue now, when times are good.

Indeed, some FoFs were far-sighted enough to take advantage of this window of opportunity. Rainer Ender, managing director of Adveq, says his firm deliberately used the fallow fundraising years to expand their access. “In 2002/3 even brand names were uncertain about how the journey would develop. So access to top brands was possible, and we utilised the window to expand our portfolio.”

Speed is also a key advantage for funds of funds. As long-time private equity investors, their ability to make commitments quickly gave them an edge over other investor groups last year. All of the FoF managers interviewed for this article said that speed of response had been more important than ever before. “You needed to be very responsive, fast-moving and process-orientated,” says Ender. “And you needed to have your relationships lined up with GPs.”

Sometimes this meant talking to managers before the formal fundraising process had even started. “Fundraising tended to be a lot more rapid,” says Steers. “So we had to be even more proactive and ensure we were in dialogue with managers before they'd put out a PPM.”

FoFs can move more quickly than other investors for a number of reasons. One is experience – having invested in the asset class, and sometimes in particular managers, for years beforehand, FoFs tend to know what they're talking about. Neil Sneddon, director of Private Equity Funds at F&C Asset Management, says: “We have a lot of longevity in the asset class. We've been through several cycles, and we know the problems funds may face later on. People value our opinions because we're straightforward and focus on the main business issues, rather than getting bogged down in minutiae.”

Scale is also important: FoFs will usually have more internal resource available to assess funds than other institutional investors, but fewer levels of hierarchy to navigate – so the decision-making process is normally faster.

So fund of funds tend to be efficient investors. And in general, managers are glad to have them. The overwhelming consensus from GPs was that FoFs remain a crucial part of the private equity investor base. “They are professional investors who are there for the long haul,” as one European GP puts it. “Once you have them on board and have shown you can fulfil their expectations, they're a great resource to have.”

“They approach the market in a very scientific way,” says another. “They're keen to differentiate themselves, so they produce very sophisticated performance data. And it's great as a new fund, because they can provide some excellent best practice benchmarking from the other companies in their portfolio.”

An American GP said networking was an additional benefit. “They'll usually have an investor day where we can go along and meet not only the investors in their fund, but also all the other fund managers they invest in.”

“We've been through several cycles, and we know the problems funds may face later on. People value our opinions because we're straightforward and focus on the main business issues, rather than getting bogged down in minutiae.”

But these benefits will not be apparent for every fund, particularly at the larger end of the scale. One GP at a large US buyout firm said: “Nothing against FoFs, but we just prefer to have direct relationships with the people who are investing in us. That way we can make sure that our investors get the information we want them to get, without any filtering or interpretation. And we can build long-term relationships with the people who are actually committing capital.”

Yet many FoFs now command so much capital that even the biggest firms cannot ignore them. “Groups like HarbourVest [Partners] and Pathway [Capital Management] are now some of the very biggest limited partners, so you have to talk to them,” as another manager puts it. HarbourVest is a case in point – last year it raised nearly $3.5 billion across three commingled structures, emphasising its position as one of the most important investors in the industry.

And it was not alone. In 2006 funds of funds were able to take advantage of record inflows to raise more capital than ever before. According to figures from Preqin, 82 funds raised $29 billion between them last year. HarbourVest's total included the $2.4 billion Europefocused International V, the biggest fund of funds raised last year, while JP Morgan raised two $1.5 billion pools. Clearly FoFs were able to reap the rewards of increased demand for exposure to the asset class.

FUNDRAISERSA selection of funds of funds that closed in the last 12 months

Fund Name GP name Fund Size Fund Focus GP Location Year Closed
HarbourVest International V HarbourVest Partners €2,400 Europe US 2006
JP Morgan Venture Capital JPMorgan Asset Management $1,500 US US 2006
Investors III
JP Morgan US Corporate JPMorgan Asset Management $1,500 US US 2006
Finance III
Merrill Lynch Diversified BlackRock Merrill Lynch $1,300 US UK 2006
PE Program III Investment Managers
Siguler Guff Distressed Siguler Guff & Co $1,000 US US 2006
Opportunities Fund II
Morgan Stanley Private Morgan Stanley Alternative $1,000 US US 2006
Markets Fund III Investment Partners
APEP Dachfonds Allianz Private Equity Partners €750 Europe Germany 2006
Danske-Private Equity III Danske Private Equity €600 Europe Denmark 2006
Auda Capital IV Auda Advisor Associates $750 US US 2006
H21PEP III Horizon21 Private Equity €564 Europe Switzerland 2006
AXA Capital Asia AXA Private Equity €550 ROW France 2006
Euro Choice III LODH Private Equity €500 Europe Switzerland 2007
SVG Diamond II SVG Advisers €500 Europe UK 2006
Wilshire Private Markets Wilshire Private Markets Group $660 US US 2006
Fund VII
Performance Venture Capital Performance Equity Management $650 US US 2006
AIG Private Equity Portfolio IV AIG Global Investment Group $637 US US 2006
Crown European Buyout II LGT Capital Partners $609 Europe Switzerland 2007
Siguler Guff BRIC Siguler Guff & Co $600 ROW US 2006
Opportunities Fund
HIPEP V-Asia Pacific and HarbourVest Partners $527 ROW US 2007
Rest of World Fund
Harbourvest Emerging HarbourVest Partners $500 ROW US 2006
Markets I

But the smartest funds of funds are already looking beyond 2007. After all, investors back them because they believe in their ability to access upperquartile performers throughout the lifecycle of the fund – not just the current generation of high-achievers. And just as the FoFs who stayed with funds through the bad times are now reaping the rewards, the best way for firms to ensure access to tomorrow's superstars is to back them today.

That means FoFs need to be spending time on the emerging managers who may be delivering top returns in five years' time. Sneddon, whose firm was an early backer of Candover, among others, says: “We like to back emerging managers within our portfolio. If you identify good groups and back them early, when the market becomes more buoyant you're not likely to be scaled back meaningfully.”

With so much else on their plate, it would not be surprising if some FoFs neglected this search for the next generation of talent in 2006 – whatever their protestations to the contrary. As one FoFs manager puts it: “When you're busy trying to get into top quartile funds, how do you find the time to think about emerging managers?” This was particularly true for those FoFs that were fundraising in 2006.

Yet this search could be critical to their long-term success.

Pantheon for one seems acutely aware of this. “It's extremely important to keep looking out for the next generation of top performers,” says Steers, “because you have to expect some existing managers to fall behind.” This process may take some time to bear fruit, she adds. “We expect to track firms for several years before committing to them.”

The answer, she believes, is to make the tracking of future stars a fundamental part of the firm's day-to-day operation. “We have an intensive monitoring process not just of our portfolio, but also a ‘shadow portfolio’ of alternative options. This process is country-specific, tracking all the managers we invest in now or may want to invest in later – even captives who are not looking for outside investment yet.”

FoFs still retain advantages over other private equity investors in such a competitive fundraising environment. As professional investors they can normally assess funds more efficiently, make decisions more quickly, take a longer-term view and use relationships to negotiate their way into top funds. But as access to market-beating returns becomes ever harder to come by, there is likely to be even greater emphasis on FoFs' ability to identify the next generation of upper-quartile performers at an early stage – because backing these groups through the formative stages of their development is by far the most effective way to ensure access in the longer term.