You recently expanded your London office to make it the hub of your European investment management activities. With the Continent still struggling to get out of recession, is it really the right time to focus on Europe?
“The strong uncertainty we had at the beginning of last year has to some extent gone away. There has been a clear demonstration by Germany and France that the Euro will continue and the risk of its demise has receded. The state of the economy, of course, is still an issue – but I think the question is when we are going to pull out of recession, not if we are going to. This is quite important.”
“But what we also stress to investors, in particular to non-European ones, is that the whole of private equity has become much more global in the last 10 years. There are many small, domestic businesses in France or Italy, for example, which can generate much of their revenues outside of Europe. So what we do, as advisors from an alternative assets business, is to select managers who have demonstrated they can find businesses that have either already got international sales or can expand businesses on an international basis. These businesses are less dependent on the European economy, and are more correlated to buoyant economies elsewhere. When Europe becomes buoyant again they can also take advantage of the European economy. We think this is where the future really lies.”
The past few years have seen a number of LPs reduce the number of GPs they work with. Does that significantly impact your business?
“This situation has arisen from the large-scale fundraising that happened in 2006 and 2007. These years have seen a lot of cash committed by LPs. But with the dramatic economic slowdown in 2008 and 2009, fewer investments – and hence few realisations – have been made, so today a lot of investors are still relatively over-committed and lack the resources to make new commitments. As a result they’re looking at those managers who have been most successful and are being more selective.”
“And you also have pension funds who’ve built a portfolio over 10 to 15 years, and who’ve realised they’ve got a large number of funds in their portfolio to manage. Therefore some of them are looking to rationalise the portfolio and to reduce the number of managers. So LPs are clearly more selective and this impacts the whole industry – whether it is primary funds or the funds of funds businesses. Few managers are immune. Fundraising is difficult at the moment, and even some of the top brand names are finding it difficult to raise funds.”
We’ve also seen a number of investors developing in-house private equity investing capabilities, in a bid to reach out to fund managers without using intermediaries. Is that a threat to the fund of funds model?
“This has been underpinned by a willingness to cut fees, and in some parts of the industry it’s a natural evolution. If you’re a large pension fund and you start accessing the market through funds of funds, then after a period of time it is possible to develop the skills and experience required to assess the market and make investments yourself. But I think funds of funds are still very useful, especially for smaller investors, who generally don’t have the skills, experience, connections or sufficient financial resources to obtain adequate manager diversification. Capital Dynamics considers that investing in 15 managers in different geographies, over a three-year period, is adequate diversification; but most funds have a minimum level of investment of 5, 10 or even 20 million euros or dollars. Access can also be difficult for new entrants to the market, and the funds of funds manager can also help investors to obtain that access.”
“And most importantly, funds of funds can bring performance. Although there is a push to reduce fees generally in the industry, I believe that the focus should be on the net return. With the differential in returns in the private equity market being significant, if you don’t remain in the upper half of performance in your selection, you run the risk of underperforming the public markets. The net return of many funds of funds, historically, has outperformed the public market significantly. We at Capital Dynamics believe they will continue to do so, so we think funds of funds still have a significant role to play.”
Capital Dynamics manages investments across funds of many sizes, types and geographies. Do LPs sometimes ask whether you are spread too thinly?
“If you put 50 or 60 positions into a fund of funds, then you’re probably over diversified. But our funds of funds tend to have 15 to 20 positions, which we believe gives adequate diversification to protect the downside without capping the upside. Our research shows that 15 funds are sufficient to protect the downside: our role is not only to generate superior returns but also to protect the downside. This is paramount with pension funds assets.”