Fund of Funds Special: How to access alpha in the lower mid-market

Funds of funds managers are pushing deeper into hard-to-access markets and backing generational change to generate alpha.

Investor interest in lower mid-market funds is not new. This area houses some of the most sought-after assets that not only have lower valuations and barriers to entry but also provide opportunities for value creation and multiple expansion.

Aside from these favourable attributes, smaller funds are generating higher average returns and are consistently outperforming mid-size and large funds, according to Cambridge Associates benchmarks over the last decade.

Interest in smaller funds is expected to continue in the near-term. According to Probitas Partners’ Private Equity Institutional Investor Trends for 2019, US growth capital funds and US small-market buyout funds attract more than 50 percent of investor interest globally.

But it’s tough for limited partners to access these funds. Those at the larger end are hampered by large minimum ticket size, and many struggle with access during the lightning-fast fundraises of the most sought-after funds.

Funds of funds can help to bridge the gap. Hamilton Lane is a big backer of small to mid-market investing, which it defines as funds with less than $3 billion in total commitments. Of the roughly 900 funds it reviews on an annual basis, two-thirds are in the small to mid-markets, says Juan Delgado-Moreira, the firm’s vice chairman and head of Asia.

Aberdeen Standard Investments is another. Graham McDonald, global head of private equity, says the lower mid-market continues to be a strong focus for the firm in Asia, particularly “hard-to-access, hard-to-diligence and hard-to-find funds”.

For Singapore-headquartered fund of funds manager Axiom Asia Private Capital, smaller funds are preferred because they have a better chance of producing higher returns, as the managers will be under less pressure to deploy capital and can be more selective in picking investments.

Axiom gathered a total of $1.6 billion in December for its fifth flagship fund of funds vehicle and a co-investment fund that will back lower mid-market buyouts and provide growth and venture capital in Asia-based companies. Investors in that fund include Michigan Department of Treasury, Montana Board of Investments and State Teachers Retirement System of Ohio, according to PEI data.

Edmond Ng

Edmond Ng, managing partner and co-founder of Axiom, says the firm tries to invest in funds that can produce a net internal rate of return of more than 25 percent and a net multiple of more than 2.5x.

“This may sound generic, but the reality is that not too many private equity fund managers globally have consistently produced this sort of returns. Our job is very challenging.”


That job, however, is made easier by being in Asia, where there is no shortage of opportunities. “Asians are very entrepreneurial. The private equity professionals here are no different. A lot of young and successful private equity professionals want to start their own firms and raise smaller funds,” he adds.

The difficulty, he says, is making sure the firm is backing the right team and properly understanding the managers’ past track record.  “Were they successful because of the firm they are in? Is their track record driven by just one or two outlier investments? How do entrepreneurs perceive them? How is their business network?” Ng says.

“We need to make sure their dealflow can continue to be strong and of high quality. It requires a tremendous amount of effort.”