Fund of funds managers are warming to deal-by-deal transactions as a means of getting in on the ground floor with emerging managers.
“We work with a lot of people looking to raise a fund who start with deal-by-deal,” Elias Korosis, partner at UK-headquartered fund of funds Hermes GPE, tells Private Equity International.
“That’s the best way to diligence them and understand the quality of their own due diligence, relationships with company management and how they work together. No due diligence questionnaire can give you the same amount of familiarity with a GP.”
Hermes held a first close on its fourth co-investment fund at its $350 million target earlier this year. The firm, which declined to comment on fundraising, expects outsized returns to become the preserve of smaller, growth-oriented managers, and large buyout funds to become vehicles for large-scale deployment, offering a safer, more diversified, low-double-digit return profile.
LPs may want exposure to deal-by-deal strategies as each transaction has its own set of economics that don’t depend on the performance of other deals. Investors may also be disenchanted with the traditional fund model or they may find it difficult to get into traditional funds because they’re too small, as is the case for some family offices.
Fund of funds managers have sometimes been deterred by the economics of deal-by-deal transactions, having typically only pursued directs and co-investments as a means of reducing fees.
“Fundless sponsors demand closing, monitoring fees and carried interest – one of the reasons that the bar is significantly higher with a lot more homework, not just on the expense side but also on the alignment of interest,” says Marc der Kinderen, managing partner at New York’s 747 Capital, a fund of funds specialising in lower mid-market US buyouts.
“We believe the expense ratio is a significant part of the attraction of co-investment. If we can’t get it for ‘free’ from our own portfolio GPs, it has to be an absolutely fabulous opportunity from an independent sponsor, and even then, we want the fees and expense ratio to be more attractive than a fund.”
Risk premium needed
Not all funds of funds managers are convinced. The additional layer of fees from a fundless sponsor can impact performance and teams unconstrained by a fund term may have less of an incentive to stick around for the long-term, says Jean-François Le Ruyet, partner at Paris-headquartered Quilvest, which has around $36 billion of assets under management across direct vehicles, separately managed accounts and funds of funds.
“Our average performance is better on co-investments that we’ve done with our GPs and our worst performance has been investments with fundless sponsors, partly due to the volatility of these deals,” he says.
“When there’s an issue it’s more complex to manage. For instance, if you need additional equity to complete acquisitions or to solve breaches of covenants, fundless sponsors need to go back and secure agreement from all investors initially involved.”
Funds of funds will therefore expect the ends to justify the means. “You’re taking more franchise risk with an emerging manager, so we want an implicit risk premium,” Korosis says. “These deals need to show a bit more upside.”