Talk to people in the funds of funds world and it won’t be long before the word “bifurcation” crops up. The sector is quickly polarising into two camps: those who can raise funds in this environment, and those who can’t.
Then again, you could apply that to the whole of the private equity industry. Fundraising is hard across the board for firms of all types at the moment, and has been for some time. The industry’s biggest traditional backers – US pension funds – remain enthusiastic about the asset class, but have become increasingly choosier and taking a harder line on fees when it comes to making traditional commitments. Regulatory changes aren’t helping GPs on the fundraising trail, either: capital requirements of Basel III and the likely strictures of the Volcker Rule have made it much more difficult for banks to invest in the asset class, while Solvency II has made it similarly tricky for insurance companies. Reduced targets and protracted roadshows have become the norm, with the time to get to a first close seemingly lengthening with each passing month.
But things are even worse for funds of funds, according to Alexander De Mol, a partner in Bain & Company’s Dubai office. To start with, he says, there is “increased pressure on fund terms” – and because funds of funds impose an extra layer of fees, they have been feeling the impact of this more than most.
Secondly, “Investors want more direct control and interaction with their fund investment … [they] increasingly look for transparency on their private asset ownership, for example for the purposes of monitoring risk”.
A further problem is that investors are waiting to see some cash back from their last round of investment before they pump any more money in.
So are funds of funds going out of fashion? In 2012, just $9.6 billion dollars were raised by funds of funds, according to figures compiled by Private Equity International. That’s well below the glory days of the first half of 2008, when this was about the run rate for a single quarter. And early signs suggest that there won’t be any massive rebound in the first quarter of 2013: at press time, funds of funds had raised about £100 million between them in the year to date. By way of comparison, buyout funds raised about $88 billion – nearly nine times as much. Performance has also been disappointing in recent years, according to most independent metrics.
Unsurprisingly, there has been some consolidation in the funds of funds world, as managers look to build scale and trim overheads. Last year BlackRock made headlines when it acquired Swiss Re’s funds of funds business to create the $15 billion BlackRock Private Equity Partners.
“In an environment where yields are low and volatility is high, clients around the world are embracing alternatives which offer higher return potential and the ability to mitigate risk,” Matthew Botein, managing director and head of BlackRock’s alternative investment group, said in a statement at the time. The deal instantly gave BlackRock a bigger footprint in Europe and Asia and extended its capabilities into infrastructure investing.
BlackRock hasn’t been the only one bolstering its geographic presence and product lines via acquisitions. Other recent deals include AlpInvest Partners’ absorption by The Carlyle Group, boosting the latter’s assets under management by some $45 billion. US group FLAG Capital Management also bought Hong Kong-based Squadron Capital (see box on p. 48), while Parish Capital was snapped up by StepStone Group (which is also now managing $4 billion in former Citi fund of funds assets as part of a secondary transaction). Previously, Hermes and Gartmore merged their funds of funds businesses, while Deutsche Bank merged its funds of funds with that of one of its acquisitions, the Sal. Oppenheim Group, and Russell Investments sold Pantheon to NYSE-listed asset management group Affiliated Managers Group. The list goes on.
A LONG-TERM PLAY
It’s not all gloom for funds of funds. Graeme Gunn, a partner at SL Capital, which in October held a $75 million first close on its latest fund, says that managers are just seeing “churn” in their investor base; in other words, there is still money there, but it’s coming from different sources. “We are seeing a switch away from many traditional sources of capital to new ones such as sovereign wealth funds, and other large Asian and developing market institutions,” he says. “Money that first time round was invested locally now has a global outlook. For example, the private equity opportunity in China has been disappointing recently – but their institutions are investing heavily in [more developed private equity markets].”
Philippe Poggioli, managing partner at Paris-based Access Capital Partners, agrees that as Asia’s institutional investor base matures, funds of funds and mid-market managers will eventually experience a trickle-down effect. But at the moment, he argues, the story is very much about large sovereign wealth funds investing directly or in mega-funds. “As a broader set of institutions in those countries develops, with more banks, insurers [and] pension funds, they will potentially start to invest in the smaller part of the market.”
However, De Mol cautions against funds of funds managers relying on Asian money to ‘save’ them – because these LPs may have very different aspirations. “As more investors come from emerging markets, they actually largely pass on funds of funds and are more inclined to invest directly.”
And for those investors who might consider fund commitments, funds of funds’ slow-and-steady reputation might actually make them less attractive to Asian LPs, many of which have come to expect outsized returns in short time periods – a legacy issue stemming from the success of prior private equity funds predicated on pre-IPO strategies. “Funds of funds have a lower risk/lower return profile,” says De Mol, “but as investors are looking to increase their overall return profile, they are keen to take a pass on them.”
As for the more traditional sources in terms of geography or investor type, even though capital in-flows may have slowed for funds of funds, LPs are by no means backing away from the asset class. “Pension funds and endowments have no choice but to remain in the asset class,” says Poggioli. “And when you look to the US you see that on average pension fund and endowments actually increased exposure to private equity last year. So I don’t see that there is a slowdown in interest from that category. On the contrary.”
The long-term attractions of the asset class are still compelling, according to Eric Warner, head of investor relations at Altius Associates, which last year reached a first close of $50 million for its latest fund of funds after three months. “Many pension funds are still very much in deficit and the main markets are not producing the sorts of return they need,” he says. “Therefore, longer term, that is probably good news for private equity and alternatives in general.”
What’s more, there are plenty of reasons for them to put their money into funds of funds – even in Europe.
“The economy in Europe is clearly underperforming, but the investment framework is still there,” says SL Capital’s Gunn. “[So] on a five-year view, where do you want your money to be? Do you want to be buying where value lies? Pricing on deals is looking more attractive today – so we take a longer term view and don’t worry about Europe. Germany, Switzerland, France and the Nordics are large economies and will remain relevant markets for private equity.”
Tycho Sneyers, a managing partner at fund of funds manager LGT, points out that the macro issues don’t necessarily impact individual companies. “The eurozone crisis provides some excellent opportunities for private equity to buy good companies with recession-tested revenues, and good management teams at attractive prices. Finding the right managers is at the heart of private equity, of course, and that’s still the key to performance.”
And if you are looking for small, local firms, a fund of funds that knows the local terrain is arguably the best way to access the best of them. “Any investor no matter what their sophistication level can figure out Carlyle or KKR as a good marquee house.,” says Michael Abouchalache, CEO of Quilvest Group, which runs a number of small, focused funds of funds. “They don’t need professionals to tell them that investing in those large buyout houses makes sense. Specialisation is where funds of funds work; where local knowledge of particular businesses and managers is needed.”
Furthermore, Abouchalache believes that small- and mid-cap managers will outperform large and mega-cap firms. “We’ve been in this asset class for 40 years so we have enough empirical evidence to say that usually, if you do your job properly in the mid-cap space, you will certainly outperform the mega-cap space.” And while it’s easy to work out which are the mega-caps “sitting in an office 5,000 miles away”, says Abouchalache, local knowledge is essential to find these high-performing mid-cap players.
Aside from in-depth specialist and local knowledge, one of the other ‘traditional’ reasons to invest via funds of funds remains access. Putting a team in place to establish such relationships isn’t impossible for investors – but it can be expensive and inefficient, particularly for smaller pension authorities, family offices and the like. “That is where the added value of a fund of fund is,” insists Abouchalache.
Daniel Allen, CIO of the State Universities Retirement System of Illinois (SURS), previously told PEI that funds of funds make a lot of sense for LPs like SURS. “We have a small staff and so we don’t have the private equity knowledge in-house to oversee a direct programme.” The pension uses Pantheon and Adams Street as its two primary advisors to make investments. “And access has become more of an issue with some of the challenges that Illinois public funds have experienced [related to state legislation around Sudan investments].”
While the specific situation in Illinois is not being faced by all LPs, the issue of restricted access has not gone away, despite fundraising having got tougher, Elly Livingstone, Pantheon’s global head of secondaries, previously told PEI. There will continue to be LPs shut out on the primary and secondary sides by exclusive GPs who only take on one or two new LPs per fundraise or limit the number of pre-approved buyers of secondary stakes. The access issue isn’t just about marquee GP names either; niche smaller funds can be equally if not harder to get into.
Often these opportunities will be farther afield, the result being that some LPs choose to invest directly in their home market, but hire a fund of funds to gain exposure to other geographies.
Petra Salesny, COO of Zurich-based Alpha Associates, says that’s the case for the firm’s CEE-focused fund of funds, which can be a “stepping stone for investors who want to get to know a region”. Some LPs will invest with Alpha for four or five years in order to accumulate the knowledge required to go it alone afterwards, she says.
EVOLVING AND CUSTOMISING
It’s obvious that the traditional funds of funds model continues to make sense for certain types of investors and investment programmes. But equally, it’s clear that fund of funds managers need to expand their offerings to stay relevant as investor needs change.
Specialised funds have multiplied with some managers branching out into other strategies or asset classes such as secondaries or infrastructure. Private debt, for example, has become a big growth area – with groups including Access Capital Partners, HarbourVest Partners, WP Global and Golding Capital offering credit vehicles and more expected to join suit.
Co-investing alongside GPs is another massive growth area, says Access Capital’s Poggioli. “This has become a natural development of the fund of funds offering. That is on the ramp up, and if you look at the offering of the big guys you will see that a lot of growth has been in the co-investment side. That will also trickle down to the mid-market funds of funds – most of them will be also pursuing that sort of strategy.”
Separate accounts are booming, too. “There’s a generation of investors that came into the asset class in the last decade – they started small, were not very sophisticated and funds of funds offered an entry into the asset class,” says Poggioli. “But as these investors got more sophisticated [and] increased their allocation to private equity, they started to look for separate accounts – to be able to outline the strategy they want to pursue, but also to reduce costs. Simply putting bigger tickets on the table on a commingled basis couldn’t achieve that.”
LGT’s Sneyers also sees several additional advantages to separate accounts. “One is that the investor controls the structure. After the Lehman bankruptcy, many people who were invested in a co-mingled fund worried that if other investors don’t honour their capital calls then the structure has a problem. And as a large investor you can avoid that risk by setting up your own fund.” Sneyers stresses that LGT has never had an investor fail to honour a cash-call – but some people prefer to be safe rather than sorry.
Separate accounts also allow for a more bespoke tax/regulatory structure, Sneyers points out. “The separate account typically is a fund – a fund with one investor but nevertheless a fund – with a domicile, and you can really think about whether it is best to have a vehicle in Delaware, Ireland, Luxembourg, Guernsey or any other jurisdiction based on what is optimal in terms of regulatory and tax considerations. There is more customisation.”
Tailored reporting is also an attraction of separate accounts, as far as LPs are concerned. “Investors can really say how they want the reporting to look, and also [specify] the investment pace,” says Alpha Associates’ Salesny. “A fund of funds has a certain strategy that all the investors sign on to – but with a managed account, we sit with them and review the strategy every half year and consider portfolio and market developments. So there is a lot more flexibility and more ways to tailor your offering towards the client.”
So things are not totally bleak for funds of funds. But as managers look to evolve by branching out into new strategies and building more separate account type relationships, it’s important they don’t lose sight of their key strengths. As Bain & Co’s De Mol puts it: “The core skill set of funds of funds is to identify great fund managers, and track their performance well to inform future investments.”
As long as they can keep doing this, it’s unlikely that funds of funds are going to disappear anytime soon.
A new wave of competition is coming from China. Global funds of funds are seeing China’s insurance companies gear their organisations to offer fund of funds products within and ultimately outside China.
One industry source explained, “The same way that JPMorgan, Deutsche Bank or Morgan Stanley have a [fund of funds] offering, which get to a nice size because they sell it to their own [banking] network, Ping An and China Life have made noises that they want to have funds of funds.”
About 18 months ago, Ping An Insurance Group hired Beijing-based director Zhao Peng from global asset manager Partners Group in a move to strengthen its global capabilities. “[They] already have a team of 17 in the fund of funds space and 80 people in private equity. The Chinese insurers have very large teams trying to do fund of funds, initially in China and RMB, but very shortly in China in US dollars, then globally in US dollars.”
In October 2012, the China Insurance Regulatory Commission released regulations that allow Chinese insurance companies to invest in private equity in 45 countries and regions. The CIRC spelled out the regulation and its requirements in the newly-released Implementing Rules, which now extend permitted investments by Chinese insurance companies to foreign private equity.
A new tranche of funds of funds with access to huge amounts of capital and international capabilities presents new competition to the global funds of funds operating today, the source said.
“[Insurance companies] are already [offering funds of funds] within China, but the products they are designing are to invest overseas. Within a year or so, the insurers, which have big balance sheets, will be able to invest internationally and that will give an additional line of capital to their teams.”
However, China’s regulatory landscape is not always clear. Recently, Ping An was prevented from investing in two domestic private equity funds, in accordance with a Chinese regulation that forbids insurers from investing in domestic funds that are not co-managed by the insurers themselves.
A spokeswoman for CITIC Private Equity, one of the funds, explained earlier that although China’s insurance industry was cleared for investing in domestic private equity in 2012, regulations tend to work on a case-by-case basis with insurance companies.
This could be the case for offshore investment, too.