Don't look now but there's a fund of funds behind you.
Private equity funds-of-funds (FoFs) are coming. Like some irresistible army they are besieging the investment community and there is no respite. Soon, say some, the FoFs will claim their victory and their dominion will be complete. It may be a scenario lifted from a sci-fi B-movie but it seems at the moment that a new fund-of-funds vehicle is born every minute. There is product after product from managers eager to fulfil a seemingly insatiable appetite for a lower risk entrée to the asset class and the FoFs are eager to mop up the pension funds' cash. Dark mutterings from some limited partners though already suggest the market is close to saturation. How will ?Invasion of the Fund Snatchers? end?
Unlike the covert invasion of an alien master race, the FoFs have in fact been anything but invisible. A recent research report suggested their number has tripled in three years. Big name players have jumped on the bandwagon ? disregarding the truism that if you can see the bandwagon, you have missed it. Sources now suggest that fund-of-funds account for 14 per cent of all fundraising and anecdotal evidence would suggest they are currently among the most ubiquitous of fundraisers.
At the recent EVCA Investors' Conference in Geneva, nearly half of the 200 investors in attendance represented funds-of-funds. Numbers from Venture Economics and NVCA, the US industry association, show that the value of US FoFs alone has almost doubled in size over the past 12 months, from $3.3bn to $6.3bn. And, at least in Europe, it is difficult to see an end to the demand for the fund-of-funds product. Because many of the compelling arguments that drew investors to FoFs remain: funds-of-funds deliver a neat package to first-time investors in the asset class. It is the instant portfolio: diversified over sector, stage, geography and maturity of fund. Just add cash to the mixture, leave for the long-term and enjoy above average returns.
Supporters of the FoF (which at times is teasingly referred to as standing for Fees-on-Fees – normally by investors with well-established portfolios of direct investments), claim that a FoF offers good value over the long term. Management fees, they concede, may be higher, but private equity investing is an expensive business. By investing in a fund-of-funds, pension fund trustees can avoid the considerable demands on finances and time of building an in-house team with the expertise to manage a portfolio of private equity funds. This, they rightly affirm, is particularly attractive to small and mid-sized investors.
FoFs are also a great leveller. At the peak of the market US general partners were said to be able to pick and choose from whom they took their money. FoFs cut through that. Invitation-only did not apply to the fund-of-fund investor. In a bear market of negative private equity returns, the attraction of access to the most popular (read: successful) funds has not diminished. In fact, the importance of being with the best in town, or at least those who seem to be, is even more acute. Past performace, while no guarantee of future performance, is immensely reassuring in a downturn. As one private equity manager observed, the mechanics of assessing a private equity fund remain so opaque that comparing like with like is almost impossible, so many investors end up buying on brand.
This is of course one of the reasons that the big boys have rushed in. But established private equity brand names, like Schroders, NIB Capital and Standard Life ? all of whom have launched FoFs – may sound the bell that marks time on the fund-of-funds frenzy. Some say a wave of consolidation beckons for the fund-of-funds players. But the long anticipated winnowing of Europe's direct private equity investment firms is still some way off: four times the number of firms still invest a quarter of the capital when compared to the US market. So don't expect the fund-of-funds newcomers to vote for their own obsolescence any time soon.
The responsibilty for dealing with the hordes of FoFs circling investors lies with the already over-worked and underpaid private equity investors themselves. Caveat emptor applies as never before. If a fund-of-funds investment is truly to work as a labour-saving device then some fairly hard work needs to be done up front with rigorous due diligence. And then hard negotiation to sweeten the returns with lower fees. This invasion does not have to end in disaster for either the FoF investment community or their investors. Just watch your back.
Nicholas Lockley is private equity correspondent of Financial News.