The fund of funds model has come under fire in the past few years. While it offers low-risk exposure to a diverse portfolio of assets, the fact investors have to pay fees to their own fund of funds manager and the GPs of the underlying funds has led to it being saddled with the “fees on fees” moniker.
This might not be such a problem for investors if returns were strong, but this isn’t necessarily the case. In 2013 research by private equity advisor TorreyCove analysed 567 global funds of funds from 2000-09 vintages and found two-thirds generated a total value multiple of less than 1.3x. While the firm believed the model had a future, those who thrived would be either very good – long-established firms with the best relationships – very specialised, or both.
Five years on, this prediction looks largely accurate, with established, pure-play firms offering increasingly customised products. In May, for example, Hamilton Lane collected $70 million in capital from nine Finnish limited partners for a separately managed account, the first time it formed a mandate for a group of investors. The fund will invest in US and European large-cap buyout funds, which the LPs would be too small to access directly on an individual basis.
This has put great on the funds in the middle of the market, which were struggling to justify their fees even before the giants began moving into the specialisations where they might have differentiated themselves.
Still, many have succeeded in carving out a niche, while at the same time several new entrants have popped up, each believing their own take on the model can help them find their way into the prized top tertile that TorreyCove identified.
Segmenting the market
In January, it emerged private debt specialist Hayfin Capital Management had hired Mirja Lehmler-Brown of Aberdeen Asset Management to lead its new private equity fund of funds platform, which will invest in mid-market European buyout houses. The firm is attempting to build on the strong relationships it formed with private equity managers as a provider of debt to finance their deals.
“Our established lending relationships with the European sponsor community provide us with the insight to allocate capital to buyout funds capable of delivering sustained outsized returns,” the firm’s chief executive Tim Flynn tells Private Equity International.
While the firm did not wish to comment on the specifics of its offering, a European fund of funds manager with knowledge of its plans tells PEI it will look to differentiate itself by building up expertise in secondaries and co-investments, which brings much greater added value than just being able to pick good funds. It will then sell this as a package of solutions, particularly aimed at institutional investors that don’t necessarily have the resources to do due diligence on these types of asset.
“The market today is much more about solutions,” says the manager. “If you know a manager well, then you buy a secondary in a restructuring situation, take a bit of primary capital and become a very strong partner, your likelihood of getting a co-investment [with that manager] is higher. That type of package is harder to evaluate and there’s less people competing there.”
Offering co-investments brings another clear benefit. It helps more closely align the interests of the GP and LP, causing the latter to apply a little less pressure on fees, to the great relief of the former.
“You can tailor the programme, add sector-specific exposure that you might find attractive and also reduce the overall fee burden,” says one fund of funds manager with an emerging markets focus. “And for many LPs, rightly or wrongly, there’s a big focus on the total amount of fees that you pay, though in my view, the net return that’s been developed should be the key focus.”
Piecing together a package of solutions is also what Quilvest, a Luxembourg-headquartered firm with $5 billion of private equity assets, does. As well as having a long track record, having invested in private equity since 1972, the firm focuses strictly on funds, secondaries and co-investments in the lower and mid-market. It keeps a close eye on its GPs and won’t hesitate to dial down its exposure to those whose funds get too big.
It has developed a large emerging markets bucket, particularly focused on Asia, and entrusted around half of its portfolio to newer managers – those with three or fewer funds. According to Hong Kong-based partner Maninder Saluja, such features highlight the ability of the fund of funds model to give investors safe, expertly administered exposure to potentially risky asset classes.
“We think mid-market is more inefficient and an area that we feel outperforms,” he tells PEI. “It requires a different level of exposure and expertise to get it right and to evaluate all the different managers. There’s value in being a mid-market player and in being a global player that can be local in emerging markets – that differentiation should allow for people who are allocating to the category that don’t have the representative teams to be able to do that sort of investing.”
Emerging markets are an area in which the fund of funds model continues to thrive as the risk matrix makes the trade-offs more palatable. The underlying portfolio can produce outsized returns and investors don’t mind paying a 1 percent management fee and 5 percent carry to access even a small piece of that upside.
Washington DC-based 57 Stars has a simple strategy of making primary and secondaries investments with top decile GPs in a set of emerging markets, including pan-Latin American buyout firm Victoria Capital Partners and Turkey-headquartered Actera Partners, according to PEI data. Its most recent flagship vehicle is seeking $600 million, $200 million more than its 2012-vintage predecessor. According to co-founder Steve Cowan, taking big positions in the smaller funds typically found in emerging markets also gives it greater influence over fund economics, another boon for LPs.
“Looking back at our most recent commingled funds, we have been able to obtain preferred economics which aggregate to an amount equivalent to about half of our management fee and preferred return,” he says. “Since those fees are already quite low, only a small amount of out-performance more than pays for the additional layer.”
In July, Cambridge Associates released a report, When Secondaries Should Come First, which concluded that the single layer of fees and earlier distributions associated with secondaries funds made them a better bet than funds of funds for most investors looking to gain initial exposure to private markets – with two exceptions.
“Selective commitments to FoFs in asset classes such as venture capital or emerging markets private equity are worth considering for investors not yet ready to invest in funds on a direct basis or those unable to gain direct access to their preferred general partners,” it wrote.
There’s no denying it’s a tough time for fund of funds managers that aren’t thinking outside the box. But the cleverest and most nimble are proving there’s life in the model yet.