Growing up, right-sizing or something else?

As far as fund of funds managers are concerned, consolidation of their industry is a question of not if, but when. Ask any participant, the answer invariably revolves around the premise that ‘this market will have to consolidate’. What tends then to follow is a description of the market's explosion in the late 1990s that led to over a 120 managers participating in the market today.

Most of these entered the business when the private equity boom was still in full swing and money managers, bankers and management consultants with little previous experience of the asset class came to think of private equity fund investment as nice work if you could get it – and rushed to grab a piece of it.

The reason why practitioners are now saying that a reversal of this trend is already underway is not simply that investor appetite for private equity product generally has deteriorated. Fundraising has obviously become more difficult as investors are dealing with the problems that the market downturn has left them with.

Big investors, especially banks and insurance companies, have left the asset class and are in no hurry to come back. High net worth individual investors, another key constituency for many funds of funds, are also feeling the pinch. But dwindling supply of capital to funds of funds appears not be the issue driving the consolidation.

“There hasn't been a loss of faith in funds of funds generally. The leading managers continue to play an important role in the allocation process,” says Tycho Sneyers of Swiss-based LGT Capital Partners. Billion-dollar funds closed late last year by HarbourVest Partners and Goldman Sachs, two of the largest managers, confirm this view, as do respectable closings held by several smaller operators in recent months.

In theory, to buy a quality fund of funds is to buy access to a widely diversified asset base, deep knowledge about the asset class and relative ease of administration. Given private equity's intense complexity and its relatively small percentage presence in many allocation models, to many investors buying into a FoF remains the most time and cost-efficient way of investing in the asset class. This is in fact an argument that is increasingly hitting home with the buyside, especially in Europe (see chart). Several large institutional investors that in the late 1990s began building in-house private equity investment programmes are now looking to purchase external expertise instead.

“Today many institutions that started out doing the work themselves are flocking to less than a dozen funds of funds,” says Hanneke Smits, a partner at Adams Street Partners in London. “On a relative basis, there is now more interest in fund of funds services, which is beneficial to our fundraising.”

The main reason why an industry shakeout seems nevertheless a certainty to so many is that managers who entered the business in the late 1990s invested while the market was still going up and hence overexposed themselves to technology-related investments especially in the venture space.

This is a damning verdict in an asset class where average performance is generally considered not good enough

These funds are now struggling to show satisfactory results with several, according to one placement agent, “deep under water thanks to the dire state of their venture portfolio.” There's no mistaking that these are tough times, especially for FoF managers that concentrated on venture. “For many of the funds of funds raised during the boom years performance has yet to happen. But some of the early data that is coming through now is looking pretty average,” says Guy Eastman, a director at Schroder Ventures (London) Limited.

This is a damning verdict in an asset class where average performance is generally considered not good enough, especially where it is generated by funds of funds that require their clients to bear an additional layer of management fees on top of the already hefty charges that the underlying fund investments themselves incur. Recent vintage funds of funds that are beginning to experience performance-related problems and don't have a long-term track record to fall back on are already finding it more and more difficult to hide. “It's no longer too early to tell,” insists Wayne Harber at Hamilton Lane, the Pennsylvania-based fund manager and gatekeeper.

M&A, but amongst equals
This crunch is unlikely to trigger a wave of mergers and acquisitions across the industry, although several practitioners report conversations with managers that are looking for a buyer. Selling a management company where it is doubtful whether the fund portfolio will stand the test of time will obviously be difficult.

Where tie-ups have occurred already, the acquired manager was generally performing well, as was the case with UK hedge fund manager Man Group buying into Westport Private Equity in December 2002. Similarly, a transaction involving Hamilton Lane and Zug, Switzerland-based Partners Group, which the two houses were rumoured to have discussed last year, would have been about combining a large US franchise with a growing European operation, as opposed to a deal where one beleaguered party would have been seeking shelter within another.

But if defensive M&A is unlikely to occur in the fund of funds sector, neither are struggling firms going to just shut down overnight. It's hard to kill a private equity firm: the fees charged on capital under management can sustain even less successful managers for much if not all of the lifetime of a fund (although this will offer little consolation to captive organisations whose parents may be having second thoughts about being in the asset class altogether).

The market will resemble the shape of a barbell: big funds at one end of the spectrum, niche players at the other

Downsizing is a more immediate prospect, particularly where newly established managers missed the fundraising target for their debut vehicles and are already having to live on less fee income than forecast in the original business plan. Small funds have had to trim their expectations – and their personnel – accordingly. “I am receiving a lot of resumes from people at smaller funds of funds at the moment,” says Smits at Adams Street.

But the real test facing the younger generation of operators is whether they will be able to raise new capital when the time comes. The big players with track record, experience and the necessary capital to invest in people and product development appear to be holding most of the cards. In addition, the large bank-sponsored houses such as Goldman Sachs, JP Morgan Chase and Morgan Stanley can leverage awesome distribution networks, and have access to their parent's balance sheets to market preallocated vehicles to third-party investors. And other large FoF specialist firms such as LGT, HarbourVest, Pathway Capital Management, Abbott Capital, Hamilton Lane and Pantheon Ventures control as powerful, typically global, franchises and appeal to a client base looking to mandate a group outside the orbit of the investment banks. Either way, investors want to be working with a seasoned manager that has established a number of key values (including longevity, depth of management and track record) around their brand names.

Be big or be specialist
Between them these two groups, whose members all manage several billion dollars in capital, are already controlling the bulk of fund of funds assets currently under management, and are expected to further increase their dominance in the future. “The big generalist funds of funds will grow and grow in the same way mutual funds became very large,” says Jan Faber, head of fund investments at Henderson Private Capital. “There are some big brand names out there that many investors feel comfortable with, which is great for building scale.” One senior executive at a large US based captive operation predicts that the fund of funds market of the future will resemble the shape of a barbell: big funds at one end of the spectrum, niche players at the other – “but the middle might be squeezed out.”

Penignon: can't see the bigger players spending time on smaller clients

‘Squeeze’ may seem an apt choice of phrase. At an industry gathering in November last year, on hearing the news that HarbourVest's latest vehicle had just closed on $2.8bn, one downbeat manager of a well-known, medium-sized generalist fund of funds commented that a squeeze was precisely what he was experiencing. “The big guys have got this market cornered. I might as well start thinking about doing something else,” he mused.

But if the barbell analogy is to hold true, there is going to be a place for smaller, specialised funds that can sell against a particularly strong set of focused skills and proprietary expertise. Geographic differentiation is probably the most frequently cited strategy that most practitioners accept will continue to enable smaller-sized firms to ring-fence and defend lucrative niche franchises. Several European firms have already built sizable businesses on the back of strong local networks of both investors and general partner groups.

Reaching out to investors in continental Europe often requires firms to develop structures that accommodate certain fiscal and regulatory requirements in ways that plain vanilla limited partnerships do not offer. For example, several groups operating out of Switzerland such as LGT, Partners Group, RMF and Capital Dynamics have pioneered fund structures aimed at achieving tax and regulatory efficiency. Some of these groups have also been at the forefront of developing liquidity-enhancing vehicles such as listed private equity funds, and using income protection mechanisms such as insurance wraps to attract more risk-averse clients to invest in the asset class. Offerings that combine private equity with hedge fund product to attract investors keen to purchase both from the same manager are another increasingly common characteristic of alternative asset product made in Switzerland.

Another option for niche players is to concentrate on winning mandates from investors with lower entry levels such as small pension funds, families and high net worth individuals, that are less likely to register on the big players' radar screens. “Customising fund of funds product for smaller clients is a key challenge for the industry,” says Dominic Penignon, managing partner of Access Capital Partners in Paris, which in July 2002 closed its second European fund of funds on €277m. “I can't see the bigger players spending time on smaller clients.”

Fund selection also offers ways to steer clear of the mainstream and operate successfully on the fringes. Specialist selection strategies such as investing in venture capital funds exclusively was successfully pioneered by San Francisco-based Horsley Bridge Partners, which today manages over $5bn in venture fund investment.

Grove Street Advisors, which counts pension fund CalPERS among its clients, is a more recent example of a US manager specialising venture capital investments. In Europe, Adveq, a Zurich-based house with €1.5bn under management, although not exclusively investing in venture, has built a substantial part of its business on the back of a powerful reach into the US venture capital scene. As mentioned earlier, venture investing by a FoF requires skill, insight and – many would say – strong nerves on the part of the LP as well as the FoF manager.

Practitioners predict that this concept of theme funds may soon be taken to another next level, with specialists leveraging niche knowledge to close in on certain venture sub-strategies such as biotechnology or IT investment, despite the challenges that the cyclical nature of these sectors present. In the buyout sector, projects such as Partners Group's current fundraising for a European midcap focused fund of funds, which has already secured €200m in commitments and is aiming for a €300m final close, could also become more common.

Differentiation, pace and diversification
Meanwhile the large players are fighting their own battles, looking for ways to make themselves stand out from within their peer group. Critics say that one of the established houses' core competencies, that of in-depth and bottomup due diligence, has become commoditised and that individual fund portfolios overlap by as much as 80 percent. To counter this, funds of funds are formulating differentiation strategies that draw on fund selection, secondaries and co-investment strategies, product development, reporting, customer service and – even – price. As the accompanying article reveals, funds of funds, unlike directly investing partnerships, still come with a wide range of different compensation structures, and while returns remain under pressure, basic fund economics may well make a difference to investors when it comes to choosing one manager over another.

The houses that raise the most capital will be facing the greatest challenge in effectively deploying this quantity of capital. This won't be easy in an environment where many of the large buyout houses are already well funded and will stay out of the market for some time, and where venture remains a distinctly tricky business.

As Charles van Horne, managing director at New York fund of funds Abbott Capital, notes: “Right now is a time to go steady. Size as such may not be a problem for a fund of funds, but an asset gathering mentality can be a problem, as it can force you to put out capital too quickly.” Abbott, which manages $4.5bn and closed its fourth fund of funds on $730m in the summer of last year, made just four allocations in 2002, against 15 in 2001.

One area where funds of funds will become increasingly busy, and where many are already highly active, is in secondaries. Unlike dedicated secondaries funds, which tend to focus on buying fully funded partnership interest ideally at substantial discounts to Net Asset Value, funds of funds have developed a considerable appetite for partially unfunded commitments, particularly where they involve general partners that the funds of funds already have relationships with.

Right now there are plenty of such assets around: one Swiss fund of funds manager tells of a recent search on the secondary market for available interests in a large, “top notch” US buyout fund which closed 18 months ago. “We found that $350m of less than fully funded commitments to this fund were up for sale, all in small chunks – $5m here, $9m there.”

Secondaries should provide rich pickings for funds of funds which can invest in them opportunistically. And doing well in this area could make a big difference when it comes to investors making up their minds over the big houses in a few years time. Says van Horne at Abbott: “When large funds of funds compete against each other, the one meaningful differentiator is performance. When the returns are out in two or three years time, it will be a lot easier to work out who's got it right.” As ever, the right numbers will make the right impression. But until then, expect a tough fight.