Time to change

The fund of private equity funds (FoF) industry has established an admirable reputation as being the optimal means for an investor new to the asset class to acquire a usefully diversified exposure to a collection of premier private equity managers and their funds. As evidence of how compelling a proposition this has become, it is now estimated that around 15 per cent of all commitments to private equity now come from FoFs ? up from five per cent in 1995.

It's not surprising therefore that this niche has become more crowded: recent research suggests that you can take your pick from between 100 and 120 different FoF managers around the world who are managing some €150bn of capital, all of it intended to be deployed in private equity. Amongst this group of managers are a handful of heavyweights who are managing many of these billions and can claim to have major clients scattered across the globe: think of Abbot Capital, Adams Street Partners, Goldman Sachs Asset Management, HarbourVest Partners, LGT Capital Partners and Pantheon and you have already named firms managing around 40 per cent of that total.

Mid-tier travails
Running in the shadow of the heavyweights are a much more numerous group of FoF managers who are endeavouring to harness an often-local franchise amongst investors (both institutional and high net worth individuals) to what has typically been an orthodox private equity investment programme. And it's amongst this group that all the talk of consolidation in the FoF industry has been focussed. Talk to any number of limited partners, general partners, placement agents or even other FoF managers and it's clear there are a number of factors at work here.

A significant number of investor clients of these small to medium FoF managers are retreating from private equity: revised allocation models and markedly reduced net worth are two reasons why this is happening. The result is that capital calls are being rejected and that FoFs are having to adjust their investment programme accordingly ? something that various GP groups have discovered, often to their dismay and irritation. The community of investors these FoFs have serviced often have limited experience of private equity investing and are now finding the asset class' long-term nature at odds with their short-term requirements.

Many of these mid-tier FoF managers are also new arrivals to the industry, having readily climbed aboard the happy returns train that was being driven by seemingly relentless stock market appreciation in the later 1990s. Some of these funds bought widely and, some would argue, indiscriminately: not only committing large amounts to buyout but also to venture at the height of the boom that was. As a result, numerous FoFs are now beginning to evidence the kind of lacklustre returns that makes the likelihood of them being able to raise a new fund remote. And when you are a new player, there's no track record to counter the dissatisfaction of your LPs.

The only reason why there has not been a series of FoF closures is that, in the words of a source at a very large FoF manager: ?Funds of funds take a very, very long time to die. You can make the management fee last a long while if you put your mind to it.? This breathing space has given a number of FoF managers the opportunity to explore a range of options other than closure: from a merger with another manager to a re-invention as a more broadly based asset manager or investment consultant. But closures will be inevitable. Comments the aforementioned source: ?There may not be many crash landings but a significant number of fund of fund managers are nonetheless going to have to come in to land. Weak returns, some hefty write-offs and no new money make this inevitable.?

Change amongst the top tier
Besides the changes that are taking place in the mid-tier of the private equity FoF community, change is also afoot at the large firms. Here a different set of forces is at work.

One key factor is that the service offering being provided by the industry-leading groups is under considerable scrutiny by other, mainstream money management firms. Several of the largest of these firms can see considerable merit in adding a private equity dimension to their product range and like the idea of achieving this by acquiring a private equity FoF manager. Inevitably they are looking at the top tier names, firms with a track record and brand that could be readily exploited by these asset-gathering machines that often harvest investment capital across the globe.

For an independent FoF manager, being acquired by such a giant may also be attractive. Although the FoF structure, where a general partnership manages a portfolio of fund investment and garners a management fee as well as carry, encourages association with the primary private equity managers they invest in, the FoF manager in fact is much more akin to other money management firms whose success or failure is largely determined by their ability to attract large amounts of capital. The prospect of plugging into one of these global capital-harvesting behemoths is very appealing. As the source at the large FoF declares: ?The big funds of funds groups are now pretty much in a state of perpetual fundraising.?

It is also the case that senior management at the big, independent private equity FoF firms think that now would be a good time to sell a stake of their equity. Comments a placement agent familiar with these companies: ?There are several firms where the founding partners are increasingly looking at taking a back seat and where forecast valuations look pretty compelling.?

Two firms about whom this scenario is being most actively debated are Pantheon Ventures and HarbourVest Partners. In the case of Pantheon, a number of European buyers are said to be looking closely at the Londonheadquartered firm. In the latter case, conjecture about potential suitors includes some of the largest US money managers – but not a financial institution.

The acquisition in September of this year of Dallas-based FoF manager The Crossroads Group by Lehman Brothers prompted many in the market to speculate that several banks were keen to acquire a private equity fund of funds, and HarbourVest would be a noteworthy prize. Says the placement agent though: ?HarbourVest came out of John Hancock and the guys were keen to buy the ability to manage their own destiny: they wouldn't want to go back into a big bank.?

Although a sale to a larger investment group is appealing, the practicalities of integrating the firms would be a challenge. For instance, the compensation structures that are in place for the founding and managing partners at independent FoF firms are most likely not going to accord with the orthodoxies of a bigger, more regimented institution. It's noteworthy that those FoF managers already attached to larger groups will make a virtue of the much flatter compensation structure they use, arguing to prospective investors that their charges make the prospect of ?feasting on fees? far more remote.

Pantheon refuses to be drawn on what it describes as ?market rumours,? and HarbourVest is also keen to emphasise the stability of the existing management team and its lack of interest in being swallowed by a larger operation. Both are acutely aware that changes of ownership or of key personnel at the firm will be a concern to prospective investors in their funds. For private equity FoFs, the delivery of superior returns now has much more to do with adopting a distinct investment approach than assembling what some dismiss as a ?basket of buyout.? In a recent interview with this magazine, HarbourVest managing director George Anson declared: ?Every investment decision we make should make a difference. If you don't think it will make a difference you shouldn't do it.? This far more discriminating approach puts into much sharper focus the people who are shaping an investment strategy ? and the implications if some (or even all) of them were to depart or retire. What seems increasingly likely as a result is that investors will insist on there being a key man clause inserted in their partnership agreement.

More broadly, a number of European LPs who are considering committing to some of the FoFs currently raising money for their latest fund are watching all of these developments closely. Placement agents are just some of the interested observers of the process. They speak of a wariness previously unfound amongst this community. As a result, as one agent puts it: ?We will see more buy side reticence about funds of funds until some of these changes are disappearing in the rear-view mirror.?