Thinking big

Ask anyone familiar with the private equity funds of funds industry for their views on the likelihood of consolidation, and the likely answer will be about ‘when’ and ‘how’ – but not ‘if’.

With an estimated 125 fund of funds managers currently in existence around the world, some say there are simply too many (their number has approximately doubled since 1997) and that there will be a shakeout sooner rather than later. Others believe even poor performers will be able to survive on management fees alone for the whole of the life cycle of the funds they have already raised, even though their next fundraising may founder on the rocks of investor apathy.

ut there is a widespread feeling in the market that funds failing to deliver the goods deserve to disappear and, indeed, are already on their way out. Says one leading European fund of funds executive: “There are far too many funds of funds in Europe. Banks and insurance companies thought it would be easy to implement their own fund of funds operation and then discovered it wasn't quite so straightforward after all and made mistakes. Now they don't want to put any more resources into these operations, and they have no active management.” This professional goes on to express a wish that such groups are put out of their misery as soon as possible because of the shadow they cast over the industry as a whole by taking the fee “without the justification” as he puts it.

Ironically, it is at the larger end of the market that signs of consolidation have become apparent – but this is not the kind of consolidation people are thinking of when referring to a possible shrinkage. Instead, Pantheon's sale to US money manager Russell Investment Group last December and Lehman Brothers' $2 billion acquisition of Dallas-based fund of funds Crossroads Group in September were strategically motivated deals negotiated from a position of strength (See separate article).

GROWING SHARE
Meanwhile, although the discussion about how many managers there really should be in this business is in full swing, the fund of funds industry as a whole appears to be flourishing. While capital commitments to funds of funds were reduced in 2001 for the first time since 1994 – and then fell further in 2002, according to data compiled by Alternative Investor – institutional investors are now wading back in, seemingly in greater numbers than ever.

According to the Report on Alternative Investing 2003, published in December by Goldman Sachs International and Russell Investment Group, last year saw European funds of funds increase their share of total private equity commitments to 41 percent of the total – more than double their 19 per cent share in 2001 (see chart). North American funds of funds also increased their share during the same period – albeit in a less dramatic manner – from seven percent to 11 percent.

The capital inflow into private equity generally is in part attributable to investor recognition that despite painful recent experiences, the asset class remains a good long-term bet, and that only by maintaining a certain level of investment year by year can the effects of cyclicality be neutralised. In addition, the value of investors' total assets – which declined markedly during the years of stock market decline – have been considerably bolstered recently by recovery in the public markets.

Many now recognise that investing in private equity is more difficult than they thought it was and that they can't do it themselves, they need help

Dominique Peninon

The perceived attractiveness of funds of funds specifically is a legacy of the tough times experienced by investors that attempted to access private equity directly, only to end up getting their fingers burnt. “Many now recognise that investing in private equity is more difficult than they thought it was and that they can't do it themselves, they need help,” says Dominique Peninon, managing director of Paris-based fund of funds Access Capital Partners.

The perceived attractiveness of funds of funds specifically is a legacy of the tough times experienced by investors that attempted to access private equity directly, only to end up getting their fingers burnt. “Many now recognise that investing in private equity is more difficult than they thought it was and that they can't do it themselves, they need help,” says Dominique Peninon, managing director of Paris-based fund of funds Access Capital Partners.

On the back of these trends, several managers have enjoyed considerable success raising capital. For instance, Adams Street Partners, the Chicago- and London-based global fund of funds manager, which aims to raise a specific amount of new capital every year, in 2003 raised a total of $962 million, of which $553 million went into the group's US fund and $409 million into the non-US partnership. The firm was able to round up the capital quickly and by July of last year stopped responding to requests for proposals from investors who hadn't committed at that point.

Also successful last year was Pantheon Ventures, which closed its third European fund of funds on €470 million – 50 percent above target. And in January 2004, Standard Life Investments beat its original target by €90 million when closing its second fund of funds on €1.09 billion.

But while longer established and larger-scale managers are clearly hitting the right spot with the buy side, for newer and smaller players the outlook is considerably bleaker.

“The brand leaders are vacuuming up all the capital, and it's becoming very hard for smaller funds of funds,” says Ray Maxwell, managing director of the private equity division at Invesco Asset Management. “If you are a relative newcomer, you need a large amount of cornerstone investment and/or a very different type of approach to have any chance of success in the fundraising market.”

FLIGHT TO QUALITY
There are obvious reasons why investors would wish to go with the larger groups. After any period of market turbulence, a flight to perceived quality is bound to occur. In this respect, the fund of funds segment is no different from the direct investment market where in-demand general partners like Permira, which last year were able to raise Europe's largest-ever buyout fund, are able to amass large amounts of capital while many of their peers have less success. There is no getting around the fact that in turbulent times, investors will head for safe havens.

Talking to investment consultants confirms the view that brand name fund of funds are very much in favour. Phil Chesters, European partner at Mercer Investment Consulting in London, says his organisation tends to advise clients to place their capital with around “half a dozen big names” and that smaller groups would “probably not” be considered. Chesters says his primary consideration is always the quality of people in the organisation and their experience as investors.

If Mercer's strategy is widely replicated, it will undoubtedly lead to megagroup dominance at the expense of smaller operators.

But if is true that, as one market source suggests, “fund of funds that don't raise at least €1 billion don't seem credible” to a large part of the market, the question arises whether this is necessarily to the benefit of investors.

Considering that a fund of funds' performance will only be as good as that of the underlying partnership it invests in, access to the best performers is obviously key. As a result, long-established groups with a big footprint have an advantage when it comes to allocating capital to the most in-demand managers. Take Sequoia Capital's most recent fundraising last year, for instance: the group capped the fund at $395 million – 43 percent less than the previous $695 million vehicle in 2000. The firm reportedly could have raised billions, a reminder to investors, especially those lucky enough to get in, of the value of long relationships with the industry's star performers.

The perceived attractiveness of funds of funds specifically is a legacy of the tough times experienced by investors that attempted to access private equity directly, only to end up getting their fingers burnt

Dominique Peninon

It is worth noting that, as the case of Sequoia illustrates, funds don't have to be big to count among those that funds of funds ought to be selecting for their clients. Attractive funds specialising in strategies such as mid-market or venture are in fact often capped at levels that make it difficult if not impossible to make large individual commitments.

Says Neil Sneddon, a member of the fund of funds team at Edinburgh-based investment manager Martin Currie: “It's worth remembering that the successful European LBO firms of today such as Candover and Cinven built their reputations as mid-market investors before they moved up in scale. The big buyout market is very competitive and there are a limited number of deals, so it's difficult to generate great returns. I'm not saying there's no competition in the small to mid-market, but it is a more favourable environment.”

Russell Steenberg, New York-based managing director of MLIM Private Equity Partners, makes a similar point about the importance of investing with the right managers at the right time. He says advisers may be doing their clients a disservice by playing it safe. “If you're a stock picker and you just buy the likes of IBM or BP, you're not going to be criticised but it may not be the right decision. It is the job of funds of funds to evaluate dynamic GPs that can provide value going forward. To fall back on track record can lead to mistakes because there is always change in organisations and past performance must be constantly validated.”

Accessing smaller funds can be an issue for large funds of funds, which by having to write big cheques in order to commit amounts that are meaningful relative to their size may be precluded from investing in such smaller vehicles. Even if a large allocation could theoretically be accommodated, GPs may baulk at the idea of creating an LP base where they become too dependent on just a handful of investors.

Even more important is the point that obviously not all small or relatively young funds of funds are the burnt-out wrecks of an over-ambitious parent organisation. There are plenty of others in the market.

“It is the job of Steenberg: don't just buy IBM funds of funds to evaluate dynamic GPs that can provide value going forward. To fall back on track record can lead to mistakes because there is always change in organisations and past performance must be constantly validated.”

Some are currently on the fundraising trial for the first time, seeking to persuade investors than not all the available capital should be used to further swell already bulging coffers. These groups, which in Europe include Keyhaven Capital Partners and ViaNova Capital among others, will be making progress reports later this year.

These will be awaited with interest, as they will offer some insights into whether there is still an appetite for newly established players with a novel proposition – or whether investors and their advisers remain cautious.

Part of what large funds of funds can provide investors with is private equity wrapped in a comfort blanket. Given the turbulence of recent times, this has obvious appeal. Whether they will necessarily be the best performers is a different question.

The same degree of comfort may not be available with younger or more specialised funds of funds focusing on particular geographies or sectors. But with a differentiated strategy, deep contacts into the general partner community within their target markets, sophisticated due diligence skills and the hunger to make their mark, they can offer interesting alternatives. Taking the obvious option is not necessarily always the best one.