What's it worth to you?

One of the biggest threats to today's fund of funds firms is the elevator. Invented in 1853 by Elisha Graves Otis, these devices are capable of rapidly transferring a fund of funds' most important assets down to the ground floor, from which point they have been known to transport themselves out the front door and over to competing firms.

The assets, of course, are people, who have an uncanny habit of seeking to maximise their economic opportunities. While fund of funds management firms can be said to have other valuable assets as well, recent transactions in the industry have been focused squarely on keeping professionals happily where they are.

The fund of funds industry today finds itself at a crossroads where the quality and skills of people at a firm have never commanded a higher premium, while at the same time the structure of many established firms is not ideal for retaining these people.

To fund of funds managers that fail to reorganise along more forward-looking lines, Bob Dylan might sing, “Your old road is rapidly agin'…”

Says a private equity professional who recently quit a major fund of funds firm: “Just go through the list of major consultants – at a lot of these organisations, you still have the case where the firm is owned by one or two people. But the organisation has grown over the past decade or two, and the question is, how do the owners monetise that position and keep people incentivised?”

Funds of funds, along with the rest of the industry, are maturing. What began as boutiques have become major institutions managing billions of dollars in capital. And with the inflow of capital in the 1990s came not only growth but competition: firms must struggle to differentiate their various approaches to the market as they gear up for what is expected to be another big wave of investment capital.

As with the underlying general partner groups to which they make commitments, fund of funds firms must show investors that they are built to outlast the tenure of their founding partners. And like most alternative investment firms, the main value of a fund of funds resides in its people – their due diligence skills, relationships, analytical talents and even tech savvy. If these people feel under-compensated, they can leave the building with disquietening alacrity.

A couple of recent transactions have been designed specifically to better ensure that the fund of funds management companies in question are structured for continued success.

Late last year, global private equity advisor Pantheon Ventures was acquired by Russell Investment Group for an undisclosed amount. Pantheon was founded in the UK in 1982 as a division of GT Management. At the time, the firm had three employees and $50 million (€40 million) under management. Six years later, Rhoddy Swire led a management buyout that established Pantheon as an independent firm. Today, it has offices in London, Brussels, San Francisco and Hong Kong, 34 investment professionals and $7 billion in funds under management.

Impressive growth, but until recently, Swire held the lion's share of the management company's equity. In an interview last year with PrivateEquityOnline, Swire said his firm had been looking for a way to broaden the ownership among key personnel “for years.”

The Russell transaction seems to have provided the long sought-after solution. Though precise terms of the deal were not disclosed, approximately 50 percent of the equity in the firm will now be made available to employees as part of an options scheme. Swire and Pantheon senior partners Dave Braman and Carol Kennedy will continue to run the business.

The Pantheon transaction came just a week after a similar transaction that, like the Pantheon sale, had been a long time coming. Bala Cynwyd, Pennsylvania-based Hamilton Lane announced the sale of a 40 percent stake in the firm to a group of investors including Hartley Rogers, the former co-head of CSFB Private Equity, and Cascade Investments, the investment arm of Microsoft founder Bill Gates.

Like Pantheon, Hamilton Lane had experienced difficulties stemming from the dominant ownership of its senior-most partners, led by Les Brun, who founded the firm in 1991 and built it into a $6 billion asset manager. Following an investment from Credit Lyonnais in 2000 that left the French bank with a roughly 24.9 percent stake in the company, Hamilton Lane's senior partners realised they would need to free up more equity if the firm were to grow to their desired size.

In early 2003, Credit Lyonnais declined to sell its stake back to the advisory firm. Two months later, six investment professionals led by principal Bradley Atkins announced they had quit Hamilton Lane to form Franklin Park Associates, a competing firm in nearby Conshohocken offering private equity advisory services.

The deal with Rogers and Gates allows Hamilton Lane to offer 20 percent of the firm's management company to employees via an options programme. In a letter to clients, Brun and chief executive officer Mario Giannini wrote, “with these steps, we believe we have positioned Hamilton Lane as an independent, employee-owned firm with the people and capital resources required to provide its clients with the types of products and services necessary to excel in the alternative investment environment.”

Both men will continue to remain significant shareholders, and to run the firm, Hamilton Lane also announced.

In conducting these transactions, Pantheon and Hamilton Lane are taking a page out of the playbook used by major private equity firms, many of which have forged strategic partnerships with outside institutions in part to create broader ownership structures. Firms such as The Blackstone Group, Warburg Pincus, The Carlyle Group, Thomas H. Lee Partners and Texas Pacific Group all have pursued similar strategic deals.

But in putting together these earlier strategic transactions, as well as the recent fund of funds transactions, buyers and sellers were left to haggle over a basic question that does not have a long history of answers: what's this firm worth?

As any private equity professional knows, an ongoing business' value is based on its expected future earnings. In the case of a fund of funds management company, those earnings come in the form of fees. But issues peculiar to the fund of funds business complicate this simple analysis.

Gregory Gooding, an M&A partner in the New York office of law firm Debevoise & Plimpton, points out that fund of funds management companies, unlike traditional investment management companies, must factor in the possibility that the firm will not be able to continue to raise new funds, thus killing ongoing management fees. “The investment vehicles of a 40-Act mutual fund complex doesn't have fixed lives like a fund of funds,” he says. “That is one risk you have to evaluate.”

While Gooding, who advised Russel Investment on the Pantheon acquisition, says the primary component of a fund of funds management company deal remains the value of the regularised management fees, additional considerations may enhance or detract from this expected cash flow. These variables have to do principally with the people at the firm. “The assumption is that the stream of income from these fees will go on indefinitely, and that the firm will be able to continue to raise new funds,” he says. “But you're also buying a brand name, a reputation and a track record. There needs to be faith in the management team's ability to replicate itself.”

This faith is greatly enhanced by the establishment of a broad-based ownership, the equity participation of younger partners, and the general enthusiasm for the firm amongst the professionals to whom the track record can be attributed. As Gooding puts it, “it would not make sense to buy an investment management firm where all of the principals are 64 years old.”

Gooding declines to comment on particulars of the Pantheon deal, but notes some additional issues that would arise in similar transactions:

  • • Although performance fees are important sources of profit at many fund of funds firms, these are typically too difficult to predict. In addition, a very high percentage of carry goes directly to management. This type of fee is therefore often of lesser importance in assessing the value of a firm.
  • • Funds of funds, or any private equity funds, often have Byzantine webs of relationships with limited partners and underlying investment recipients. Terms and conditions are different from relationship to relationship. “There should be a very high emphasis on understanding all the side deals that have been entered into,” says Gooding.
  • • One advantage that private equity funds have over traditional asset managers is that the clients can't walk away as easily. Funds of funds often lock up investor capital for a decade or more. However, many funds of funds also manage separate accounts for large investors, which have an easier time ‘firing’ the manager.
  • • Incentivising junior partners is important for the long-term outlook of a business, but like most traditional asset management companies, the retention of ‘key men’ at fund of funds firms is paramount. “A significant portion of the purchase price is paid to people who are continuing to run the business,” says Gooding. In such cases, key men are paid through ‘earn-outs’ with ‘long tails,’ meaning the money for their stake in the company is paid gradually, contingent on their continued presence and strong performance at the firm.
  • For all the importance of people, there is what might be called franchise value to an established fund of funds management company that is partially independent of its people. A delicate asset called access is one example. Fund of funds franchises with long histories of access to top-tier firms tend to stand better chances of gaining access to follow-on funds merely by dint of mutual institutional history. On the investor side, certain funds of funds carry weight because of their brand name. Of course, access and brand are assets that are nearly impossible to value in an industry as relatively immature as private equity.

    Luckily for sellers of fund of funds management companies, larger financial institutions have in recent years taken a shine to fund of funds programmes. And these institutions are coming to believe they must buy, not build.

    Last September, Lehman Brothers acquired Dallas fund of funds manager Crossroads Group. In an interesting example of where else value may lie in established fund of funds players, the New York financial services giant was attracted in part to Crossroads' elaborate back-office capability, an asset Lehman may leverage in the construction of other alternative investment programmes. Crossroads also has a long history with prestigious venture capital firms – aka access.

    In 2001, financial services company Amvescap acquired Denver-based private equity advisor Sovereign Financial Services, later combining it with its existing fund of funds division Invesco Private Capital.

    In 2000, Dutch bank and insurance conglomerate ING Group acquired a controlling stake in New York-based fund of funds manager Pomona Capital.

    Private equity fund of funds programmes look attractive because they have certain attributes that traditional asset managers don't. Colin McGrady, a managing director at Dallas-based private equity consultant Cogent Partners, says he sees the recent attraction as partly related to the long-term nature of funds of funds. “It's a product that's going to get you locked into your clients,” he says. “You know you have a reason to be in contact with them for ten years. It keeps them in the fold. You can't get that in equity, fixed income, or even hedge funds.”

    And in a brutally competitive asset management market, traditional money managers themselves need to differentiate. A firm that can offer stocks, bonds and access to a private equity fund its client may have read about in BusinessWeek is “selling sizzle,” as McGrady puts it.

    As the private equity fund of funds industry continues to consolidate, the buying and selling parties will themselves need to separate the sizzle from the substance in determining a management company's value. The answers will be arrived at using part art and part science. But as with any primary capital commitment to a private equity fund, money will only change hands after are the parties are comfortable with the people issue. Who is talented, and are the talented ones incentivised to stay, or are they itching to ride Mr. Otis' invention to a brighter future?