Advice <italic>&agrave; la carte</italic>

At some point, just about anyone involved in private equity has thought about starting a fund.

And what's not to like about a private equity fund? The list of positive attributes is long: funds place a legal requirement on limited partners to send in money whenever requested. They have life spans of ten years or more. The LPs might commit to one or even two additional, larger funds before they get back much money from the first one. The fees are the best part – you get carry from the profits and management fees from the word “go”.

Investment bankers are particularly enticed by the allure of the fund – many have jumped from the agent to the principal side of the deal business after suffering for years from client envy.

Likewise, people who advise on private equity partnership investing are not immune to the seductions of fund management. In short, managing money is potentially more lucrative than offering suggestions.

Fund management also offers greater long-term stability. To a large extent, pure advice givers live at the behest of their clients. If a major client goes elsewhere for advice, the associated revenue disappears in a flash. The same dynamic applies to human assets at the firm. In an industry where a firm's most valuable revenue generators – its people – leave the building each day, consulting firms that offer advice only can be truly devastated when core advice-givers go down the elevator and don't come back up. Funds, at least, provide fee income that the firm owns.

Not surprisingly, most major private equity investment advisors, and a broad swath of smaller players, have adopted business models that include both pure advice and money management. The advice-plus-management firms argue that the expansion of their services was in response to investor demand and in accordance with investor interests. Not surprisingly, the small but zealous clutch of advice-only practitioners question whether the hybrid model treats all clients equally.

Michael Forestner, director of alternative investments at St. Louis, ([A-z]+)-based Hammond Associates, says that of the firm's roughly 80 clients, about half have private equity programmes. All have non-discretionary accounts, meaning Forestner's firm offers advice on potential investments, but is not given authority to commit capital on behalf of clients. This advice runs from suggesting an asset allocation model to fund selection and due diligence. “We have some reverse inquiry searches where a client submits a name and asks us for an opinion,” says Forestner. “But we also come up with groups on our own that we think are good.”

Although the idea of raising a fund of funds has “come up from time to time” among Hammond Associates partners, the firm has decided against the move. “A lot of our clients like the fact that we don't offer any product,” says Forestner. “The conflict of interest issue is more visible now than it ever has been.”

The chief concerns cited by industry observers – and frequently pointed out by advice-only investment consultants – about firms that offer both advice and money management relate to the potential for favouring one client at the expense of another. But there are other potential conflicts of interest as well. Here are some scenarios, as suggested by the advice-only camp:

  • • When an opportunity to commit to an exceptionally strong private equity fund presents itself, but the allocation is limited, an investment advisor has an incentive to offer the opportunity to its fund of funds, from which it can collect carry, and not to its pure advisory clients, from which no performance-related fees are collected.
  • • An investment advisory firm has an incentive to steer clients into its more expensive fund of funds products, when perhaps a more nuanced and less pricey advisory relationship would make a better fit.
  • • A firm has an incentive to recommend its own fund of funds products over products offered by competing firms, even if the competing products might present a more suitable mix of underlying partnerships for a particular client.
  • • In a competitive fundraising environment, an investment advisory firm that throws its energies behind a new fund of funds may get distracted from its advisory work.
  • “There are inherent conflicts when you are managing money for a share in investment profits and also advising clients,” says Bradley Atkins, the chief executive officer of Franklin Park, a new private equity investment advisor based in Bala Cynwyd, Pennsylvania.

    Atkins, in fact, formed Franklin Park specifically based on the premise that institutional investors increasingly will be attracted to investment advisors that eschew money management. The firm was launched in April 2003 after Atkins led a spinout of six professionals from Hamilton Lane, a dominant private equity advisory and money management firm based less than a kilometre away from the new Franklin Park offices.

    To date, Franklin Park has signed up five clients for its fund-free services, including the City of Philadelphia Board of Pensions and Retirement; the Overseas Private Investment Corporation; the New Jersey Economic Development Authority; and a large fund of funds that Atkins declines to name.

    The firm's biggest client – the Connecticut state pension – appears to have been won in large part because its treasurer and investment council agrees with Atkins' argument about keeping advisory work unsullied by money management. In a pension document highlighting a meeting at which Franklin Park and several other investment advisor finalists made their pitches to state treasurer Denise Nappier and the investment advisory council, Nappier is described as asking if “Franklin Park's decision to be an advisory firm only is a long-term business decision or if it is a reflection of their start-up profile.”

    In the document, Atkins replies to Nappier that his firm will indeed not seek to raise a fund of funds but notes that other “traditional advisors” are gravitating toward the asset management business and away from consulting.

    The meeting minutes also note that Connecticut was not considering renewing its advisory relationship with INVESCO Private Capital because, in part, of “questions about the firm's commitment to the consulting business.”

    Conflicts aside, advocates of pure advice say cost and the ability to build relationships with GPs are two more reasons to avoid funds of funds, no matter who is managing them. Says one consultant: “Funds of funds sell themselves by telling LPs they get experience and relationships. This is the biggest lie in the industry. Funds of funds make sure their clients learn nothing. Otherwise, why would the clients come back?”

    Nevertheless, many investors – especially smaller investors – make debut allocations to private equity through funds of funds, thinking this the best option for getting their proverbial feet wet.

    Stefan Hepp, the CEO of Zollikon, Switzerland-based investment adviser Strategic Capital Management (SCM), argues that buying a fund of funds makes sense for investors who are looking to put to work a limited amount of capital, even though it is an expensive way to get exposed to the asset class. “A fund of funds is ok for the first $100 million. But as things progress, you have to reduce costs. No investor can justify paying a 1 percent management fee on a billion dollars managed by funds of funds.”

    Hepp says that by employing the services of a “pure” consultant such as SCM, an investor can cut costs by some 50 percent, not to mention get a better education and sense of control in the process. “Working with a consultant who has an element of discretion is the same as working with a fund of funds, but on a more cost-efficient basis and with the option of building a customised programme,” he says.

    Hepp adds: “As investment programmes grow, institutions face the challenge to exercise control over the asset allocation and thus avoid the overlap of commitments to individual partnerships as well as the uncertainty with regard to the ultimate allocation of funds across geographies, sectors and financing stages that result from multiple fund of funds commitments. Experience shows that institutions addressing the issue opt for tailor-made solutions that may take the form of discretionary mandates or non-discretionary advice or a combination of both.”

    Investment advisors that offer a mix of products and services, such as Hamilton Lane and Darien, Connecticut-based Portfolio Advisors, argue that potential conflicts can be neutralised. They also claim that institutional investors have a range of needs that may include both advice and capital management. The pure advice model, they point out, has drawbacks of its own.

    Brian Murphy, a managing director at Portfolio Advisors, says his firm offers customised investment programmes to its clients, and funds of funds are an essential component for some. For example, investors new to the asset class that want exposure to venture capital will not have access to the top funds no matter how much good advice they get. This access, says Murphy, is best gained through a fund of funds with established relationships.

    As with many other aspects of the private equity industry, size is a factor when structuring the best way to commit capital. Investors with smaller allocations will not be able to make the requisite commitments to otherwise appropriate funds. “Funds of funds are the great equaliser,” says Murphy. “It allows our small clients to get the same diversity as our big clients. Some of the smaller pension plans [that are LPs in Portfolio Advisors-managed funds of funds] have consultants that tell them they should do 50 percent buyout, 30 percent VC and 20 percent special situations. But there's a problem – they only have $5 million.”

    Portfolio Advisors manages separate accounts for clients with $100 million or more to commit to private equity. Murphy says those larger clients may choose to have a discretionary or nondiscretionary relationship with the firm, but a recent trend has been for investors to ask for a mix of the two. For example, an institution with a solid in-house staff might want general advisory work supplemented with discretionary work or a fund of funds for a specific strategy. Or it may want pure advisory work on partnership opportunities but more involved relationships on co-investment opportunities.

    Murphy insists that potential conflicts resulting from a mix of money management and consulting can be avoided. “Are there conflicts? Yes, if you create them,” he says.

    Specifically, Portfolio Advisors pursues “fair and reasonable” policies when deciding how to allocate an investment opportunity among clients, mixing pro-rated allocations with the “everybody- gets-five-million” approach. Clients that have prior commitments to an underlying GP tend to get preference for follow-on allocations, Murphy says, with the balance of allocation divided among the newer clients. Portfolio Advisor's longstanding relationships with many GPs allows it typically to secure the allocations it requests, he adds.

    One major drawback of pure consulting, as opposed to money management, say advocates of the latter, is that without a limited-partner requirement to advance capital when requested, an investor can often get bogged down in its own process for following up on investment advice. This can lead a GP group to not take seriously an allocation request from an investment advisor.

    “I can tell you that when we sit down with a fund that is oversubscribed, they like the discretionary money a lot better,” says a gatekeeper with nondiscretionary clients as well as funds of funds under management. “Non-discretionary LPs are being eliminated. It's a time efficiency thing.”

    The gatekeeper notes that some pension plans require that GPs show up to make presentations on particular days when the investment committee and board are together. The time that elapses between a recommendation from an investment advisor and final approval from the board can sometimes kill an institution's ability to get into a hot fund.

    “Life will be easier, and you'll probably have a higher quality portfolio if you have a discretionary account,” says Murphy. “It might cost you more, but it will be more than paid for by higher performance.”

    Franklin Park's Atkins says his firm encourages its clients to be “actively involved” in the investment process so that the delays associated with separate approval processes are minimised. “There should be no surprises to the GP or to the client,” he says.

    To date, no client has gone against a recommendation from Franklin Park. “Knock on wood,” says Atkins.

    The major dividing lines between money management and advice are control and fees. Of the latter, money managers will charge a management fee for the life of the fund as well as some form of carried interest based on performance. While fees and carry vary within the funds of funds market, these vehicles are approaching something akin to standard market terms, according to industry observers.

    Pure advisory firms, on the other hand, vary widely in the way they charge for their services, an indication of how difficult it is to place a value on good advice where no performance fee is in place.

    “There's no market standard for fees in private equity consulting,” says Franklin Park's Atkins. “Our fees are a function of the resources and time that we dedicate to clients. The State of Connecticut is a very time-intensive client – they have only one person internally. So the fees that we charge them reflect that much time and attention.”

    Forestner says Hammond Associates typically charges a negotiated flat-rate pricing for clients unless they are in asset-building mode, in which case the firm charges a higher “implementation schedule” for the additional work.

    SCM's Hepp says his firm's fee schedule is a function of how many active relationships the firm advises on. For example, an account with €500 million invested across 50 partnerships would cost the same as an account with €700 million across 50 partnerships. But €700 million invested across 75 partnerships would cost more.

    Atkins points out that some institutional investors have incentive fees already built into their requests for proposals for private equity programmes, but Franklin Associates has to inform them that it cannot charge such fees. Is it hard to turn down the opportunity to profit from good investment decisions? “Yes,” says Atkins. “But you have to walk away from assignments when it doesn't make sense for your business model.”