The fund of funds business has got to go through an exercise in refining itself and redefining itself in terms of what its value proposition is. The original value proposition was aggregating capital in order to participate in transactions which required larger sums of capital than the individual investor had. Now that's no longer the case in most instances. The original investors in funds of funds have enough capital, and in some instances have enough resources internally; in other instances, they believe that they don't need incremental resources that directly make investments in the managers that would have been populating their fund of funds structure. So in order for that industry to continue, it's going to have to better define its value proposition in terms of specialisation…in order to generate superior return in that particular silo.
One of the notions in this business has been the concept of over-commitment in order to achieve your target outstanding allocation. That is to say that if I'm an investor and I want – to make the math simple – a 10 percent invested allocation in private equity for my total portfolio, and I want $100 million in private equity, I may commit to funds for a total of $150 million on the belief that the total amount of outstandings drawn on those commitments may only equal the $100 million that I'm looking to have in my portfolio. What's happened in some instances is that there have been capital calls that would cause people to be in excess of their target allocations.
I think like any other industry, or any other financial asset class for that matter, there's a natural evolutionary cycle where there is an identification of a need, a proliferation of providers to satisfy that need, and then there is consolidation that takes place as the market begins to recognise the better performers from the inferior performers and begins to…push its capital to the better performers. What I do think it means for funds of funds going forward is that those that will be successful – I don't think the industry will disappear, though I do think it will be reduced in size – will be those that have a differentiatable product.
I also think there's tremendous price pressure on funds of funds. Historically, going back to the older days, typically funds of funds managers had a fairly significant management fee and a profit participation in the profits of the underlying managers in which they'd invested. Increasingly there's been pressure on pricing such that in many instances the profit participation has disappeared, and in other instances the pressure on the management fee that a fund of funds manager can charge might disappear.
It becomes more difficult for a fund of funds manager to support the operation that provides that high quality of service. For those funds of funds managers which have been in the business for a long time, and have multiple funds of funds products currently operating at the same time, you get some benefit of scale. But I don't think that is a winning combination going forward. I think it's an exceptionally tough market for a first-time fund of funds manager, unless they have a uniquely differentiated product. I think it's a tough market for an experienced fund of funds manager.