A merging market

Certain dynamics in the private equity fund of funds management industry suggest that a round of consolidation is not only likely, but also, according to some seasoned professionals, long overdue.

Simon Hamilton works in the private equity fund finance team at banking group Investec. His team specialises in lending to GPs and funds and is currently examining a number of opportunities on behalf of fund of funds clients to finance mergers in the sector.

Hamilton says that as capital poured into the private equity asset class – and accordingly into funds of funds – in the run up to 2008, the number of managers grew dramatically in response to demand. These included a number of in-house captive teams within financial institutions.

When this growth was abruptly curtailed, says Hamilton, a number of managers were faced with two problems: either they had not raised sufficient capital to cover their costs with the fee income they receive, or the institution under which they had been formed had lost its appetite to retain the team. “This has created opportunities for successful funds to look around the market for acquisitions,” says Hamilton, adding that both small and large players had approached his team to discuss potential mergers.

As the scale of the financial crisis hit home during 2009, industry consolidation was a prevalent topic of discussion among private equity practitioners both in the primary fund and fund of funds sector. For example, a survey conducted halfway through the year by accountancy group Smith & Williamson revealed that among mid-market firms in the UK, two-thirds of executives anticipated that the number of private equity firms in the market would reduce. “Many firms,” said head of private equity for the accounting firm Brian Livingston, at the time “may have little choice but to merge or shut down”.

However, while a wide-ranging round of private equity firm consolidation has yet to materialise, one of the industry’s most significant deals of 2009 – the takeover of HRJ Capital by Capital Dynamics (see boxed article for more detail) – raised the question as to whether the fund of funds sector would be a more likely candidate for increased consolidation.

Elements of fund of funds management suggest that consolidation could be a more realistic prospect among fund of funds managers than among direct private equity firms. For one thing, as more than one source mentions, among funds of funds, a manager’s “ego” is less likely to provide a stumbling block to a takeover; there is less of a direct connection between the individuals at the firm and the investments they make.

The Capital Dynamics acquisition arose from a very specific set of circumstances, says managing director Katharina Lichtner, and these circumstances are not likely to be widely replicated: “It was a very particular situation. We are not expecting it to be part of a wider phenomenon.”

Despite the scarce consolidation so far, a number of professionals strongly believe that it is long overdue. Hamish Mair, head of private equity funds at F&C Investments, describes the fund of funds industry as “crying out” for it.

“I have for a long time been of the view that consolidation is overdue,” says Mair, “I was proved wrong for a couple of years as new managers continued to establish themselves and raise capital – often with little or no track record, raising money from just one source. But I expect more consolidation.”

Another veteran of the industry, Solomon Owayda, lends his weight to the prognosis that the fund of funds sector is due a shake-out. “Common sense would tell you that there should be consolidation,” he says. “You could count on one hand the number of funds of funds that were in the business when I started in the late ‘80s. Now there are hundreds. Common sense tells you that not all of them are going to survive.” Owayda was formerly chief investment officer for fund of funds manager SVG Advisers and recently joined Siguler Guff as managing director.

Not everyone is in agreement that consolidation is inevitable. Dan Kjerulf, a partner at Danske Private Equity, says the drivers for such a trend are mixed: “Why does consolidation make sense? You do it for economies of scale, you do it for access and you do it for specialised competence in fund picking. These two latter points can’t really be upscaled,” he says. “Investment judgement is something that still rests with relatively few people and is very difficult to institutionalise.”

While a number of market participants agree that consolidation on some sort of scale is likely, the economics of fund of funds management mean that it will not happen quickly. “The fund of funds industry has big barriers to exit; even if you are not performing well, your investors cannot redeem their money,” says Tycho Sneyers, a partner at Swiss fund of funds manager LGT Capital Partners. “Often managers don’t go out of business as fast as they should,” he adds.

Certain special situations, such as that which arose at HRJ Capital, will ensure that opportunities continue to present themselves on a sporadic basis. They will only be seized if, as was also the case with the HRJ acquisition, they yield very specific benefits, such as increased market share, a new set of investors or a new set of skills.