Survival of the fittest

Talk of consolidation in the fund of funds industry is far from new.

This time last year, many were predicting consolidation en masse within the funds of funds players. After all, this sub-set of the private equity industry has seen tremendous growth over the last decade and, until recently, fundraising by funds of funds accounted for only around 10 percent of all capital committed to private equity each year, according to Prequin. Yet as the industry has matured and its investors become more sophisticated in their needs, the drive for consolidation appears unstoppable.

“Even before the financial crisis, consolidation had been due,” says Hamish Mair, head of private equity funds at asset manger F&C Investments. “I was surprised that during the last few years of expansion that there were still new entrants to the market.”

Everybody has been waiting for consolidation to come, but it will be very slow because revenues in this business are extremely sticky

André Jaeggi

But times have changed. Funds of funds have suffered as fundraising conditions have got tougher for all types of fund managers, with limited partners opening their wallets less frequently and widely. Between January and November last year, funds of funds accounted for just 6 percent of private equity funds raised, demonstrating just how hard it has been to attract LP capital, but also perhaps a flight to quality among LPs that invest in funds of funds.

The result should be fewer funds of funds in the market over the next few years – it just might take a little while for the shake-out to happen. “Everybody has been waiting for consolidation to come, but it will be very slow because revenues in this business are extremely sticky,” says André Jaeggi, founding partner of Ji Portfolio Services and non-executive director of Swiss fund of funds Adveq.

Indeed, there have already been a few examples in Europe. Last year, as part of a larger transaction between their parents, Paris-headquartered Access Capital Partners purchased Finland’s Pohjola Private Equity Funds to create a €4.5 billion asset manager; in the UK, Gartmore Private Equity and Hermes Private Equity merged to create Hermes GPE with a combined £4.2 billion ($6.8 billion; €4.9 billion) in assets; and RREEF Private Equity and Sal Oppenheim Private Equity Partners were absorbed by Deutsche Bank’s DB Private Equity, creating a €6 billion group.

The need for scale is one of the largest drivers for consolidation in the market. “Simple economics is an important factor,” says George Anson, managing director at funds of funds manager HarbourVest Partners. “Funds of funds need critical mass to operate effectively in today’s market. It’s very hard to retain an adequate number of talented people if you are running a smaller fund. Scale is important for a fund of funds to offer a credible proposition to investors. Quite what the tipping point is is hard to say, but I imagine it would be hard to continue even at the €1 billion assets under management level.”

Jeremy Golding, managing partner of funds of funds Golding Capital Partners, agrees. “You need critical mass to ensure that you have the right resources to be able to add value,” he says. “Over the last 10 years investors have become much more sophisticated in their understanding of private equity and their requirements have increased correspondingly.”

DIVERSIFICATION PLAYS

While there remains room for generalist funds of funds able to cater for smaller investors needing to outsource their private equity operations, most managers have realised they need to offer more – and more specialised – products.

As a result, funds of funds are increasingly adding to their business lines. While secondaries and co-investments have long been part of the fund of funds toolkit, these are playing a heftier role in their investment strategies. SL Capital Partners, for example, brought in Patrick Knechtli from Coller Capital in 2009 to boost its secondaries capabilities. “We felt for a long time that pricing in secondaries was unattractive and so we weren’t very active in that space,” explains David Currie, partner and chief executive of SL Capital Partners. “But a couple of years ago, when the pricing corrected, we stepped up our activity levels. Pricing has tightened again but there are still opportunities to be had.”

He adds: “The plain vanilla fund of funds investing in primary and secondary funds and co-investments will continue to appeal to smaller investors that don’t have the capacity to make direct fund investments. Others might take a more tailored approach by building a portfolio of investments according to a specific strategy and this is likely to be on a segregated account basis – I see that as a growing part of what funds of funds will do.”

Having a choice of products is becoming increasingly important, particularly for the larger players. “We find that you need a suite of products to offer investors,” says Anson. “For example, we may present one fund to investors, but they then commit to a different strategy. If you don’t have what investors are looking for at a particular point in time, then you risk losing out.”

As a result, some of the specialist funds of funds might be an attractive add-on for some funds of funds groups. “Funds of funds need to be acutely aware of what LPs are looking for,” says Anson. “We recently established a senior loan operation because we could see that investors were looking for yield. But you do need to hire or buy-in dedicated expertise to launch different products. You also need to tread the line between offering a number of products while not straying out of your comfort zone.”

Regulatory change is another key driver for consolidation (see p. 32). “A big consideration will be the AIFMD as it will cause managers to incur additional costs,” says Currie. “In the UK, we have always had to be regulated and hold regulatory capital. Yet that’s not the case in some other EU markets and so the players there will find that they have to recapitalise their business and bring in additional people. I can see that some of them may look to link up with others as a result.”

Banking regulations could also cause some fund managers to come out of the woodwork as the pressure to hold regulatory capital mounts. “There are banks and other financial institutions that face regulatory constraints on their underlying capital,” says Jaeggi. “It may be that a number of captives come on to the market over the coming years instead of spinning them out.”

Clearly, there are a number of forces that may drive consolidation in the fund of funds market. Some may be forced by economic considerations; others by LPs’ changing appetites. Either way, the industry will look quite different in 10 years from the way it does today.

“The question is: who will be the large investment banks of the future?” asks Jaeggi. “Now that you’ve seen Carlyle take over AlpInvest and other asset managers such as BlackRock increase their interest in private equity, we could see the emergence of multi-asset managers that offer a variety of products. These will look very much like the investment banks of the past.”