Don’t be a JAFOF

Somewhere around the middle of the 1990s, the population of middle market buyout groups had grown to such an extent that even industry old-hands had a hard time keeping track of them all.

Around this time, it became clear that being a “buyout firm” was no longer a unique designation. What was once an obscure financial pursuit was becoming an asset class, and the fund managers within it were increasingly competing with one another for deals and for investor dollars.

A pejorative acronym arose that perfectly captured this crowding phenomenon – JAMMBOG (just another middle market buyout group). A number of variations on the acronym – JAMBOG or JAMBO – are in circulation.

Many partners fearful of having their firms labeled JAMMBOGs began stressing supposed differentiating aspects of their investment platforms – industry focuses, for example, or unique deal-sourcing techniques. Some stressed proprietary ways of working with portfolio company CEOs. Others claimed to be kings of their respective target geographies, i.e., “We are the leading private equity firm in the Louisville-Columbus-Indianapolis triangle. . .”

David Snow

Today there are just about zero middle market buyout firms in the US that call themselves generalists. You might call your rival a JAMMBOG, but you reach for your brass knuckles if someone calls your firm by that name.

The maturation of the US and Western European private equity market has moved upstream to the large population of providers of co-mingled investment capital for funds, aka the funds of funds. May I introduce a new pejorative acronym? Prepare yourself for the rapid extinction of the JAFOF (just another fund of funds).

In the earlier days of private equity, a fund of funds in and of itself was a unique player. Funds of funds provided – wow, get this! – one-stop diversified portfolios of buyout and VC funds, usually with the benefit of lower minimum commitments. They also claimed to provide solid manager selection and monitoring for investors new to the asset class.

Fast forward to the present day, and the private equity game has become more advanced, to the extent where the core skills of the fund of funds manager now seem to be somewhat commoditised. The investors who once needed asset-class toe-dipping advice now need advanced nautical engineering. Where generalised manager vetting was once in high demand, investors now want to build diversified portfolios within very specialised industries and geographies. They are increasingly likely to want a fund of funds focused only on agricultural strategies, for example, or on the Lousiville-Columbus-Indianapolis region.

Many investors now require outsourced expertise with regard to transactions other than regular-way fund commitments. Direct and co-investment is a big focus. And, of course, secondary transactions may be the most popular specialty, allowing investors to take advantage of liquidity options both as buyers and sellers of mid-life private equity funds.

All of these more advanced advisory services offer the core benefits of a fund of funds – diversification, access, selection. But they involve more advanced skills. Manager selection within niche strategies requires that the fund of fund manager exert tremendous effort vetting many smaller managers, often in far-away locations and in languages other than English.

Direct and co-investment advisory requires experience evaluating direct deals. The best direct investment advisors will have convincing reasons for saying “no” to many opportunities.

Secondary investing also requires a deep understanding of the value of the underlying portfolio companies and the

But as Kim Kardashian says, you've got to fake it 'till you make it. And the way to make it in today's market is by not being a JAFOF.

David Snow

markets that affect their fortunes. This is not the same as choosing the best GPs to manage a collection of empty, blind-pool funds.

The demand for non-JAFOF services is evident in recent fundraising statistics. According to private equity advisory firm Triago, secondary funds may raise $22 billion in 2011, while traditional funds of funds will be lucky if they reach the $13.5 billion they raised in 2010.

The smartest fund of funds managers already have spent years transforming themselves into providers of diversified services. Many now offer specialised and even customised funds of funds to clients. Co-investment and direct programmes are also offered, as are secondary portfolios. Many funds of funds charge more for these specialised programmes, but given the increased competition, one wonders how much longer this can last.

Indeed, the line between “fund of funds” and “secondary fund” is blurring. Triago estimates that the percentage of secondary deals done by “funds of funds” rose to 34 percent last year. Detractors from the pure-secondaries side of the market will no doubt question the expertise of these fund of funds interlopers.

But as Kim Kardashian says, you’ve got to fake it ‘till you make it. And the way to make it in today’s market is by not being a JAFOF.