Fund of Funds Special: Is bigger better?

This isn’t an easy time to be a fund of funds. 

In the boom years, they offered limited partners preferential access to the biggest and best buyout funds – and, in many cases, expertise in an as yet unfamiliar asset class. So investors were only too happy to pay for their services.

But times have changed. So competitive is the fundraising environment at the moment, with so many managers (of all stripes) in the market for capital, that the balance of power has noticeably shifted. Access is no longer such a problem with the top funds; indeed, LPs are in such demand that they can afford to push for lower fees and higher incentives before committing their capital.

We’re also in a period when belt-tightening is the order of the day – and big institutional investors, many of whom are facing up to more losses across their portfolio as Europe’s sovereign debt problems rumble on, are as keen as anyone to make every penny count.

In this environment, paying a second set of fees to funds of funds to manage your private equity allocation seems to be getting increasingly difficult to justify. Judging by the sector’s recent fundraising totals, at least, it looks as though limited partners’ appetite for middlemen is dwindling. 

According to Private Equity Connect, PEI’s data service, the amount of money raised by fund of funds has fallen successively in every one of the last five years. 

When funds of funds were the height of fashion in 2007, managers raised $36.1 billion globally. Last year, just $5.29 billion was raised. (There’s a cyclical aspect to this, of course. But the trend seems clear.)

The more confident in the industry argue that this is just an inevitable consequence of private equity coming of age. As LPs get more used to the asset class, they have less need for an intermediary.

“Any person working in the private equity industry has to expect some evolution,” says Kevin Albert, global head of business development at Pantheon, a leading international fund of funds with $24 billion under management.

“Investors not only require the services of a fund of funds – or a manager of managers, if you will – but they [also] want to be trained. A part of what we do is to train investors to evolve into being a direct investor.”

Other major players argue that despite the shrinking market, there will always be a number of smaller limited partners for whom funds of funds remain the most cost-effective option.

“It is definitely true that some investors no longer need to use fund of funds,” says Michel Abouchalache, chief executive of Quilvest, the office of Argentina’s Bemberg family. “But there are also some who do not have this [private equity investment] function in-house. If you have money you want to put to work in the emerging markets, or Europe, or the US, you need to be committing at least $100 million annually to make it worth having an in-house team.”

Tougher customers

But these days, even if funds of funds can find clients, they have to work much harder to keep that shrinking pool happy. 

According to Albert, that means the old ‘one size fits all’ approach is no longer sufficient. “The traditional pre-selected co-mingled fund is in an advanced stage of its life cycle.” 

This is forcing funds of funds to adapt, he says. “One of the big challenges with co-mingled funds is to create a strategy that suits everyone. So we have created special accounts where clients can pick a bespoke strategy using around 75 percent of an off-the-shelf fund and round out the rest with a customised mix of strategies.”

But the bottom line still counts. Fund of funds typically charge a one percent a year management fee, plus their own performance fee of 5 percent – but this comes on top of the underlying management and performance fees of general partners, which average 2 percent and 20 percent respectively. In these cost-conscious times, that can look rather steep. 

Dermot Crean, managing partner at placement agent Acanthus, says smaller funds of funds are starting to feel real pressure to cut fees. “If you are just a small pension fund, you haven’t got a hope in a conversation on fees with a large fund; you just have to fall into line. But the mid-market is different,” he says.

Professionals in the industry do accept that fee levels have become an issue for limited partners – but they argue it is just one factor in what is essentially a flight to quality. 

“I don’t think it is just about fee pressure,” said an executive at a major European fund of funds, who agreed to speak on the condition of anonymity. 

“You find that some funds of funds who have proven themselves to investors are doing fine; in fact, they are capturing a much larger market share. But some funds who don’t have critical mass or who have had a lot of turnover of staff are struggling.”

Crean agrees size now means everything in the fund of funds world – particularly if you are targeting the most lucrative clients, such as sovereign wealth funds.

“We are also seeing a lot of demand from clients in the Far East and Asia Pacific. There are a considerable number of large [government-affiliated] entities like sovereign wealth funds or state pension plans who still have a lot of money to invest,” says the executive.

“If you want to deal with larger, more sophisticated clients, then your fund has to be in the billions – probably double digits.”

A different kind of access

Scale is also still crucial for getting access to the best general partners, says Abouchalache, whose firm manages around $18 billion of assets.

“It’s hard to categorise exactly what size you need to be, but I’d say you need to be around our size. It is still difficult to get into the top five percent of GPs if you don’t hit that size,” he explains.

Some in the fund of funds industry say access is still a key reason to use a fund of funds manager – but they argue it is access to a particular sub-set of general partners that counts.

“If you want to go to the large managers, this is not as big an issue. But a lot of capital is looking to allocate to mid-market managers – and for people who have only invested in mega-funds for the last few years, they need to use a fund of funds to access them.” says one fund executive. “We offer access to successful smaller mid-market funds and most of them are heavily over-subscribed.”

George Anson, managing director of HarbourVest Partners UK, whose international parent has more than $18 billion of assets under management, says there are many niche areas where fund of funds remain the best (possibly even the only) route to a general partner.” Even a large investor still might not be able, for instance, to access West Coast venture capital funds,” he says.

One area where all funds of funds executives agree that they have a unique selling point, in terms of access, is in emerging markets.

With the developed world in an economic funk, virtually every institutional investor wants to increase their allocation to emerging markets. 

Research by Private Equity International found recently that limited partners plan to increase their allocations to Asia from 17.9 percent in 2010 to 21.8 percent this year. Projected allocations to Latin America, the second most popular emerging market, are just 3.2 percent – tiny by comparison. Although the resource-rich nations of South America are seen as good safe bets, China, whose economy has grown at an average rate of 10 percent a year for the last 30 years, remains the hottest ticket for investors.

But investing in emerging markets is far from straightforward. A recent study by PriceWaterhouseCoopers, the accountancy firm, found a combination of corruption, government interference, and a lack of transparent financial information costs investors an average of 50 percent of the value of their deal.

Rising in the east

With that level of risk, local knowledge is crucial – particularly in Asia, and even more so in China. “When you get into Asia, because of the absence of transparency, most investors still want to hire a manager,” says Albert. 
For limited partners, using a fund of funds manager in a region they don’t know is far safer than taking a bet on a single private equity fund.

David Pierce, chief executive of Singapore-based fund of funds Squadron Capital, puts it: “Even investors who don’t normally use a fund of funds use Asian specialists to help them identify and access fund managers that are physically, geographically and culturally remote. Often they will invest directly alongside or with assistance from the fund of funds manager.”

Pierce warns that because private equity has expanded so quickly in Asia, investors need to be very selective about where they put their money. 

“The private equity industry has grown very rapidly in Asia, and many groups were formed under assumptions of quick returns that don’t really fit with our asset class. Although these things take time, we are starting to see a shake-out. The 2005-2006 vintages have now returned some cash, but many investors are cautious about whether the vintages that followed, which involved much bigger commitments than seen before in Asia, will perform.”

However, Pierce believes that even if China’s stellar economic growth does begin to slow down as inflation takes its toll, it won’t put investors off. “There’s bound to be a moderation in the rate of economic growth, even in China, but most investors are still interested [in putting] more money to work in Asia,” he says. 

Safety in numbers

So what lies ahead for funds of funds?

Clearly all is not lost. Abouchalache argues that the preferential access general partners give funds of funds will come into its own again for investors when the market picks up. “In two to three years we could see access become a real issue again, especially if you believe that sovereign wealth funds are going to enter the asset class in a major way,” he says.

And Anson draws a comparison with secondaries and co-investments – two other areas where clients will also continue to need the expertise of an intermediary, he says.

But it’s clearly true that a smaller proportion of the capital allocated to private equity is being channelled via funds of funds these days – and that there’s pressure on fees across the board. So in this shrinking market, seeking economies of scale through consolidation an obvious strategy.

Anson, whose company HarbourVest faced down activist shareholders to buy Swiss-listed rival Absolute Private Equity for €806m last year, is a firm believer that big is beautiful. “I think it is the case that any group that is either subscale or is pursuing a single strategy of investment or focusing on just one geographical area has been hit.”

Consolidation makes particular sense in the listed arena, where shareholders have long been dissatisfied with the gap between share prices and net asset value.

But takeovers are one thing; mergers of funds of funds would be a different matter entirely. “It is always very hard to do any merger of equals,” says Anson. “A merger means the usual things – jobs are going to be lost somewhere. People will always ask: do we need to have two London offices?”

Others in the industry point out that consolidation will be slow, because limited partners’ investments often have very long tails. 

Nonetheless, Pantheon is currently in the market for the right bolt-on acquisition, according to Albert. “We’ve looked at a couple of [takeover] situations in the last couple of years and if the right thing came up, we would be quite aggressive.”

This is likely to be part of a broader industry trend, Albert argues. “I wouldn’t be at all surprised to see some more consolidation amongst fund of funds, and between fund of funds and consultants.” He cites US-based Stepstone Group’s purchase of Parish Capital as an example.

Consultants, unlike fund of funds, do not typically invest their own money alongside limited partners; they focus on providing investment advice. Historically they have had a big advantage for LPs: they were much cheaper. However, Albert argues the price gap has narrowed significantly – making them both less attractive to limited partners, and potential prey for takeovers by funds of funds.

The ever-increasing amount of red tape is also a strong argument for scaling up, he suggests. “The regulatory environment encourages consolidation. Pantheon can afford to have two full time compliance people, but smaller outfits just cannot.” 

The financial advantages of consolidation are also significant. “If you are running a large fund, what you are really in is the management fee business. One percent of a few billion is a lot of money over many years,” says Crean.

Funds of funds are not going away. But in a polarised future, there may be just two types: global giants, and experts in a particular strategy or geography (as we explore overleaf), with the middle completely squeezed out. 
Or to put it another way: funds of funds may need to go large, or go to China.

Shrinking pools