Starting FLAG

In October, US-based funds of funds FLAG Capital Management bought Hong Kong-based peer Squadron Capital from owner Search Investment Group. Financial terms of the transaction were not disclosed, but the deal boosted FLAG’s assets under management from about $4.7 billion to more than $6 billion. Squadron was in the process of investing its Squadron Asia Pacific Fund II, a generalist fund that closed on $400 million in August 2010, as well as raising a successor fund with a target size of $400 million, according to PEI data.

The timing is interesting, because the fund of funds model is under particular pressure in Asia at the moment. 
“Performance is one of the key challenges to funds of funds,” says Hong Kong-based Juan Delgado-Moreira, managing director at Hamilton Lane. “Few have done really well for their investors. They take a long time to invest and so the fee drag is high – there is a big gross to net spread. They often pick too many funds and over-diversify.” And as any private equity investing textbook will tell you, a strategy of index investing will not yield desirable returns
Asian funds of funds are by no means exempt from these structural issues. 

“The fund of funds model in Asia is challenged in many of the same ways it is in the US and Europe and the principal issue is the double layer of fees,” says Nirav Kachalia, a Singapore-based managing director at Morgan Creek Capital Management. This is a particular issue at a time when LPs are lowering their return expectations for private equity. 
Returns from funds of funds on a global level are disappointing to say the least – at 5.8 percent on a five-year rolling IRR basis to December 2011, they haven’t even achieved the returns made by buyout funds (6 percent), according to Preqin figures. 

But there is added pressure in Asia, Kachalia says, as many of the more successful GP groups have done such a good job of brand-building and developing their investor relations capabilities. “There aren’t that many hidden gems in the market and so, while it is still more difficult for Western investors to invest directly, that spread of difficulty is narrowing.”

In addition, funds of funds have mushroomed in Asia. From a low base in the early 2000s, today there are some 27 Asia-focused funds of funds on the fundraising trail seeking an aggregate $16.2 billion, according to PEI data. In Europe, there are just 12, seeking roughly $4.4 billion.

By the end of October, Asian funds of funds had raised $3.2 billion in capital, an amount close to the $4.2 billion raised in the much deeper US market and well above the European total of $2.5 billion. This kind of growth would be unsustainable even without the performance concerns LPs may have.

The funds of funds’ response is that they provide real value in the region. Much of the capital that goes into Asian GPs comes from funds of funds, because it is hard for investors themselves to do the research and due diligence required.
“Funds of funds clients in Asia tend to be largely US and European investors because there are no deep pools of pension fund capital here other than in Australia and Japan – the sovereign wealth funds have built their own teams and so are more interested in separate accounts,” says Brian Lim, a Hong Kong-based partner with funds of funds manager Pantheon. “It is hard for these overseas investors to commit to Asian funds from thousands of miles away – they don’t have the resources or the local knowledge to make informed investment decisions.”

Another issue is Asia’s fragmented and dynamic markets, particularly India and China.

“There are new managers emerging on a weekly basis, fund managers are constantly changing strategy to keep up with the market and there is a lot of information that needs to be constantly updated and refreshed,” says Conrad Yan, a Hong Kong-based partner at Campbell Lutyens. “For us as a placement agent on the ground, it’s an exhausting exercise. For resource-constrained LPs trying to access the market from the West, it’s even harder.”

And there is a constant stream of new investors, many of whom will need hand-holding. “There are still plenty of LPs that don’t have investments in Asia yet, while at the same time most now believe they have to start taking the market seriously,” says Pantheon’s Lim. “As long as we can continue to produce good returns net of fees, funds of funds will have an important role to play in Asia.”

But there are signs that pressure is starting to mount on the plain vanilla – or generalist, primary-only – fund of funds model. Doug Coulter, a Hong Kong-based partner at funds of funds LGT Capital Partners, says: “Investors are looking for a blend of different strategies, including secondaries and co-investments.”

This has been the mantra for some time. But Morgan Creek’s Kachalia adds that a more concerted effort is underway to explore other strategies now.

Branching out carries risk, of course. Secondaries require a different skill set – and are few and far between in Asia, which may lead to overpricing if demand soars. Co-investments carry a much higher risk of loss than fund investments, as some investors have found out the hard way.

“Many have done co-investments and not all have done well – we’ve seen a number of write-offs in Asia” says Hamilton Lane’s Delgado-Moreira. “So funds of funds have not only been slow to deploy capital, they also have to go back to investors having lost capital in co-investments when they are still in funds I-III.”

Ultimately a shakeout will result, though when and how is debatable. Lim thinks it will be a slow process. “It takes a long time to invest and then divest, so it may well be some time before funds of funds find that they can’t raise another fund.”
But others suggest the shakeout is already underway. “Consolidation is starting to happen as it becomes difficult for some funds of funds to raise capital,” says Kachalia.

Not everyone will be able to find a suitor like FLAG, though. “The big question is whether there is anyone willing to absorb and pay for these groups. I’ve seen a handful of groups in Asia start looking for an exit and it’s not clear that anyone is really willing to buy them. I think we may see decomposition as many funds of funds manage out their existing assets rather than a wide-scale consolidation.”

Most agree that the large, global platforms will continue to gather ever more assets, given the challenges and costs of running a funds of funds business. For the others, it may be a case of refining strategies and becoming a niche player – provided they have a loyal band of LP supporters – or being snapped up by one of the asset management houses, if they have enough scale to make the business viable.

For the rest, the future looks a little bleaker than it did in the heady days a few years ago – unless, of course, Asia has a new boom, says Delgado-Moreira.

“If we see another bull run – and that is a distinct possibility as investors search for growth – this could save the fund of funds industry. Although that may not be a great outcome for returns.”