Funds of funds Tricks up the sleeve

Pantheon is a “funds platform”. Neuberger Berman “offers private investment portfolios”. SL Capital Partners is a “global private equity firm”. Adveq is “a partner for private market investing”. HarbourVest Partners is “a private equity investment firm”.

They are all perhaps better known as being among the world’s largest managers of private equity funds of funds. The $531 billion industry is going through a major transition, with managers buying rivals or being acquired, expanding new products such as customised accounts and starting programmes to tap new sources of capital – such as defined contribution pension plans – for the first time.

The evolution is occurring as traditional sources of capital have started to dry up. And it’s not just the banks and insurance companies withdrawing from the asset class as a result of the regulatory restrictions introduced following the financial crisis. Pension funds are increasingly putting money directly into buyout and venture funds rather than paying fees to the intermediaries – which have traditionally been a 1 percent annual fee and 5 percent carried interest.

“People almost view the term ‘fund of funds’ as a negative, although a commingled fund can serve a very important purpose for many,’’ says Francesco di Valmarana, a London-based partner at Pantheon, which manages $25.4 billion. “You run up against the reluctance to pay another layer of fees [plus] the rigidity of a commingled fund.”


The fund of funds was created as a way to pool capital from pension funds, banks, insurers, family offices and high-net-worth individuals. As the private equity industry became more transparent and investors became more knowledgeable – thanks to better information flows and accumulation of experience – pressure built on funds of funds to justify their services.

“It’s critical to show you can add that value,” says Peter Von Lehe, a New York-based managing director at Neuberger Berman. “We have to work harder, provide higher quality of service, better investment returns, for lower fees.”

Neuberger Berman, Pantheon, HarbourVest, SL Capital and Adveq are just some of the managers now increasingly working with clients through customised accounts. The accounts provide more flexibility and enable firms to build bespoke private equity portfolios for clients using a combination of primary funds, secondaries, private debt, infrastructure funds and direct co-investments. This way, managers can meet clients’ specific risk-return requirements.

“When we build those mandates, they don’t just include funds on a primary basis; we also make use of our capabilities as a team across primaries, secondaries, co-investments and private debt to build an optimal portfolio for a client,” says Von Lehe.

At HarbourVest, which has committed more than $25 billion to newly-formed funds, 10 percent of assets are now in separate accounts, says London-based managing director George Anson. “We are aiming to get to 15 percent,” Anson says. “We didn’t have a separately managed account 10 years ago.”

Combining primary, secondary, co-investments and other private assets enables managers to improve returns earlier in the life of the investment. “Investing in secondaries and co-investments helps mitigate J-curves and it helps to justify the fee,” says Adveq’s chief executive officer, Sven Liden.

Creating bespoke funds also leads to “fee sculpting,” in which managers devise new ways of charging for services, says Graeme Gunn, a partner at SL Capital in Edinburgh.

“You’re definitely seeing a reduced overall fee and the sculpting of fees early in the fund life is increasingly the norm – lower startup fees that ramp up after the first three or four years,” Gunn says. “If a client gives you a large sum of capital, they can negotiate further.”

The challenge to fund of funds was made explicit in the California Public Employees’ Retirement System’s 2013 review of private equity investments. CalPERS said that its large commitment to funds of funds, at 12 percent of assets, was “a drag on the portfolio” and that an “extensive review of the unfunded commitments and options for maximising value” is under way. CalPERS’ funds of funds have a net IRR of 4.1 percent, compared to 11.4 percent for primary funds, 12.8 percent for co-investments and 14.8 percent for secondaries.

CalPERS’ review of funds of funds is part of a trend. The percentage of large pension funds that invest in private equity fund of funds fell to 82 percent in 2012 from 91 percent in 2005, and the percentage of small pension funds investing fell to 64 percent from 83 percent over the same period, according to research from the London Business School.

The declining number of pension fund investors helps explain why last year 43 funds of funds raised a total of $9.9 billion, according to data compiled by Private Equity International. That’s a quarter of the $39 billion raised in 2008 by 106 funds.