Falling out of favour?

Back in 2008, raising a co-mingled private equity fund of funds was not a significant problem. $40 billion was collected by funds of funds globally that year, according to PEI’s Research and Analytics division. Fast forward to 2014 however and the picture is very different. Some $13.5 billion was amassed for funds of funds globally, putting the year behind the $23.4 billion raised in 2013, and even the comparatively meagre $15.9 billion garnered in 2012.

That begs the question whether funds of funds are simply no longer an attractive option for LPs.

There is a perception that funds of funds bring low value, admits Sven Lidén, chief executive officer at Adveq, but he insists that perception is wrong.
“Funds of funds are certainly out of favour with certain groups of investors,” agrees Roger Pim, managing partner at Edinburgh-based SL Capital Partners. “Raising capital for funds of funds can be challenging.”

So why is that the case? There are a number of reasons. First, many LPs have become more sophisticated in recent years and are adding resources and developing in-house private equity skills so they are able to bypass the fund of funds players. Dutch pension fund providers PGGM and APG are good examples of this trend, having sold their stake in AlpInvest Partners in 2011.

Additionally, where funds of funds were often able to provide preferred access to certain high performing managers, they are no longer the only gateway to a particular fund. “Access has in recent times been more freely available in a more challenging fundraising market. Funds of funds now don’t always have privileged access to the most oversubscribed funds,” says Andrew Sealey, managing partner and chief executive officer at Campbell Lutyens.

Sealey’s view is echoed by Lidén. “Most large investors find it quite easy; they have 20 managers coming to their office and pick three managers they’d like to invest their money with. And you will only be proven wrong after four or five years.” Therefore a lot of those investors will do their fund selection themselves now and won’t outsource their investment decisions to a fund of funds.

MORE CONTROL

Another reason why investors have been more reluctant to back traditional co-mingled funds of funds is the fact they would like more influence over how their money is invested. The dislocation suffered in the Global Financial Crisis has sparked the rise in managed accounts, according to Lidén. “A lot of LPs wanted to have more control over their investments and have therefore moved from funds of funds to mandates.” Adveq now has a handful of such mandates, whereas five years ago it had just one.

LPs’ increased appetite for managed accounts is also observed by Edward Sopher, a partner at Gibson Dunn & Crutcher. “For instance, [investors] might decide that they will use one manager for their US portfolio and [another] manager for their European portfolio.”

Ardian is another group to have rapidly built out its segregated accounts in recent years, according to Benoit Verbrugghe, Ardian’s head of the US. “We have about $4.1 billion of mandates, which is significantly more than five years ago.” But while the funds of funds model is still “very interesting” for investors that are after specific niche strategies, it is not effective for all strategies, he admits.

“If a large state pension plan wants specific exposure to the US mid-market, venture, or to a specific sector, a fund of funds can be a good solution. But if you want to have access to a large-cap fund, I don’t think building a fund of funds programme will add value.”

Administering a number of these separate accounts is not more time-consuming for funds of funds managers, Lidén insists, but firms should not take too many mandates, he warns. “Because then you could start having some conflicts of interests, where a number of managed accounts are chasing the same opportunities. [This] then brings you to allocation problems.” Lidén believes that up to 10 managed accounts with very different strategies is viable, but no more than that.

As well as offering more tailored investment structures, many funds of funds have also been changing their product range. For example, SL Capital historically raised a one-size-fits-all product including primaries, secondaries and co-investments, and is now offering all three strategies separately. “We have a niche secondary fund, a mid-market co-investment fund and a primary fund solutions focused on the smaller end of the market. This way we can give investors the full flexibility they want,” says Pim.

Adveq has also been changing its product line. Last year it raised its debut co-investment. Late primaries, secondaries and co-investments now represent 40 percent of Adveq’s total investments, while 60 percent of investments remain allocated to primaries, says Lidén. “The big advantage of offering secondaries is that you can add value very quickly. That is the same with co-investments, which can create value much quicker than a fund investment.”

Pantheon, which was already offering secondaries and co-investments, has also been giving investors more flexibility recently, according to the firm’s managing partner, Paul Ward. “One thing we have changed in the recent past is that investors can opt in or out of those choices in our primary co-mingled programmes.”

By offering separate accounts, many managers have also become more flexible with some of the clients’ demands for customisation, says Sopher. However, the downside for the managers is that they cannot charge as much for these separate accounts as they would for a more traditional blind-pool fund of funds. “Generally investors look at managed accounts to make sure that the money is invested in the way they would like it to be, but also because they are able to take advantage of more favourable economics,” says Oliver Rochman, a partner at Proskauer.