The headline figures for the fund of funds industry look dire: fewer funds raised less money in 2015 than in any year since 2005. And that was during a fundraising boom.
But while only 37 firms successfully raised a fund of funds last year, they gathered almost the same amount of capital as 63 managers had managed in 2010, according to PEI Research & Analytics.
The obvious conclusion is that the big are getting bigger – a phenomenon helped by acquisitions like Aberdeen Asset Management’s purchase of FLAG Capital or HarbourVest Partners absorbing the Bank of America Merrill Lynch fund of funds team.
That’s not quite the full picture, though. A quieter – but, as one industry participant put it, “dramatic” – shift in market dynamics is easily obscured by focusing exclusively on traditional fundraising figures.
Historically, the fund of funds industry “revolved around the commingled fund model”, says Kevin Albert, New York-based global head of business development for fund of funds Pantheon. “It was extremely efficient to herd everyone into one vehicle with one strategy and deploy big chunks of money. We had to rethink that model and the first approach was to be open to and willing to do separate accounts.”
Separate accounts allow an institution to customise a strategy and get their fund of funds manager to run it for them – and often for them alone. “The elimination of the ‘fund’ has probably been the most dramatic change,” says Albert.
This change has been driven by a confluence of factors, the most obvious being the maturation of the asset class. Twenty years ago private equity was seen as exotic. Institutional investors needed a guiding hand to evaluate and gain access to managers and secure top-tier returns. But after years watching and learning, many LPs have decided they don’t need that sort of assistance any more.
“It has been fairly typical for some types of LPs – generally the larger ones – to manage primary portfolios for a cycle – or two or three – through a fund of funds programme, [then] they get their sea legs and progress to do either part or all of the asset class themselves,” says Albert.
“Investors (now) generally want to be closer to the assets and many today have more direct involvement, investing in funds, building a portfolio themselves,” agrees Graeme Gunn, a partner at Edinburgh-based fund of funds SL Capital.
And this move towards LPs building their own exposure rather than going through a fund of funds has been most pronounced at the top end of the market, because as John Gripton, managing director at Swiss asset manager Capital Dynamics, says: “There’s a huge differential between upper quartile and lower quartile managers, but less differential in large buyouts and many investors can now find their way to this end of the market.”
A previously key selling point – that funds of funds help investors access elite GPs – has been worn away by LPs building their own relationships.
“That used to be the fund of funds pitch but it’s not a skill or a value proposition as valued as in the past,” says Robert Collins, managing director at Partners Group. “If you’re an undifferentiated fund of funds, it’s been a difficult situation for a number of years. Margins are eroding and there’s not a tremendous value-add when it comes to access.”
Sven Lidén, managing director and chief executive officer at Zurich-based private equity manager Adveq, puts it more bluntly. “There’s too little visible alpha in a pure fund-picking strategy. You have to prove you are worth your fees. And some managers have not been able to prove they are worth it.”
Considering 111 managers raised a fund of funds in 2008, the figures for 2015 suggest fewer and fewer have been able to prove their worth. Some have also come unstuck by doubling-down on an outdated fee model and been outmanoeuvred by managers who have adopted a more flexible approach.
The more hands-on LPs have forced funds of funds to re-assess their offering and provide tailored rather than one-size-fits-all solutions. Hence the rise of separate accounts.
“Over the last five years, mandates have become a more important part of business than funds of funds. They are now over half of our business. The big trend is customisation through mandates and specialisation,” says Lidén.
The increasingly specialised nature of such accounts can be demonstrated by one mandate SL Capital has for a single large institution: it only buys stakes in infrastructure funds on the secondary market. Most LPs are able to get these highly specialised solutions for a simple reason: their size.
“Many [US] state pension funds value the fund of funds format, but their scale and bargaining power means the preference for them now is a ‘fund-of-one’ or customised account built specifically for their needs,” says John Toomey, Boston-based managing director for fund of funds HarbourVest.
Despite their popularity, separate accounts are not a panacea for a fund of funds and bring their own challenges.
“The problem is they come with very high running costs and are very inefficient unless you have $100 million or more to commit. And we saw lots of demand from folks smaller than that,” says Albert.
In response, Pantheon created a platform that allows institutions to structure a customised investment strategy “at much lower volumes” than $100 million. An example of this platform in action came last March when California’s Orange County Employees Retirement System hired Pantheon to run a customised programme for them and a number of other California public pension schemes.
Alongside separate accounts, the maturation of the investor base has also compelled managers to come up with more sophisticated investment plays that LPs cannot easily make themselves. As one fund of funds manager put it: “We had to create strategies which were harder for investors to internalise.”
Falling into this category are tangential alternatives strategies that provide exposure to infrastructure, real estate, private credit or debt and “real” assets – typically farmland or timberland.
Co-investments have also grown to become a cornerstone of the fund of funds business because they offer something most LPs genuinely can’t get without the resources of an intermediary: direct exposure to companies. “Lots of clients hire us just for co-investments, or private credit or debt or secondaries. These are the things they can’t do on their own,” says Bon French, executive chairman at private markets firm Adams Street Partners.
Arguably the king of the ‘non-vanilla’ fund of funds products developed over the last decade has been the secondaries fund.
In 2009, around $12 billion-worth of private equity fund interests were bought and sold on the secondaries market, according to advisory firm Greenhill Cogent. By 2014 and 2015, that figure was closer to $40 billion. And fundraising has been a similar growth story: just $8.1 billion was raised for secondaries-dedicated funds in 2008, compared with $33.2 billion in 2014 and $21.4 billion last year, according to PEI Research & Analytics.
With their experience and knowledge of managers and strategies globally, buying and selling fund stakes is an obvious extension of a fund of funds business. But the growth of secondaries has in large part been prompted by GPs themselves, who by switching from passive observers to active participants realised they could open an additional revenue stream.
“The first 20 years of the secondaries market was LP driven – the owner wanted to sell and they came into the market to do that. What’s changed is that GPs have been catalysing and creating secondaries transactions by organising tenders for their LPs,” says Toomey.
But some believe the influx of money means the secondaries value proposition is waning.
“We see transactions at a certain size that are extremely competitive with lots of people bidding for portfolios. In general the discount has been shrinking and that shows more and more money flowing into a steady pool of opportunities,” according to Lidén.
And with GPs encouraging the buying and selling of ever-larger volumes, and more funds being raised to capitalise on this, a painful end for some secondaries programmes is being forecast.
“Secondaries look easy with NAV going up over 14 of the last 16 quarters and [these conditions] reinforce aggressive behaviour from buyers. This means returns for traditional LP interests are getting compressed and when the market turns – and it’s a ‘when’, not an ‘if’ – some of the less experienced players will pull back or disappear altogether,” Toomey warns.
From creating customised products, to scouring new asset classes, scaling back fees and offering more co-investments, funds of funds are going to ever greater lengths to satisfy LPs.
As Toomey says: “Institutional investors want their managers to do more and to pay them less – this is true in all asset management. That’s okay, that’s the direction of travel and it benefits players of scale.”
One of the reasons managers are willing to do more for less is driven by the industry’s biggest fear: the disappearance of long-relied upon sources of capital.
Defined benefit (DB) pension schemes, the model employed by most US public pensions and the largest funder of private equity since the 1980s, are in terminal decline. “Private equity grew up and was moulded around defined benefit schemes, where the J-curve doesn’t matter because of the long-term nature of these schemes. It was a fungible pot of money with no requirement for daily valuation or liquidity,” says Albert.
But, according to Albert, the model that instead revolves around defining retirees’ contributions, rather than promising specific benefits, is causing firms to develop new products to fit such plans’ requirements. “Defined contribution [DC] has won,” he says.
The numbers suggest he’s right.
Consultant Towers Watson says global assets in DC plans have grown 7 percent per year since 2005 to reach more than $15 trillion. There are now more assets in DC than DB plans in the United States. If this trend continues, the tipping point globally will come soon.
Unlike DB plans, DC plans put investment decisions into the hands of individual retirees and typically have portability and redemption requirements ill-suited to a traditional private equity fund, which also prohibits investment from unaccredited investors. The task, then, is to create a product that would be suitable for DC plans.
“Defined contribution schemes are in some ways the future of private equity,” says Gunn, although he believes “the DB decline will be slow, it’s not going to turn off overnight, especially given the recent flow of capital from private equity exits”.
Figuring out how DC plans can best invest in private equity is one that behoves managers and pensioners alike; DB schemes have outperformed DC schemes in every size bracket from 1992 to 2012, largely due to their ability to invest in alternatives such as private equity, according to Boston College’s Centre for Retirement Research.
“In a DB plan, private equity has been an important component of the return profile,” says Collins.
Changes within the fund of funds industry in recent years could be described as Darwinian. The most successful GPs have evolved to offer a wider private markets solution for clients – to the extent that they will balk at being described as a ‘fund of funds’ given their broader capabilities and business lines. Expect the evolution to continue in line with changing investor dynamics. Who exactly the LPs will be in 20 years’ time – and what they’re likely to want – is still very much up for debate.
THE WAR ON FEES
For years, it was an accepted industry tenet. Investing in a private equity fund would cost an institution an annual management fee of around 2 percent relative to the size of the fund and the manager would take 20 percent of the fund’s profits after clearing a pre-agreed hurdle rate. This is the so-called 2-and-20 model. Funds of funds charge a layer of fees on top of those – historically around 1-and-10 – for their services.
But both primary and funds of funds managers have been facing intense pressure from investors angling for more beneficial economics – which is part of what’s driving the separate account trend – on what tends to be the most expensive asset class in an organisation’s portfolio.
“There has been tremendous pressure on fees, especially since the financial crisis. Funds have had to get more thoughtful. Some have come up with collaborative structures with LPs, many firms now charge management fees on invested as opposed to committed capital, and overall fees are lower on average today,” according to Kevin Albert, global head of business development at Pantheon.
Fees on funds of funds have come down to under 1 percent, according to one LP spoken to for this article, and carried interest charges are now below 10 percent. Preqin data show management fees charged by funds of funds last year averaged 0.93 percent, down from 1.04 percent in 2014, while average carried interest charged was 6.8 percent in 2015, down from 10.4 percent a year earlier.