Fund of firms: How private equity is investing in itself

“How many multi-hundred billion dollar industries are out there that are virtually untouched by private equity? I can only think of one, and it is private equity itself,” says Thomas Morgan, co-founder and managing director of Hycroft Capital.

New York-based Hycroft, a boutique investment bank, set up its “fund of firms” business in November, joining the likes of Goldman Sachs Asset Management and Neuberger Berman, which completed the first private equity GP stake deal in 2014.

Rather than invest in underlying private equity funds, a “fund of firms” raises funds to acquire stakes in general partners themselves.

The strategy is straightforward: acquire minority stakes, often less than 20 percent, in private equity firms without taking board seats or being involved in day-to-day operating controls.

Investors in the strategy can reap several benefits, including vintage diversification through exposure to the GP’s portfolio of funds, stable returns from the manager’s fees and a shortened J-curve.

“You don’t have to wait four or five years before you start getting returns,” one market source says, highlighting the similarity between the fund of firms strategy and that of the secondaries market.

So why is interest increasing now? It’s a timing issue, sources say, with the industry having reached a tipping point in maturity where private equity firms need to address strategic and operational issues.

Funds of firms managers point to several benefits for GPs selling stakes in their own businesses. As some funds of firms are structured with infinite timelines, investee companies gain access to permanent capital, which can help with GP commitments and allow businesses to invest in strategic initiatives, such as opening new offices or moving into adjacent asset classes.

The strategy can also help with succession planning. With many founders reaching retirement age and a generation of younger partners poised to take their firms to the next step, backing from a fund of firms can provide the necessary liquidity to support the transition.

The fund of firms space is small and still nascent. As few as four deals have been completed to date and the market has deal volume estimated at below $3 billion in total since Neuberger Berman’s Dyal Capital Partners’ 2014 investment in Providence Equity Partners, the first of its kind.

Nevertheless, it’s a market expected to grow. Goldman Sachs is reportedly planning to follow-up on its $1.5 billion Petershill II fund with successor funds for the strategy, and Neuberger Berman wants to raise $2.5 billion for its Dyal Capital Partners III vehicle, according to documents from New Jersey’s State Investment Council.

Credit Suisse has also launched Anteil Capital Partners, a business within its international wealth management division, which aims to acquire up to 12 stakes in alternative asset managers, mainly hedge fund GPs.

It’s likely there will be more such funds emerging and Morgan says he expects rapid growth in the sub-sector. “It starts like the beginning of a rainstorm: a few drops here and there, then boom, the monsoon,” he says. “I think that’s going to happen at some point.”