Have it your way

The maturation of the private equity market is creating a new class of investors who are faced with a luxury of choices: in-house versus outsourced investment staff; separate accounts vs. funds of funds, set menus versus ‘Chinese menus.’ Be careful what you order. David Snow reports

Christopher Wagner, the senior investment officer of alternative assets for the Pasadena-based Los Angeles County Employees' Retirement System (LACERA), confirms what private equity advisors find attractive about the separate accounts business – he likes separate accounts better than funds of funds.

Wagner also points out something that private equity advisors don't like about the separate accounts business – his pension is on its third separate accounts manager in 12 years.

Make no mistake – the $26 billion (€21 billion) LACERA has a long-term commitment to the private equity asset class. The California pension has had an allocation to alternatives since 1992, and its target currently stands at 7 percent. But the firms LACERA has chosen to help manage its allocation to private equity have had short- to medium term relationships with the pension.

LACERA first dipped its toes in private equity through a separate account managed by Invesco. In 1997, when its contract with the asset manager came to an end, the pension switched to Bala Cynwyd, Pennsylvania private equity advisor Hamilton Lane. In February 2001, Wagner noted the strong performance of the pension's diversified alternatives portfolio and recommended a $540 million allocation increase to Hamilton Lane's account. But at the end of the year, Hamilton Lane was out as an advisor and London- and Irvine, California-based Pathway Capital Management was in.

Wagner says there are “a lot of reasons” for changing separate account managers, ranging from concerns about conflicts of interest to politics at the pension board level. He notes that although LACERA has the option of ‘firing’ a separate account manager, it has never done so. Instead, the pension has sought fresh management teams with each contract expiration.

The ability to switch managers is one reason Wagner says his pension finds separate accounts so appealing. A parting of ways with a separate account manager, although often accompanied by a penalty of some sort, is far easier than getting out of a partnership in which investors are co-mingled. Funds of funds, like single-GP private equity funds, require limited partners to be committed for the life of the fund, which can be as long as 12 years or more. The options for ‘firing’ a fund of funds manager are fairly grim. Either the investor must sell its partnership interest at a discount on the secondary market, or, more drastically, may cease honoring new capital calls but risk facing draconian capital-account slashings, not to mention gaining the reputation as a difficult LP.

More importantly, though, LACERA likes the fees for separate accounts better than those associated with funds of funds. “If you want to put money to work each year, and you do it through a fund of funds, after a few years your management fees are going to be huge as opposed to what you can negotiate as a separate account client,” Wagner says. “That to me seems to be the biggest point.”

Of course, every investor is different and has different needs, and there are two crucial things to note about LACERA. First, it is a comparatively large investor, in that it must put hundreds of millions of dollars to work, as opposed to the mere tens of, or single-digit millions found among high-net-worth and small-institution investors. Second, it does not have the budget to hire an extensive alternative investment staff. These two qualities put the Los Angeles pension squarely in the middle of a trend that private equity advisors are seeking to exploit – the continued growth of private equity as an institutional asset class, and the continued need for investors to outsource the process of selecting and monitoring good GPs.

Despite a several-year slump in private equity valuations, fundraising and investing, the institutional outlook for the asset class remains strong. According to a recent survey conducted by Goldman Sachs International and Russell Investment Group, called ‘Report on Alternative Investing by Tax-Exempt Organizations 2003,’ fully 70 percent of North American respondents have allocations to private equity, up from 64 percent in 2001. In Europe, 58 percent of those institutions surveyed have private equity programmes, an increase from 55 percent in 2001.

There is always the chance for that money to go somewhere else

Not only are more institutions committing to private equity, but their commitments are expected to increase in percentage of total assets, if only slightly. Although the North American average allocation to the asset class held steady at 7.5 percent from 2001 to 2003, the survey's respondents forecast an average 8.2 percent allocation by 2005. In Europe, the average allocation increased to 4 percent from 3.6 percent over the same time period, and respondents forecast an average 2005 allocation of 4.5 percent.

As institutional private equity investment programmes increase, however, a concomitant trend is boding especially well for advisory businesses – these institutions are increasingly seeking to outsource. The amount of work required of a single institution to perform due diligence on and maintain communications with GPs is daunting. And in the case of public institutions, the skills gained in these activities are often richly rewarded in the private sector, which causes a brain drain.

An investment professional at a major private equity advisory firm says: “If you look around the institutional investment world, there are a lot of private equity programmes in existence, but these programmes are run by one, two or three people, especially at the mid-sized institutions with allocations [to the asset class] of between $250 million and $500 million. Maybe they have a guy or two who do it part-time. They are also having trouble keeping good people due to compensation issues. They're throwing up their hands and saying, ‘Life's too short – let's retain an outsourced firm to monitor a program for us.’”

Statistics on separate accounts are hard to come by as capital committed to underlying GPs is not often tagged according to whether or not the investor relies on a consultant. But anecdotally, most private equity advisory firms report robust recent interest in separate accounts. In addition, if the growth of funds of funds can be used as a proxy for the general growth of outsourced allocation management, a rising tide is surely lifting all boats. Among the findings of the Goldman Sachs/Russell survey is the worldwide phenomenon of funds of funds drawing increasing percentages of capital committed to private equity. In 1997, just 2 percent of North American private equity was committed through funds of funds; last year that figure rose to 11 percent. In Europe, the surge to funds of funds has been even more dramatic – from 16 percent in 1999 to 41 percent in 2003.

The growth of funds of funds, in fact, also indicates the participation of newer and/or smaller investors in private equity. New, because initial allocations to the asset class are now frequently made by investors that lack any expertise or staff, and funds of funds endeavor to provide total solutions for both. Small, because due to economies of scale, most advisors only make separate account programmes available to investors with at least $50 million to invest. “The market's standard approach has been to ask for $100 million and settle for $50 million,” says one such advisor.

For those institutions or family offices large enough to qualify, separate accounts offer certain advantages over funds of funds, according to their backers. Most separate accounts charge fees based only on committed capital. Although annual management fees are negotiated, a source at a major private equity separate account manager says a typical fee on a $100 million commitment is 75 basis points, a rate that begins to trail off after a period of six or seven years by about 10 percent per year.

By contrast, some funds of funds charge performance fees on top of the carry taken by the underlying GPs, not to mention the management fee. Separate account managers typically only charge incentive fees on coinvestments and direct investments of between 5 percent and 15 percent, where a client's capital is invested alongside a GP group or directly in an advisor-sponsored deal.

As the investment board of LACERA would argue, separate accounts allow more flexibility in working with, and ditching, the advisor. Contracts are typically negotiated for a set amount of years, after which the advisor must compete anew with other advisors for a new contract. Should the investor become dissatisfied before the contract is over, it may fire the advisor, but there is often a previously negotiated ‘break fee’ for doing so.

From the advisor's point of view, however, the relatively transient structure of separate accounts is among their least attractive features. “The money is less sticky,” says a manager of both funds of funds and separate accounts. “There is always the chance for that money to go somewhere else.”

Comments another outsourced private equity programme manager, “The real issue with separate accounts is the term of the relationship. If someone has you for two or three years and then they have to go, that isn't good.”

The manager adds that there is no way to get around the comparatively weak capital lock-up provisions of separate accounts, other than selecting good clients. “You have to look them in the eyes, literally, and see how committed they are to the asset class,” he says, adding, “We haven't been burned by this too often.”

Established investors with mature portfolios are now less interested in the offthe-rack ‘well balanced’ portfolios offered by many funds of funds and traditional separate accounts. They may have rock-solid relationships with, for example, the best buyout managers, but zero exposure to the middle-market or distressed markets. For these investors, an advisor who can offer a niche-heavy programme is highly desirable.

The demand for specialised investment programmes can be seen in the secondary as well as primary private equity market. A secondary advisor says many of his clients “realise they have been too focused on large cap and want to redeploy to middle-market. They view their portfolio as too concentrated with the largest names, especially in buyouts. As the funds have grown, they are reevaluating how they maintain top-quartile performance without exposing themselves to too much concentrated risk.”

Taking on a mandate outside of your core is the bigger burden on your team

A portfolio manager at a major state pension says he plans on hiring advisors to do work on specific sub-strategies. “In a portfolio as large as ours, you have some product categories that would be too labour-intensive” for the inhouse staff, he says. “I think a separate account would be attractive for these.”

This growing desire among investors for customised private equity programmes is transforming the business of both separate accounts and funds of funds, as well as heating up the debate regarding which model is best for investors and which is best for advisors.

Customisation now touches every aspect of the investor-advisor relationship. In the separate accounts arena, many larger institutional investors want to only partially outsource their investment programmes. In some cases, they want to outsource specific niches while leaving mainstream strategies to internal staff. A subset of this choice is discretion – some contracts designate the consultant as a full fiduciary; others have the consultant conduct due diligence and maintain relations, with the final investment decisions made by the client. “I suspect that every advisor would prefer the former and every investor the latter,” says a wealth management professional. “I also suspect that the larger the commitment, the more likely the relationship is nondiscretionary.”

A separate accounts manager confirms this suspicion. He says his firm recently decided not to rebid for a major pension client because it insisted on a nondiscretionary account. “The relationship didn't work for both of us,” he says.

But the first thing that comes to investors' minds when they hear ‘customisation’ is strategy focus. Increasingly, investors are seeking to rebalance portfolios through separate accounts. Cory Pulfrey, a managing director at Morgan Stanley Alternative Investment Partners, says his firm has seen an increase in the number of investors asking for separate accounts. “The players fall into two buckets,” he says. “One type of investor wants to exclude something. They say, ‘we want to exclude the US,’ or, ‘we read about the bubble so venture doesn't sound too good.’ Another type want to fill a niche.”

As an example of the later type, Pulfrey cites CalPERS' use of Grove Street Advisors to help the California pension giant fill out an allocation to venture capital, a programme characterised by many commitments to smaller funds – just the sort of administrative burden that CalPERS is seeking to outsource.

So-called niche investing is going mainstream. US institutions now frequently seek out separate account managers for European investing, and vice versa. A number of sources said large investors have lately shown a particular interest in middle-market accounts. The Goldman Sachs/Russell survey found a spike in interest for distressed fund managers, who in 2003 occupied an average of 14 percent of US respondents' portfolios, up from 8 percent in 2001.

Indeed, large investors in need of some custom portfolio touch-ups now find many advisors willing to do whatever work is requested.

Life's too short – let's retain an outsourced firm to monitor a program for us

One of the most overtly customisation-focused separate accounts programmes in the market now is Credit Suisse First Boston's aptly named Customised Fund Investment Group. This group, co-led by managing directors Mike Arpey and Kelly Williams, is described by CSFB as having $8 billion in commitments in over 450 private equity funds and coinvestments. CSFB, its website reads, “believes that building customised portfolios represents the best approach to private equity investing, both for new entrants and for investors seeking to expand their exposure to the private equity asset class.”

Unusually, CSFB markets its customised programme to high-net-worth individuals as well as institutions.

Other notable separate account specialists going after customised business are Pathway Capital Management, Goldman Sachs, Pacific Corporate Group and Hamilton Lane, according to sources.

Although all advisors would prefer to win a ‘core’ account, many are finding robust business in being niche managers. “It's a good business model to create something specially for a client,” says a separate accounts-only manager. “We'll work with a client to do any sort of carve-out. There's nothing we won't do.”

Fund of funds managers are also recognising the selling points of customised products. Traditionally, the terms ‘fund of funds’ and ‘customised’ would not be mentioned in the same breath. Often called co-mingled partnerships, funds of funds by their very nature require all investors to ride in the same boat. Now, the boats are being broken down into different ‘buckets.’

Chuck Flynn, a managing director and global head of private equity fund investments for Deutsche Bank, says his firm has noticed that “the desire for more customisation has gone up each year in the context of funds of funds. Investors are saying, ‘you know, we really do need a customised suit. We're loaded up on the US and we just need Europe,’ or, ‘We're stocked up on venture, can we just do middle-market?’”

Deutsche Bank is creating what Flynn calls ‘modular funds of funds’ which allow investors to chose from several modules representing different strategy focuses when investing in a fund of funds. The bank also gives certain investors modules representing feeder funds to single managers and coinvestment funds. Flynn also calls this approach a ‘Chinese menu’ – a reference to the many choices available within the context of a single meal.

Funds of funds now offer customised strategies as well as other tailor-made features. Jeff Ennis, a managing director in the Santa Monica office of the Wilshire Private Markets Group, says his firm primarily focuses on funds of funds, but offers ‘single investor funds’ for investors that want increased exposure to certain managers included in the main vehicles. The firm also has separate funds for investors in need of specific tax treatments.

Limited partners excited about all the choices at their fingertips should know that, while choice is good, the restaurant with the thickest menu isn't necessarily the best place to eat.

In other words, investors who need to outsource due to a shortage in expertise and resources should be aware of the strains that separate accounts – any customisation, for that matter – can create on the resources of the advisor.

Advisors like funds of funds not only because they lock up capital and have traditionally commanded higher fees, but because they are more efficient; every investor receives a report on the same underlying managers. Separate accounts, buckets, modules, side vehicles – all of these are separate partnerships that come with distinct administrative burdens. Hence, the minimum commitment of $50 million.

“Separate accounts are a hassle if you don't have to do them,” says an advisor that mostly offers funds of funds. “Whether they're for large or small investors, they require the same amount of work. Each has a special report and special meetings.”

Wilshire Private Markets Group's Ennis says his firm sees its job as to get the highest rate of return possible for its investors, period. After it selects what it believes are the best managers, Wilshire is reluctant to invest with the best of the rest, as it were. “In our minds, we're running a single due diligence process,” he says. “We'll pass if someone says, ‘Hey, why don't you guys do emerging markets for us?’”

Questions about investment standards convinced Chicago- and London-based Adams Street Partners to stop accepting separate accounts clients in the early 1990s, according to Hanneke Smits, a partner in the London office in charge of fund investments. “[We did so] to avoid the decision-making problems inherent in [separate accounts], and to reduce administration” she says.

Smits notes that although her firm will occasionally invest with a first-time fund, it has turned away investors interested in setting up customised emerging manager programmes. “This can be difficult to square with your own investment principles,” she says. “Do you commit to a manager that you wouldn't invest with from your main fund? We can't say, ‘This manager isn't good enough for the main fund, but it might fit over there.’”

Investors hoping for plumb allocations within specified niches should also beware of allotment problems that may arise if an advisor has too many separate account clients clamoring for the same manager. An advisory firm with a key GP relationship may only have a set amount of capital it may commit to a given fund. Potential allotment problems are of particular concern to separate account managers because they handle many distinct partnerships. Notes Deutsche Bank's Flynn: “You don't want to burden a GP with 20 new names – that's just courtesy.”

Sources warn that separate account clients who do not make it into A-list funds may get allocated to the B-list within a given strategy.

An advisor's ability to conduct meaningful due diligence on funds in the requested niche should be examined, say sources. One fund of funds manager, whose firm occasionally takes on separate accounts, says: “What investors should be asking about is if a firm has ten different investment programmes that it needs to run, and there's not much overlap, how is the investment staff using its time?”

He adds: “The greater administrative burden is related to the number of underlying partnerships, not the number of investors. If you take on a mandate that is outside of your core – that's the bigger burden on your team. You're going out and sourcing and doing due diligence on funds that you otherwise wouldn't do.”

LACERA's Wagner knows all about the work required for vetting new funds. His pension is willing to pay Pathway to take care of the bulk of that task, and Wagner gives credit to his investment board for “being savvy enough to know that our existing managers may not repeat good performance from fund to fund. You need to vet as many opportunities as you can, and we don't have the staff for that.”

Nevertheless, when LACERA decided to initiate an emerging managers programme, it did not ask Pathway to take up this new mandate. The pension also decided against a fund of funds because of what Wagner describes as snowballing fees. The alternative investment staff of LACERA runs its emerging managers niche programme in-house while outsourcing its core programme – an exact reverse of the market norm. Wagner estimates that the inhouse programme takes between 40 percent to 60 percent of his staff's time, but that this is a worthy use of his pension's limited resources. “We're looking for the best managers like everybody else,” he says.