Intelligent or ignorant?

In the wake of an influential limited partner's claim that funds of funds represent “ignorant capital”, Andy Thomson investigates whether they still have a key role to play in the private equity industry

For funds of funds, the words of legendary investor David Swensen were not exactly a ringing endorsement. As a reminder, his recent interview with the Wall Street Journal included the following reflection: “Fund[s] of funds are a cancer on the institutional investor world. They facilitate the flow of ignorant capital. If an investor can't make an intelligent decision about picking managers, how can he make an intelligent decision about picking a funds of funds manager…?”

If you want to get into European turnarounds, for example, that's difficult to do if you're based in Montana. There are no brand names in European turnarounds, you can't flick through a book to select your managers – you need to be on the ground

Antoine Dréan

It was reported that the influential head of Yale University's endowment was aiming his criticism primarily at hedge funds of funds rather than their private equity-focused counterparts. Nonetheless, the timing of the criticism raised a few eyebrows – it came shortly after the announcement that Yale endowment, noted for its outstanding performance over the years, had lost 25 percent of its value between June and December last year.

Some private equity professionals think the market downturn will indeed expose some “ignorant capital” – and that, as a result, the funds of funds sector will be forced to slim down. Says Antoine Dréan, founder of Paris-based placement agent Triago: “There are around 250 funds of funds around the world today, and a lot of them are of the “me-too” variety. They sold access, small tickets and manager selection and now people don't want to pay for that – a lot more LPs are doing it for themselves.”

Dréan believes that the way forward for funds of funds is greater specialisation. “There will be a market contraction and people will have to focus on specific segments. If you want to get into European turnarounds, for example, that's difficult to do if you're based in Montana. There are no brand names in European turnarounds, you can't flick through a book to select your managers – you need to be on the ground.”

This goes to the heart of a powerful argument put forward by those who reject Swensen's notion that you should take responsibility for your own investment decisions – namely, some investors simply can't invest in private equity in the way that Yale can with its hefty in-house team of specialists. For certain types of investor, funds of funds remain an obvious choice – arguably, the only sensible choice.

“The basic raison d'etre for funds of funds has not necessarily changed,” says Katharina Lichtner, managing director and head of research at Swiss alternative asset adviser and manager Capital Dynamics. “It's a good way to diversify if you lack geographic reach, selection skills and you do not have a large allocation to make.” She adds that funds of funds can also be a useful entry point to the asset class for investors keen to build knowledge of the asset class and “participate in knowledge transfer” before switching to an in-house programme at some point in the future.

Those who believe funds of funds still have an important role to play point to the unnerving volatility that prevails at present. “There will be a significant shake-out in the [private equity] industry,” says Peter Laib, managing director at Zurich-based funds of funds manager Adveq. “Not all the buyout funds that are in the market this year will be able to raise money. There will be team instability and some will have to scale down. Some younger members of teams, who can't get carry, will try and spin out.”

In Laib's view, this unpredictability is a reason for immature private equity investors to entrust their capital to experienced custodians. It is not, in his view, a reason simply to steer clear of the asset class – such a course of action would risk missing some potentially outstanding vintage years. “By the end of this year, prices should have bottomed,” he says. “At the end of 2009 and into 2010 there should be massive, extraordinary equity opportunities with very good, inexpensive companies up for grabs.”

He continues: “As an investor, you should be prepared to commit to the asset class today to take advantage of this prospect. Most LPs do understand this – the ones that are not committing are those with liquidity issues or difficult supervisory boards. But if they understand it, and they can invest, then they do.”

Charles Soulignac, chairman and chief executive of Paris-based funds of funds manager Fondinvest Capital, underlines the point that LPs must commit in tough times to benefit when the upcycle commences:“You might be interested in investing in 2009 to 2010, but it will be difficult to gain access to the best funds if you haven't built a relationship with them already.”

Aside from GP selection and relationship-building, geographic diversification is another compelling reason for investors to turn to funds of funds. And, in this context, emerging markets continue to be an increasing priority. David Pierce, chief executive of Hong Kong-based funds of funds manager Squadron Capital, believes there are at least two compelling reasons why demand for Asia-focused funds of funds remains strong even in today's more challenging fundraising market.

First: the diversity of the region's individual markets. Says Pierce:“Funds of funds are a good choice in Asia because it is a geographic expression rather than a single market. And Asia is a huge geography at that, remote from most investors, very complicated to understand and difficult to resource in terms of language skills and cultural understanding.”

Second: the need to be in close contact with the region's managers. “Investing directly from outside the region is a risky way to proceed because of the brevity of a lot of track records here. It's difficult to assess GPs unless you're close to them. The valueadd we offer is our longevity on the ground and ability to assess what's really going on.”

Continuing support for Asia-focused funds may also reflect a widespread belief that, while the region did not prove immune to global recession, the case for investing there remains strong. Pierce notes some interesting developments: “The dramatic correction in public market valuations has had some big knock-on effects. One of these is that some of the competition to private equity has been eliminated. For example, hedge funds did a lot of pre-IPO investing in China and India.”

He continues:“I believe the opportunity in emerging Asia is becoming broader and deeper. And in developed markets such as Japan, pressure on corporates is all the greater. Exports have been squeezed dramatically and companies need to focus on their core competencies. We're optimistic about the future of private equity in Japan.”

Nick Morriss is co-founder of EMAlternatives, which manages separate account mandates for institutional investors fromits offices inWashington DC, Amsterdam and Shanghai. The firmadds an emergingmarkets component to existing private equity programmes and its clients include California Public Employees Retirement System, which in 2007 gave it a discretionary mandate to focus on emerging managers in global emerging markets with fund sizes of less than about $1.2 billion.

He maintains that “the rhetoric had run ahead of the reality” in terms of emerging markets' ability to withstand global economic turmoil, pointing out that “domestic demand has not made up for the loss of exports”. While he sees plenty of opportunity ahead, he believes that “it takes a sophisticated investor to recognise that now is not the time to pull out and is the time to get in”. He adds: “Ask institutions today whether they plan to make increased allocations to emerging markets this year and it's as likely as not that the answer will be no. Understandably, a lot of investors are running round like headless chickens because their core portfolios are suffering.”

In developed markets, where investment in funds of funds is well established, there are concerns over the prospect of defaults. This was brought into the spotlight when SVG Capital, the London-listed funds of funds manager which invests most of its capital with buyout firm Permira, recently renegotiated credit facilities and sought up to £200 million in fresh capital to shore up its balance sheet and ensure it could meet future commitments. The firm also took up an offer from Permira to reduce its commitment to the Permira IV fund to 60 percent of the originally agreed level.

Asked about prospects for more default issues and whether this may end up damaging the reputation of funds of funds, Laib says: “With traditional funds of funds that have simple, transparent structures, you wouldn't expect many problems. There could be issues for those with big high-net-worth bases and several distribution vehicles, including listed vehicles, where you're distributing to investors you don't know.” However, there is also a view that, relatively speaking, funds of funds are in a position to enhance their reputation with GPs. Says Laib: “The ‘quality pyramid’ of LPs is in transition. At the top you had US endowments which were seen as long term, stable and good representatives to have on the advisory board. But now they have liquidity issues and are dropping out of funds – so there is a window for other LPs, like funds of funds, to expand those top quality relationships.”

This would arguably be an ironic outcome in light of Swensen's remarks. At the very least, appetite for private equity remains strong and investors still need the assistance of an intermediary to execute certain strategies. Inevitably in times like these the onus is on funds of funds managers to go the extra mile to demonstrate their ability to add value. The long-term viability of the most persuasive should not be in question.