Understanding funds of funds: why they matter now

Although some will argue that the fund of fund phenomenon has yet to pass through an inevitable period of contraction, the impact they have already had in bringing private equity into the portfolios of previously untapped institutional investors has been huge. So how are they coping in today's tougher climate?

It's no surprise that many private equity funds of funds (FoFs) are going through the motions at the moment. Given the overall state of the private equity market, could it be any different?

Fund of funds act as middlemen between investors and private equity managers channelling capital into the asset class. Their rise to prominence is very much a product of the private equity boom of the late 1990s. Ten years ago, there were less than a dozen such vehicles; half way through the decade, still no more than 25 existed. Today, well over 100 different operators are in business, evidence of just how many new entrants spotted an opportunity to set up shop in the late 1990s as general partnerships mushroomed and private equity funds' appetite for fresh capital grew ever larger.

Funds of funds have prospered because of their ability to help institutional investors get into the asset class in ways that would otherwise not be available to them. Tellingly, they can provide a launch pad for investors that have not invested in private equity before; they also offer a means to spread allocations (both big and small) across a wide range of venture capital and buyout funds and in so doing build an instantly diversified portfolio. FoFs also sell themselves on their due diligence and fund selection skills that, they argue, few limited partners possess or can acquire in ways that make economic sense. And they are able to open doors to top-performing general partnerships that both newcomers and practised limited partners may not on their own get close to.

From boom to bust
It was these attributes that made investors pile into funds of funds when the private equity boom was in full swing. According to Asset Alternatives, the US private equity research firm, funds of funds worldwide raised $20.2bn in 1999, $23.2bn in 2000 and $13.8bn in 2001. In the US, FoFs have for a number of years now typically accounted for more than 10 per cent of all private equity dollars raised per annum. In Europe, funds of funds became the partners of choice for the majority of investors who were looking to build a private equity programme for the first time.

However, now that the stampede into private equity is over, there is near unanimous consent across the private equity industry that the explosive growth of funds of funds was in fact hardly less excessive than the venture capital binge itself. The result is a market place in which almost everyone regards the prospect of consolidation as a certainty. Every fund of fund manager interviewed for this article agreed that a regrouping was inevitable to enable the market to absorb the current oversupply of players and product. While few predict any dramatic short-term changes ? ?there won't be anything cataclysmic, that's just not the nature of this business?, says one fund manager – many firms are predicted to be facing a difficult future going forward, especially those that arrived in the market late in the day.

Many practitioners contend that when demand was at its peak, several new players decided to raise capital because it was easy to do so even if you didn't have a track record. ?Fund of fund investment looked easy from the outside?, says Helen Steers, managing director of Frank Russell's private equity business in Paris. ?Many saw the opportunity and launched themselves into the market without having a clear idea of what their marketing or investment strategies would be.?

Now that the climate has cooled dramatically, that erstwhile enthusiasm has given way to a debate over which strategies will help funds of funds cope best with the current climate. And in this environment the novices are predicted to come off worse. ?Most newcomers won't survive?, predicts John McCrory, chief executive of Westport Private Equity and a veteran in European funds of funds management.

These late FoF entrants are facing difficulties on a number of fronts. Those that started making allocations in the late 1990s often invested at a considerable pace to get enough capital into the ground to catch up with more long-established rivals. Many of them are now suffering from overexposure to those recent venture capital and buyout vintages that will struggle to deliver the goods. Older firms are finding the effect less bruising, as exposure to pre-bubble vintage years allows them to absorb more pain. But for firms lacking sufficient time diversification in their portfolios, it may be a tough call to stay in business: ?Now that the market is in a more rational period, the penalty for failure in current funds will be magnified going forward?, believes Jeff Gendel at FoF manager Independence Holdings in New York.

Finding the next generation model
To pull through the current downturn and avoid the ultimate punishment of new capital drying up, funds of funds must concentrate mainly on one thing: performance. According to Bruno Raschle at Zurich-based Adveq, ?quality and absolute return is all that counts.? Westport's McCrory agrees: ?The flight to quality is massive at the moment.? And the quality that counts is to be found in the numbers.

Exactly where those fleeing to quality should be headed is of course subject to heated debate. There are different schools of thought as to what a fund of funds manager should look like, and competition between them is fierce. Specialised private equity managers ? the Harbourvests and Pantheons at the top end of the market as well as medium-sized players such as Westport and Adveq – are competing against the fundof-funds arms of large financial institutions such as Goldman Sachs and JP Morgan, who between them manage around $14bn of assets in private equity funds of funds alone. The specialists often accuse the mega-FoFs of operating in private equity for the wrong reasons, namely to lock investors in for a long period of time and sell them a raft of other investment products on the side. Few will dispute that this model has its strengths, such as access to a captive investor base (a distinct advantage when it comes to asset gathering.) But, say the critics, the model also creates conflicts of interest, rests mainly on brand recognition and obliges the protagonists to try and do what is proving to be increasingly difficult in the current climate: to place large amounts of capital in wellperforming general partnerships.

Placing capital is of course a challenge that is facing everyone operating in the current market, whatever their size or operational set-up may be. Alongside suitable investment structures, funds of funds also need to evidence relevant experience and sound judgement. This often means that the successful FoF manager will have come out of the private equity industry. ?The firms we find compelling are those that have the necessary operating experience to accurately determine the skill set of a given General Partner group. This would include, amongst other things, the operational value added that a GP brings to their portfolio company opportunities and also the valuation methodologies utilized, so that one may determine whether their existing portfolio valuation is accurately reflected,? says Wayne Harber, a managing director at US investment adviser Hamilton Lane.

Searching for performance
The ability to select the top-performing funds and subsequently place significant amounts of capital with them is ultimately what sets successful funds of funds apart. It is wrong to assume that access to the right GPs is less of an issue under current market conditions where it seems many general partners are scrambling for investors and can no longer afford to be picky about whom they will let invest in their fund. The fact is that fewer GPs are raising capital at present, so there is significantly less product available. And even though the bulk of private equity firms will return to the market eventually, the vast majority are certain to be offering vehicles that are smaller in size than last time around. Many expect this to be a moment of truth for many funds of funds, the point when the question of who really has the ability to place will be answered.

?Finding that winning 20 per cent can make all the difference between a great and an average performer?

Since virtually every manager claims to have the necessary access, investors complain that it is increasingly difficult to make out who really has the relationships that will ultimately pay. Kerrin Rosenberg, who advises UK pension funds on alternative investment strategies on behalf of investment consultant Bacon & Woodrow, notes ?a high degree of overlap between the general partnerships that fund of funds are invested in. It's always the same names that pop up in the investment memoranda. They seem to have difficulty differentiating themselves.?

Ivan Vercoutère, a partner at Swiss investment management firm LGT Capital Partners and originator of several FoFs, accepts that differentiation is critical for any fund of funds to attract clients. But he argues that any two managers can still differ dramatically in their performance even if as much as 80 per cent of their underlying fund investments overlap. ?The remaining 20 per cent can make all the difference between a great and an average performer?, says Vercoutère.

Finding that winning 20 per cent has become a priority among fund of funds managers with an ambition to outperform. Vercoutère says his team scout all over Europe and the US to find the funds that will give LGT an edge, be they sector specialists, product innovators or even that most endangered of species, the first time private equity fund. It's worth noting too that Vercoutère is a staunch advocate of funds of funds investing alongside their clients in the funds they select to maximise the alignment of interests. Meanwhile, Raschle at Adveq is looking to set his firm apart by concentrating on seed investments and steering clear of late stage situations; and McCrory sees opportunities in backing mid-market funds. All three agree though that the megafunds are best avoided. And all of them also share the view that their ability to go after the unconventional is what puts them in a better position than their investment bank housed rivals whose sheer size makes it difficult for them to pursue the contrarian strategies that the specialists consider necessary to come up with that winning bit of performance.

Another strategy that is gathering fresh momentum among funds of funds is to move into secondaries, something many are predicting to be the hottest FoF offering of 2002. At first sight, this may appear a less than original move: it is certainly no secret among private equity professionals and their investors that a lot of venture and buyout portfolios are currently for sale. But even the funds of funds that are looking to move into secondaries for the first time may find that they have a distinct advantage over the specialised players that operate at this end of the market only.

Many funds of funds have become extremely thorough in their due diligence not only at the underlying fund level, but also inside the investment portfolios of these funds themselves. This rigorous analysis provides them with both an intimate knowledge of the asset quality residing in a portfolio as well as a chance to get there first if another limited partner in the fund wants to liquidise its position. Moreover, the general partners may in such a situation have an incentive to grant the fund of funds access to extra information in comparison to an external secondary buyer, because it is the fund of funds, not the secondary, that the GP will be counting on next timeit raises a fund.

Influencing LPs
The fact that a GP will look to a FoF investor as a liquidity source illustrates how far funds of funds have come in terms of setting themselves up as catalysts in the private equity investment process. Having until relatively recently sat low on a GPs popularity ranking ? many general partners used to regard funds of funds as awkward partners with limited understanding of the private equity business and a consequent propensity to irritate – FoFs are now much more welcome as LPs in private equity funds. ?They do an excellent job as asset gatherers finding smaller pensions funds, families, insurance companies and banks to bring into the private equity capital base?, says Doug Miller, founder of International Private Equity, the placement agent. As such they stand to benefit from private equity's continued movement towards the mainstream as an asset class.

Both US and European observers say that by and large investor demand for the FOF product is holding up despite the downturn and that, while commitments are certainly taking longer to come through, they still materialise. LGT's Vercoutère points out that ?the most positive news at the moment is that we have not had any retractions from investors who have decided to go into the asset class.? Harber at Hamilton Lane is also optimistic: like many, he speaks of an increase in demand among European investors, whilst allowing that new commitments from US institutions are likely to decrease for a while.

?More and more UK pensions are thinking about going into private equity?

Rosenberg at Bacon & Woodrow refers to the current sea change among UK institutions as one of the reasons why mid- to long-term prospects for the fund of funds industry are encouraging: ?More and more UK pensions are thinking about going into private equity. The overwhelming majority will go in via funds of funds, because they have the ability to deploy the right amount of resources. It's a natural solution.?

Funds of funds are also credited with the educational role that they play when introducing investors to the asset class. Working with a fund of funds, either by way of a bespoke private equity investment programme or through a co-mingled product, has enabled many of the larger institutions to become experienced private equity operators in their own right. This does mean though that such investors look beyond the FoF and instead invest in general partnerships directly.

Meanwhile general partners too have come to appreciate the educational influence funds of funds bring to bear on their investors. At the moment several GPs are hoping that the information funds of funds are feeding back to LPs about the state of the market and GP portfolios is having a calming effect. And if Bruno Raschle's experience at Adveq is anything to go by, this is indeed working. Says Raschle: ?Honesty and a proactive dialogue are instrumental to maintain good relations with investors right now. So far we have been pleased with the way investors have responded to the news we've given them.?