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When access is an issue

Funds of funds have become an increasingly popular route for institutions to gain exposure to the private equity market – a trend that looks set to continue. What are the drivers behind this? And what is it that funds of funds have to offer their limited partners?

The huge growth in the private equity fund of funds market over the last few years can have escaped the notice of few people in the industry. In the space of a decade, this area has grown from a handful of players to becoming a sub-industry in its own right, with 123 funds of funds managing a total of $130bn worldwide. Much of this expansion has occurred over the last five years and has been driven mainly by increased investor appetite for private equity.

This rapid growth has created a market that is unlikely to be sustainable. Many are predicting a shake-out of funds of funds over the coming years as the poorer performers and those with no clear differentiator find that they are unable to raise successor funds. Yet however many funds of funds quietly disappear from the market in the next few years, investor appetite for gaining exposure to private equity in this way remains strong. This was one of the clearest messages from yesterday's AltAssets Fund of Funds Forum. Attended by 145 people, including 70 institutional investors and 50 fund of funds players, the forum aimed to educate and inform current and prospective fund of funds investors. The fact that so many institutional investors chose to take part in the event simply proves that interest in funds of funds is far from on the wane.

Different investors have different reasons for investing via funds of funds. For many, they offer a first point of contact with the industry. The London Pensions Fund Authority is an example of this. As its director of finance and investment Amanda Walker explained, the fund recently decided to allocate 7.5 per cent to private equity and has just signed agreements with three funds of funds to gain access to the industry. For others, such as the Co-operative Insurance Society, funds of funds can offer expertise in a particular area that an investor may not have. CIS's investment manager Richard Hotchkis explained that he used funds of funds in Europe and Asia ‘because they have the expertise in these regions that we just don't have'.

And for others, funds of funds provide a level of diversification that would otherwise be impossible for many investors to achieve on their own, either because of the administrative burden involved or because they are only able to invest a small amount in private equity. West Yorkshire Pension Fund, for example, has limited its investments directly into funds to eight managers. With the rest of its private equity allocation, it invests in funds of funds, said head of pensions and investments Stuart Imeson. Other reasons include a lack of internal resources, the ability to take advantage of secondary positions, a fund of fund's access to co-investment opportunities and the fact that funds of funds can help investors learn about the asset class before investing directly in funds.

But there is one other reason that has crept up the list over recent years: access to the best performing funds. One of the first lessons that investors should learn before entering the private equity market is that it is not worth investing if you do not commit to the best funds. The dispersion of returns in the asset class is vast. As Adveq's Andre Jaeggi pointed out, earning a median return in private equity is not worth it - you may even earn less than the public markets once you have taken costs into consideration. ‘If an investor has to wait ten years for 1.7x his capital, then it's not worth doing. You may as well invest in government bonds,' he said. ‘Two-thirds of the money that flows into the market is by definition badly invested because it doesn't earn a premium to compensate for illiquidity.'

It's clear therefore that successful private equity investing relies heavily on selecting and investing in only the best funds - something that is less apparent in private equity than for other asset classes. As Martin Currie's director of private equity Hamish Mair pointed out, ‘you can't put too much emphasis on track record to assess future performance. You have to look at the team, its motivation and incentives, its skills, etc. These factors are far more important in determining future success'.

The problem is that, even if an investor is able to identify which are the best performing funds, it may be unable to compete for access. GPs generally prefer, wherever possible, to reward loyal previous investors by offering them the opportunity to re-up rather than taking on new ones. The ability of many funds of funds to provide large sums of capital and the relationships that many of the long-standing players have with the best funds (some of them will have been investors in their first fund) makes it difficult for newer and/or smaller investors to muscle in on these funds. It's a point not lost on Knightsbridge's Joel Romines. ‘Access takes years to develop,' he said. ‘I wouldn't want to be in the position of starting our business now.'

Access to the best funds has always been an issue in the market to some extent. Some GPs are so sought-after that they raise funds by invitation only. But the issue has become rather more important over the last year or so. In contrast to the bubble days of the late 1990s and 2000, many firms are looking at scaling back the size of their next fund to reflect that fact that their investment pace has slowed considerably since then and that company valuations have dropped dramatically. The most notable example of this was the recent fundraising by US venture firm Sequoia. Earlier this year, it raised $395m - almost half of the $695m it raised in 2000 - and the fund was many times oversubscribed, so keen were investors to get a piece of the Sequoia action. And this is a phenomenon we are likely to see more of as some of the bigger US early-stage names come out fundraising in 2004 or 2005.

So far, though, access has really only been an issue in the US. ‘This is predominantly a US problem,' said Wilshire Private Markets Group managing director Daniel Allen. ‘We've seen it in funds in the $300m to $500m range that want to stick to the strategy they know and have proven. These are funds that are focused on getting paid through their carry rather than fees. With these, you have no choice but to be there early.'

But it is possible that access becomes a problem elsewhere, too. Investor appetite for the mid-market buy-out sector, particularly that in Europe, has increased dramatically over recent months. It is not unlikely that the best funds in this area will find themselves oversubscribed in the future, said Allen. ‘The access story of tomorrow will be mid-market funds,' he said. ‘Many of them are already finding themselves in the position of turning money away.' And the problem could become more acute in Europe than in the US because of the country-specific focus most mid-market players have. ‘If you think that each European country only has one or two top performing mid-market funds, then it seems obvious that access to these will increasingly become an issue,' said NIB Capital Private Equity's partner, co-investments, George Westercamp.

If these trends play out as expected, then it could change the dynamic of the relationship between top performing GPs and LPs. It's already clear that the most popular funds are able to dictate the terms on which their investors commit. ‘Terms and conditions have not changed in favour of LPs as much they should have done,' said Unigestion managing director David Chamberlain. ‘Good managers can apply their own terms and conditions and if you want to invest, then you have to swallow them.' But it could be that investors are increasingly going to have to prove their worth in order to gain access, too. ‘Investors will need to demonstrate to top performing GPs that they want them in their fund,' Chamberlain added.

The trends could also result in less money being raised by the funds of funds themselves. The argument goes that if the best funds are raising less money, then funds of funds will have to do the same or risk diluting their returns by investing in sub-optimal performers. ‘It's an issue for every fund of funds to rightsize their programme in response to smaller private equity fund sizes,' said HarbourVest Partners managing director George Anson. ‘This needs to be addressed head-on. We as an industry need to assess what the market will look like in the future. It's tough to turn money away, but we must do it.' It was a view echoed by David Gamble, chief executive of BA Pension Investment Management. ‘The most clever funds of funds have seen that the only way to limit the potential downside is to limit the size of their funds,' he said. ‘It's very difficult to turn down money, but it's also true that you are often given lots of money at precisely the wrong time.' (A point not lost on Invesco Asset Management's director, private equity, Ray Maxwell, who explained that his firm had put off fundraising in response to the limited opportunities available.)

This type of discipline will be hard for a lot of funds of funds, especially as the predictions are that European investors in particular are set to increase their allocations to the asset class. But, as with the funds themselves, it's the most disciplined funds of funds that will be the best performers. With more investors attempting to invest in smaller funds of funds that can boast access to the best funds, the end result could be quite ironic. Could it be that access to funds of funds becomes an issue for some investors? We'll be watching the developments with interest.

We would like to thank everyone who attended and participated in our inaugural forum and helped make the day such a success.

Our next event is the AltAssets Venture Forum, which will take place on 3 December 2003. Please click here for more information.

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