Fundraising woes and changing investor preferences are diminishing the influence of private equity fund-of-funds managers.
No longer can a fund-of-funds manager's decision whether to invest in a fund make or break that fund.
In fact, some insiders estimate that 20% of current fund-of-funds managers might not survive because of fundraising problems. According to Preqin, an alternative investment research firm in London, funds of funds accounted for a mere $10.7 billion of the $225 billion raised worldwide by private equity funds in 2010, the lowest total since 2004. In 2009, funds of funds accounted for $27.4 billion.
“Commitments by funds of funds typically represent about 15% of total private equity commitments,” said Thomas Lynch, a managing director in the New York office of alternative investment consulting firm, Cliffwater LLC.
Funds of funds' share of all commitments most likely held steady in 2009 and 2010 because they still had capital to invest, Mr. Lynch said, but he expects the percentage to decline as a result of their fundraising challenges.
According to Preqin, the number of private equity funds of funds and the amount of capital amassed by them has been falling steadily since 2007, when $58.1 billion was raised in 172 funds. Of the 15 largest private equity funds of funds, only one — SL Capital Partners' €700 million ($962 million) European Strategic Partners 2008 — managed to meet its fundraising goal and closed. Seven were abandoned in 2010 vs. five in 2009.
Another problem is returns. “Funds of funds are coming to account for their performance and at the end of the day, that's a good thing,” said Robert Ackerman, managing director and founder of Palo Alto, Calif.-based venture capital firm Allegis Capital.
Private equity funds of funds returned 11.6% for the year ended June 30, according to Preqin. The overall private equity internal rate of return for the year ended June 30 was 19.18%, according to the State Street Private Equity Index.
Private equity executives have noticed the changes. For example, EnCap Investments LP on Feb. 1 closed its eighth North American oil and gas private equity fund, the $3.5 billion EnCap Energy Capital Fund VIII LP. The fund had a similar number of fund-of-funds investors as EnCap's previous offerings, but the investors were different, said Hallie H. Kim, co-head of investor relations and fundraising for the Houston- and Dallas-based firm.
“Some of the funds of funds were bought or stopped fund-of-funds investment activities,” Ms. Kim said. Others simply chose not to raise another fund, she added, declining to name firms.
Eighteen months ago, BlackRock Inc., New York, stopped raising more capital for a planned $1 billion private equity fund of funds, closing with $790 million in commitments. The reason cited: a difficult fundraising environment.
Merge, close or change
Industry professionals predict that many funds of funds will either merge, close or change investment strategies.
“We believe the bottom 20% (of funds of funds) will not survive,” said David Fann, president and chief executive officer of PCG Asset Management, a La Jolla, Calif.-based consulting and investment management firm. “Attrition will be over several years as management fees run out on existing funds, coupled with an inability to raise new capital.” PCG Asset Management manages six funds of funds.
Cliffwater's Mr. Lynch said: “Successful fund of funds managers will continue to morph into specialized managers or customized managers.” Some are expected to specialize in distressed-only, small buyouts, early stage venture and geographic specific funds that “will have more appeal than generic strategies,” he said.
The attrition is particularly unwelcome for certain private equity funds, such as those offering niche investment strategies that count on funds of funds as their primary sources of capital, Mr. Fann said.
“Generally, with fewer (funds of funds), it will make it harder for smaller funds or funds with novel investment strategies to raise capital,” Mr. Fann said.
The private equity fund-of-funds industry already is starting to consolidate:
• Citigroup sold its private equity fund-of-funds business to consulting and investment firm StepStone Group LLC and private equity firm Lexington Partners in July.
• Gartmore Investment Management merged its private equity fund-of-funds business with that of Hermes Fund Managers in April. The venture, in turn, was acquired in January by Henderson Group as part of its £78.1 billion ($121.6 billion) acquisition of Gartmore Group.
• Deutsche Bank created a combined private equity fund-of-funds business in April by merging DB Private Equity with the private equity business of newly acquired Sal. Oppenheim Group.
One of the most recent deals was the December acquisition of a majority stake in private equity and real estate fund-of-funds manager Landmark Partners by New Delhi, India-based investment firm Religare Enterprises Ltd. This merger did not sit well with all of Landmark's investors; the $6.7 billion Los Angeles Water & Power Employees' Retirement Plan declined to approve the merger in December.
“This is a significant organizational change that will result in a different organization than what the board initially approved,” Sangeeta Bhatia, the fund's retirement plan manager, said in a Dec. 15 memo to the board.
She said the plan's general consultant, Pension Consulting Alliance, had not been given certain governance documents or employment contracts to review as requested. “As a result, PCA recommends not signing the consent (to the change in ownership),” she wrote.
While their numbers will be diminished, private equity funds of funds will not go away entirely. One of the 10 largest private equity funds closing last year was the e1 billion ATP Private Equity Partners IV, a fund of funds sponsored by Copenhagen-based ATP Private Equity Partners that closed in the fourth quarter, according to Preqin.
“Some investors are still interested in investing in funds of funds to have exposure in countries where they don't necessarily have the knowledge — for example, U.S. investors who want to invest in Europe or European investors who want to invest in U.S. middle-market companies,” Benoit Verbrugghe, senior managing director and head of the New York office of AXA Private Equity, said in an e-mailed response. Also, “it is a good way to have access to the U.S. middle market, which is very deep.”
“Fee-sensitive'
AXA Private Equity manages private equity funds of funds and invests directly in private equity deals as well as on the secondary market. The firm has $35 billion in assets under management.
However, many investors are “fee-sensitive about private equity,” said Frank Morgan, president of New York-based Coller Capital U.S., which specializes in the secondary market.
“Many investors used funds of funds to get into private equity initially or to get access to high-flying venture capital funds they could not get into,” he said. The industry now is more mature, and investors don't want to pay the extra layer of fees required to invest in a fund of funds, he added.
Some fund-of-funds managers are making changes to entice investors. PCG Asset Management is one of them.
“We're focused on improving our value proposition to investors by delivering a blend of attractive terms and conditions, and creating vehicles where asymmetrical investment risk-returns can be achieved,” Mr. Fann said.
Still, while some smaller institutions will continue to invest in funds of funds, “the secular growth is over,” Cliffwater's Mr. Lynch said.
Some private equity firms also are shying from new investments with funds of funds as investors because funds of funds demand more information and do not reinvest with existing fund managers as often as traditional limited partners, Mr. Morgan said.
Allegis Capital's Mr. Ackerman said his firm prefers a direct relationship with investors rather than through a fund-of-funds manager: “We like to have a relationship between us and the source of capital.”
Source: PI Online