Alternative Insight – January 2019

Funds-of-Funds: New models for a changing market

Funds-of-funds are an established segment of the private equity market, but their role is evolving.

A primary fund-of-funds (FOF) pools investors’ capital to subscribe for interests in other investment funds. FOFs have long been established in the private equity industry, because they offer certain benefits to investors:

  • Diversification – the FOF can structure its portfolio of fund holdings to represent a variety of investment strategies, vintages, countries and industrial sectors, from which its investors gain exposure to hundreds of companies.
  • Economies of scale from centralising, in the FOF’s hands, the demanding work of sifting and evaluating prospective GPs around the world, reviewing and negotiating (often complex) fund terms, and then monitoring funds on an ongoing basis.
  • Specialised knowledge and market intelligence, which derive from being an active and systematic participant in private equity funds around the world, and is especially valuable given that the private equity market is often neither especially transparent nor easily comparable.
  • Access to top-tier primary GPs who might not otherwise be accessible for smaller or less experienced PE investors and are often oversubscribed.

Like other asset classes, FOFs took a hit on investor returns in the global financial crisis. They have bounced back, but their total annual fundraising has yet to surpass the $55 billion raised in 2007. Moreover, in the last few years, primary funds have been raising capital at a faster rate than the FOFs that invest in them, so that FOFs’ relative share in the class is shrinking: according to Preqin’s 2017 survey of the sector, FOFs represented 4% of capital raised that year, down from 15% ten years earlier.

Traditionally, FOFs charge their investors ‘one-and-ten’: a 1% annual management fee and 10% carry, which neatly echoes primary funds’ longstanding ‘two-and-twenty’. But this creates a double layer of charges, because FOF investors also pay primary fund costs and fees. As big institutional investors have increased their allocations to the class, grown familiar with the workings of private equity, and expanded their in-house portfolio teams, they are better able to appraise competing GPs and administer more of their PE fund commitments directly, and are less amenable to paying the double layer of costs.

So how are FOFs navigating a tougher fundraising environment?

With average fee rates at big PE funds gradually falling (in part because they are raising ever bigger pools of capital), many buyout-focused FOFs have followed suit and cut their own fees, to 0.5% or 0.75%. There is considerable willingness, particularly among venture capital FOFs, to innovate – for instance, using ratcheted carry, where the FOF’s carry percentage increases (e.g., from 5% to 10% to 15%) as it distributes more cash to its investors. And the vast majority of FOFs continue to pay preferred return, generally between 6% and 12%.

Discounted fees ease, but won’t eliminate, the impact of the double layer of costs. An FOF will consistently beat the returns from direct commitments to primary funds only through superior fund selection and portfolio construction.

Primary fund subscriptions are made into “blind” pools and typically held over a period of five to 15 years; there is no liquid public market into which to sell, and relatively little information about the funds themselves is publicly disclosed. This makes GP due diligence, both qualitative and quantitative, especially important in making good portfolio decisions:

  • Understanding how effectively GP management team members work together, each professional’s background and competence, the firm’s succession and emergency planning, and its approach to investor relations.
  • Analysing a GP’s track record – the overall performance of the investments the firm has made, and performance broken down by team member, vintage, and strategy – and comparing it to competitors.
  • Interrogating GPs’ investment ideas.

Sitting alongside a program of direct fund investments, FOFs offer the opportunity to diversify down roads less well travelled (for example, first-time GPs and niche specialists like emerging countries or special situations), where the FOF’s fund-selection expertise comes into its own.

Customised solutions are fast becoming a significant new business line for firms that manage FOFs – from tailoring their clients’ asset allocations to separately managed accounts and specialised “fund-of-one” mandates. Indeed, FOFs face some competition for this type of work from giant multi-strategy managers like Blackstone, whose own diversification across private equity, credit, real assets and hedge funds allows them to offer a comparably broad choice (albeit of own-branded funds only) to their investor clients.

Industry leaders have spoken of a trend among institutional investors to look past the borders that have traditionally marked out private equity from real assets from private debt and see them as one composite sector. It helps, therefore, to have capabilities diverse enough to match clients’ imagination. Managers can add scale, breadth and depth organically or, more speedily, via acquisitions. This has led to a wave of consolidation in the industry, beginning in America and now reaching Europe, with several big, recent M&A deals involving managers with significant FOF business lines, such as Adveq’s acquisition by Schroders (2017), the merger of Aberdeen Asset Management and Standard Life (2017), and Alantra’s purchase of a strategic stake in Access Capital Partners (2018).

In the same vein, FOF houses have been raising separate private equity secondary funds, a discrete type of fund-of-funds that has boomed in the last decade. Unlike their pure primary FOF cousins, secondary funds buy LP interests in mature primary funds, opportunistically and typically at a discount. They have shorter investment horizons, undertake thorough valuation analysis of the target fund’s portfolio companies, and are focused on corporate exits.

This sort of repositioning and adaptability in servicing LP needs should see FOFs protect their role in the private equity industry in the coming decade.