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Single investor private equity fund of funds: why compromise?

Fund of funds is a relatively new concept for private equity investments and makes this asset class accessible to a broad base of potential investors. But a new, even more flexible type of fund of funds has emerged. The single investor fund of funds allows institutions to customise their investments to suit their needs. Here FERI Private Equity presents the benefits of using this type of vehicle to invest in the asset class.

Private equity funds have special characteristics. First of all, they hold shares of companies that are not publicly traded. The legal structure is usually that of a limited partnership or a national equivalent, such as a fonds commun de placement à risque in France or Kommanditgesellschaft in Germany.

Furthermore, private equity funds have a limited lifetime, usually ranging from ten to 13 years, and they pool a limited number of investors who commit a fixed amount of money when the fund is set up. Subsequently, this money is invested in ten to 30 companies by a team of investment professionals within a one to five year time period. Towards the end of the fund's lifetime or sometimes earlier, the fund realises its investment in these companies. This may involve a trade sale to another company, an IPO or another form of exit. The investors get paid back along with these divestitures.

This pattern of cash flow distribution is not as uncommon as it may seem: real estate investments and life insurance policies (for private investors) have similar cash flow characteristics.

Until recently, the high degree of perceived risk associated with private equity - among other reasons - has prevented investors from allocating to this asset class. But with the rise of private equity funds of funds, especially single investor funds of funds, this has changed.

A fund of funds pools money from a number of investors and invests it into about ten to 15 private equity funds. The allocation process should minimise overall risk. This can be achieved by committing to funds with differing regional and/or investment focuses. Plus, risk is further reduced because several investment teams will contribute to the fund of funds' performance. This level of risk diversification could not be achieved by investing in a single fund.

Of course, a fund of funds involves additional fees. These include set-up costs, annual management fees (ranging from about 0.5 per cent to four per cent of the committed capital) and often a performance-related fee after the payment of a preferred return of at least eight to ten per cent to the investors.

The market for private equity funds is not very transparent. There is no public data on the performance of individual funds available, making it impossible to benchmark a fund's management team. Data privately available from the management company of a fund relies very much on the valuation of private companies held in their portfolio. This means that quantitative data is unreliable until a large proportion of the funds portfolio has been realised and paid out to the investors.

The industry average displayed an annual internal rate of return of 20 per cent; yet top quartile funds achieved about 30 to 40 per cent throughout the last few years, according to figures released by Venture Economics*, and this gap continues to widen. Furthermore, a review of return data for US private equity funds has shown that past performance has been a fairly bad indicator of a successor fund's future performance. Asset Alternatives studied 182 venture capital firms that had raised at least two funds. Their analysis found that only five per cent of the firms performed in the top quartile between 50 and 75 per cent of the time and only three per cent of firms performed in the top quartile more than 75 per cent of the time. Hence, a particular fund's return potential and level of risk are hard to assess at the beginning of the allocation process. This forces investors to put strong emphasis on fund research and analysis.

Selecting the right funds is much more important in private equity than in public equities. Why? Because institutions cannot usually exit their investments for at least ten years.

To assess the quality and relative risk of funds, a professional manager of a private equity fund of funds can analyse hundreds of factors. Unsurprisingly, many of these factors are qualitative rather than quantitative.

But even if an investor had sufficient knowledge and resources to judge potential target funds, it would not guarantee access to them. This is especially true for the high quality funds, which usually are very selective when admitting new investors to their existing investor pools. They often require a minimum investment of €5m or more. This can be a major barrier for potential investors. If inexperienced in private equity, committing €100m or more to compile a diversified private equity portfolio may make investment committees feel uncomfortable.

Private equity funds of funds, on the other hand, can substantially reduce the initial investment requirement. The fund of funds market has seen a dramatic upswing in recent years. This is a clear indication that this investment vehicle serves as an important way for new investors to access the asset class.

There are more than 100 private equity funds of funds worldwide today, with committed capital exceeding €20bn. Surprisingly perhaps, the growth has also been spurred by a number of investors who used to invest directly into private equity funds, but are now shifting their assets into funds of funds.

As private equity markets have become more sophisticated, the demand for flexibility and responsiveness to investors' needs has also increased. This demand comes mainly from institutional investors, who have very specific investment objectives and legal and tax structuring requirements. They, in particular, have been rethinking their private equity investment strategies via standard funds of funds products and managed accounts.

Today's informed investor is looking for:

• access to the best funds that match specific investment criteria and fit the investor's overall asset allocation
• risk diversification
• tax and legal structures that meet the institution's needs
• differentiation between the funds available so that institutions can offer a fund of funds product to their clients
• customised monitoring and a single reporting source

Single investor funds of funds allow for all these. As the name implies, they are funds of funds tailored to suit the individual investor's needs. These customised funds of funds might have a regional focus or take a diverse approach (US, Europe, Asia, etc.), a mid-market buyout fund of funds, a small cap fund of funds, a biotech fund of funds, a life insurance policy with major private equity investments, or evergreen structures among many others. 

Additionally, the investor may diversify their fund of funds by the number and type of underlying funds. The investor can also control the investment committee and will have more rights over the decision-making process than in a standard fund of funds product. Leverage strategies, over commitment strategies and the fundraising and commitment timetable can all be fully customised.

Customised funds of funds have the flexibility to take account of legal and tax issues that are important to their investors. They can assist in structuring capital guarantees on invested capital to enable insurance companies to make private equity investments out of their capital stock. They can also set up tax transparent and efficient investment vehicles. Single investor funds of funds can address all these issues.

Some fund of funds managers offer managed accounts that fulfil some of the above criteria. However, the minimum investment requirements usually start at about €100-; but a few others, such as FERI Private Equity, have reduced this entrance level substantially, without putting any higher cost burden on the investor. Why should an informed investor settle for the compromises of buying standard funds of funds then?

* All US private equity funds (buy-out and venture) measured from 1969 to 31 December 2000. Measured on a pooled average basis, the result is 19.1 per cent and measured on a pure average, 23.5 per cent

Dirk Söhnholz is the co-founder and managing partner at FERI Private Equity. Before joining FERI he was chief financial officer and managing director for operations and HR at TelePassport AG, a venture capital-backed Telecom start-up company. Before this, he was a management consultant at the Boston Consulting Group in Germany and Mexico and head of controlling and IT at the Gerresheimer Glas AG.

FERI Private Equity GmbH is an independent consulting firm offering a range of services in the areas of private equity funds, hedge funds and other products in the alternative asset class. Their clients are German and international institutions including banks, insurance companies, and pension funds as well as high net worth individuals. FERI Private Equity GmbH offers its clients customised fund of funds products and consulting services. This includes analysis and selection of the target funds, as well as the set-up and the management of the fund of funds.

©FERI Private Equity GmbH, May 2001