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Why specialised fund of funds focusing on US venture capital complement a private equity portfolio well19/12/2007. Source: BPE Fund Investors. Holger Seidel
 Fund of funds have become one of the most important LP groups in private equity funds. According to The 2007 Fund of Funds Review approximately 38 per cent of worldwide private equity assets are controlled by fund of funds. Smaller institutions having assets under management below $10bn are the most important customers of these fund of funds, writes Holger Seidel of BPE Fund Investors.
What is the reason for the growth and success of fund of funds and why are specialized fund of funds such an attractive proposition in a maturing industry?
Why Fund of Funds?
The growth of the fund of funds industry has been driven by its ability to offer the fund of funds investors convenient access to a diversified private equity portfolio while keeping the inherent risk of the asset class low.
According to Weidig/Mathonet fund of funds have a much better risk-return ratio than direct investments and fund investments. Thus, fund of funds are the first choice for investors who do not have the capital base, access or experience to build a well-diversified portfolio themselves.
It is a well known fact, that there is a big dispersion of returns in the asset class. The best funds have a tremendous outperformance over the industry and it is everyone’s goal to invest not only in the “top quartile” but in the “top decile” of the funds in the asset class. Of course, past performance does not guarantee future performance, but according to a paper by Kaplan/Schoar it is likely that fund managers “whose funds
outperform the industry in one fund are likely to outperform the industry in the next”. Fund of funds managers often have very good relationships with these top tier funds and, thus, offer investors access to the best funds which in many cases would be considered “closed shop” and therefore inaccessible for most investors.
Particularly in a fragmented and opaque market, such as US venture capital with almost 2,000 funds, fund of funds are a very efficient way to build a portfolio for investors who want to invest in this historically best-performing market segment. Building up an own team of specialists, for instance for the US venture capital market, requires both time and money. Hence, institutions with a private equity allocation not exceeding $ 50 million are the “sweet spot” for fund of funds. The additional cost layer caused by fund of funds is frequently a subject of criticism. This common misconception, however, ignores the fact that the additional costs are usually overcompensated by the diversification and the access to top-tier funds offered by the fund of fund.
Specialization
The private equity market has matured significantly over the past decade. Institutions have increased their private equity allocation and according to surveys many plan to increase their allocation to this asset class further. Naturally, when investing in private equity for the first time, most investors have started allocating capital only to sectors with perceived less risk, chiefly buyout funds. Therefore, large cap buyout funds or diversified fund of funds have been a good choice for inexperienced private equity investors. Now that many investors have built a “basic” private equity portfolio, further diversification of the portfolio can best be achieved by adding more specialized investments.
In light of above stated characteristics of the private equity industry, such as fragmented markets, lack of transparency, high barriers to entry and wide dispersion of returns, identifying and gaining access to funds that would add diversification to the existing portfolio could require more resources than the investor is willing or able to deploy. This is also where specialized fund of funds offer a great value proposition.
Venture Capital in the US
Venture capital enables–and to some extent drives–innovation. Already in 1440 Gutenberg’s invention of the printing press was financed by venture capital provided by the wealthy money-lender Johann Fust, and the more recent YouTube $ 1.65 billion dollar deal shows that this form of financing is still indispensable for pioneering ideas. Not only that, but some of the most successful companies, such as 3Com, Amazon, AOL,
Apple, Cisco, Compaq, Google, Intel, Microsoft, Netscape, Oracle or Yahoo have been financed with venture capital. In addition to having helped build great companies, venture capital has generated (and still does) outstanding returns. In summary, venture capital not only fosters the economy but also offers attractive returns.
Especially the US provides an ideal environment for venture capital investments, i.e.:
- Maturity of the Venture Capital Industry: The US is the country with the most successful and experienced venture capitalists. The great number of excellent venture capital funds offers the possibility to build a specialized but in terms of focus, stage and region diversified fund of funds portfolio.
- Universities / Science: The US has many of the world’s leading universities which will continue to develop breakthrough science and bread a large number of successful entrepreneurs.
- Buyers: The US has a great corporate customer base for technology as well as healthcare products developed by innovative start-ups. In some cases not only the product / technology but the whole company is bought by these customers.
- Entrepreneurs: There is a huge number of seasoned serial entrepreneurs with a passion to build companies. And equally important, these entrepreneurs are usually willing to step back as CEOs (and look for new opportunities) when the company needs a different skill set to take it to the next level.
- Liquidity: Even though the IPO market in the US has been very sluggish for the last years and Europe overtook the US in number and volume of IPOs, the NASDAQ remains the premier market for high quality tech IPOs and provides much greater liquidity than its European counterparts.
Summary
Summarizing the above, specialized fund of funds, for instance those focusing on US venture capital, are well-placed to supplement and diversify private equity portfolios while minimizing risk. They also provide investors efficient access to top tier “closed shop” funds which increases potential returns.
BPE Fund Investors was founded in 1998 by its managing partners as part of the Berenberg Bank, Hamburg, and spun-out in 2001. The firm manages specialised venture capital funds-of-funds, investing primarily in Northern America, as well as Europe, focusing on technology, telecommunications, media and healthcare. For more information see www.bpe-fi.de.
BPE makes no representation that the above information is accurate, complete or up to date.
The presentation was prepared for the Private Equity World Germany 2007 conference organised by Terrapinn.
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