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Funds of funds - a growing industry, but for how long?

Once a relatively small part of the private equity investment scene, funds of funds have become big business - so big that their numbers have tripled over the last three years. But is this growth sustainable? And does it really mean a greater choice for investors?

Observers of the private equity market cannot have failed to notice the abundance of funds of funds on the market these days. It seemed as though barely a week went by last year without the announcement of at least one new player on the market - Europe saw such well known names as NIB Capital, SEB Asset Management and Nordea launch debut fund of funds vehicles in 2001. And this year has already witnessed the announcement of new US entrants. San-Francisco-based Progress Investment Management and Minnesota-based Advantus Capital have both launched debut fund of funds vehicles in the last few weeks.

Funds of funds: 14 per cent of firms raising capital

The figures bear out this impression of fast growth - in terms of fund-raising and number of players. Funds of funds make up a surprisingly large proportion of funds currently raising capital, according to AltAssets' data. As much as 14 per cent of current fund-raisers are funds of funds. Figures just released by Venture Economics and NVCA show that the amount raised by US funds of funds has almost doubled in the past year, from $3.3bn in 2000 to $6.3bn in 2001. This is even more spectacular when considering that venture capital fund-raising slumped by just over 60 per cent for the same period.

And evidence suggests that the actual number of funds of funds active in the market has exploded in recent years. In 1998, there were 55 private equity funds of funds worldwide; a conservative estimate gathered from our data and corroborated by a number of market participants says that there are now at least 180 in existence.

Why the growth?

The increase in institutional money flowing into private equity in Europe has undoubtedly created a demand for more funds of funds. Institutions, particularly in Continental Europe are upping their allocations to the asset class or entering the market for the first time. Funds of funds can certainly provide these institutions - especially small to mid-sized investors - with the practical option of outsourcing their private equity investments to an experienced team. For many investors, this saves them the expense of establishing an in-house resource, puts their money to work faster and allows for broader diversification by fund, sector, geography and vintage year. It will also grant new investors access to funds that they may not otherwise be able to invest in - either because they do not have the contacts or because the target funds are ‘invitation-only'. And, although management fees will be higher overall, funds of funds claim to be a cheaper alternative in the long term. Any extra costs incurred in management fees will, they claim, be recouped by higher than average returns and savings on internal resources.

Consolidation to come

But this explosive growth is not sustainable. Many established players even argue that the market cannot support the current number of funds of funds. Ray Maxwell of Invesco, for example, predicts that many funds of funds will not be able to raise enough cash and expects the number of players to diminish with time. There is only a limited pool of institutional cash destined for the fund of funds market and he expects to see considerable fall-out as firms struggle to raise the cash.

And this process could start to play out fairly soon. Philippe Poggioli from Access Capital Partners says that we will soon start to see fall-out from the fund of funds sector - not a quick wave of people leaving the market, rather a gradual decline. Joel Romines of Knightsbridge Advisors agrees. ‘We will see a massive contraction of fund of funds but the venture industry works through its excesses fairly slowly so there will be a lag,' he says.

Ivan Vercoutère, a partner at LGT Capital Partners is equally pessimistic. ‘The barriers to entry are relatively low. But many funds of funds will not be able to deliver on their promises.' He expects to see a degree of consolidation as less experienced firms flounder.

So there is a rocky road ahead for many funds of funds players - and for their investors. With a ceiling on the number of firms that can survive in the current economic climate, we can expect the fund of funds scene to look quite different a few years - or even a few months - from now.

Survival of the fittest

So who will be the survivors? Unsurprisingly, it's the firms that can demonstrate a solid level of industry expertise and an impressive track record that are most likely to weather the storm. This is not something to be taken for granted in the fund of funds sector - there is a clear deficit of expertise in some corners of the market. ‘The industry is not that professional,' says Maxwell. ‘Many fund of funds managers do not understand the industry. Their success is not due to their track record but because they have been in the right place at the right time.' As a result, investors must be prepared to go through rigorous due diligence in order to filter out the dregs.

Faced with the problem of finding the best players in an increasingly crowded market, many institutions may be tempted to go for ‘safe' options. In fact, some of the more established fund of funds managers have pointed out that, although consultants may tell you otherwise, it is not always advisable to go with the ‘safe' brand names. ‘Safe' does not necessarily mean successful, or profitable. A fund's process of due diligence and the way it goes about selecting funds is far more important. Investing in a first-time fund, run by experienced hands, can be just as successful as investing in a more established fund if its management can prove they are tapping into a network of impressive deal flow. It is also worth bearing in mind - before choosing a fund of funds - that consultants are not always as fund-savvy as they claim.

New developments

But once the current noise surrounding funds of funds starts dying down, what will the market look like? In the short-term, we may well see pressure on management fees as competition hots up in the fund of funds arena, says John Porter of Hamburgische Landesbank. This is most likely in the European market where there are fewer established players and the playing field is more level. A ‘price war' may also develop in the US market but here there is a stronger core of established firms with access to the top quartile partnerships, and these firms can afford to charge premium prices.

And, in time, as larger investors become more familiar with the rules of the game, and develop their own relationships with private equity players, there will inevitably be a shift away from the fund of funds route. Investors will use funds of funds as a learning experience - a ‘window on the market' - until they have reached a certain level of in-house expertise and can go it alone.

But there will still be small to medium-sized investors - smaller pension plans, local authorities, small corporations and companies that lack in-house expertise and the large sums of capital required to invest across a spread of funds - who will rely on fund of funds players to navigate the private equity waters on their behalf.

The complexion of the industry will also change as funds of funds adapt and innovate to meet the needs and demands of their investors. We have already seen some players announcing the launch of listed fund of funds products, partly in response to the restrictions that some investors have on investing in unlisted vehicles. Schroders, the asset management group, had a first closing at E172m for its listed private equity fund of funds vehicle a few weeks back. Swiss bank Julius Baer has also recently launched a listed product.

Just as is happening in the direct fund investment market, we are also likely to see more of a shift towards specialist funds of funds. Institutional pressure has already been building for more specific programmes, allowing for a greater degree of specialisation in particular areas. A brand new market entrant, Eiger Capital, for example, is specialising in technology venture capital fund investment. More established player Horsley Bridge specialises in US early-stage venture capital.

As this year progresses, we are unlikely to see the same frenzy of activity from new fund of funds entrants bursting onto the private equity stage. There will be a great deal of splashing about but the waters will gradually subside to more realistic - and more sustainable - levels.

Emma Hyde is the manager of the AltAssets Fund Calendar. She manages the team of analysts at Almeida Capital who identify and review all private equity fund managers around the world.