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Why go the fund of funds route?

Funds of funds are gaining increasing recognition as a viable way to invest in the private equity industry. Here Fondinvest Capital looks at the rise of these funds and details why they represent an excellent investment opportunity.

A recognised asset class

Over the past five years, private equity has experienced a growth never seen before, both in terms of capital under management and amount invested.

Although the US accounts for two-thirds of the industry globally, Europe, after its substantial growth, has raised about E30bn by 2000 with a comparable amount invested. This equates to a sevenfold increase over the past five years.

This recent enthusiasm shown by a number of investors can be explained by several factors:

•  limited returns for bond investments
•  lack of visibility on equity markets
•  a permanently growing economy

The rise of the ‘new economy' and the development of technologies, such as telecommunication and media technologies, combined with the arrival of various actors (business angels, seed funds), have made private equity unquestionably attractive.

This flow of funds, or supply, triggered the increase in amounts invested, or demand. The situation resulting from this tremendous growth might appear to some as unbalanced and the chances are that the returns witnessed recently will not be sustained over the years to come.

A complex asset class

The comparison of the private equity industry in Europe in 1990 and in 2000 shows the complexity of making an investment:

• the number of investment teams grew from 200 to 1,000.
• the average size of a fund went from E50m up to E600m, and mega-funds have been launched (fund size of more than E3bn).
• total number of funds raised per year went from 20-30 to over 100.
• performance range went from +98.8/-76.6 per cent to +624.5/-84.7 per cent, according to Venture Economics. 
• for a large number of players geographic coverage went from national to European, or even to global for a few of them.
• passive investment strategies have moved to active shareholding strategies.
• positions in companies have gone from minority to majority stakes. 
• realisations of investments have partly gone from sale to the market after IPO to trade sale, particularly for young companies.

All these changes took place gradually and created a patchwork of different situations, turning the private equity industry into a complex asset for investors.

2000, a year of ‘euphoria', and certainly a year of change for the market

2000 began in the same euphoria as the previous three years, which were boosted by the strong growth of investments in high-tech areas and internet.

Investors, being shown IRR returns above 100 per cent, kept on investing massively. A large number of investors, as well as private equity fund managers, forgot some basic fundamentals. First of all, private equity performances have to be measured over a long period of time. Then, an IRR approach only makes sense if it covers a significant enough period, at least five years. Moreover, the notion of return on investment on cash did not seem to be a significant measure.

The stock market turnaround in March 2000 modified the private equity industry for a number of reasons:

• a gradual decrease in allocations as a direct result of mechanical over-allocation due to the down move in value of stock markets 
• a number of fund managers, particularly those active in early stage investments, realised that a company couldn't have a long life doing sales without turning a profit, and with management methods varying too much from conventional methods 
• the myth of liquidity through IPO.

In that sense, 2000 has been the year of a turn in the market, slowing the euphoria of flows of funds into the industry and showing the market the way back to fundamentals. This year demonstrated the cycles of private equity evolution.

Private equity, a cyclical industry

The analysis of 20 years of development of the private equity industry in Europe shows obvious cycles:

Two periods can de identified: 

 ‘Euphoria': years 1985 to 1990 and 1995 to 2000.

Carried by the evolution of stock markets, institutional investors enjoy larger financial resources. Looking for diversification, they allocate more funds to private equity. They are attracted by the potentially high investment returns on investment available in the industry, often a result of good investments boosted even further by high exit values.

Fund managers already active on the market enjoy substantially more financial resources. Thanks to this dynamism they are in a position to offer satisfactory returns. However, they have to face an increase in price for their new acquisitions. At the same time, they also have to face new entrants on the market, less experienced and sometimes not as rigorous in terms of valuation or investment conditions.

‘Deceleration': years 1990 to 1995 and 2000 to …?

Institutional investors face a slowdown on stock-markets and therefore have fewer funds to allocate to private equity. This situation derives from an allocation system that does not rely on risk/reward criteria but on asset classes.

Some fund managers, especially the euphoric ones, have to cope with difficult situations for their portfolios, particularly from a liquidity point of view. In addition to this, some players decide to withdraw from the industry.

Investors' returns in the industry decrease and investors are less attracted to private equity.

2001 - 2002: The right time to invest

Since the second half of 2000, the private equity industry has been experiencing a slowdown in its expansion. First signs are already showing that the industry is changing and that clients - investors - are now in a stronger position than fund managers.

Since autumn 2000, it has become significantly more difficult to raise funds from investors. Thorough due diligence happens more frequently and investment decisions take longer. Generally speaking, fundraising has experienced a serious slowdown since the second half of 2000.

Still, this evolution in raising capital has not changed the private equity business: companies still need to strengthen their equity and large corporations keep on disposing of some of their subsidiaries. The high tech and internet areas still need capital.

A good side of the slowdown is that acquisition prices are decreasing significantly.

Fund manager teams that have been able to remain cautious, in general professionals who have performed well, and who are not involved in difficult and time consuming investments, will have the means to be active investors further down the road. It lies with the investor to choose the right fund manager teams.

In order to remain active in their market and to achieve attractive new investments, other fund manager teams will have to reduce their commitments to some investments, particularly those too demanding in terms of time and money, and for which returns are hard to predict.

Investors in private equity funds will have to re-assess their asset allocation, partly due to the lack of visibility on some private equity funds' returns and partly to continue selecting the best management teams. Furthermore, they will have to sell some of their commitments to get liquidity earlier.

Funds of funds represent undeniable investment opportunities

Today, funds of funds have become popular in the private equity industry and they have a more significant impact worldwide:

• their number is growing consistently : 55 fund of funds in 1998, 66 in 1999 and more than 100 in  2000.
• amounts invested in them are increasing substantially : US$14.1bn in 1998, US$18.7bn in 1999 and over US$25bn in 2000. 
• their contribution to total private equity investment has been higher each year: 12.1 per cent in 1998, 15.6 per cent in 1999, and over 20 per cent in 2000. 

There are a number of reasons for the success of funds of funds:

• syndication and diversification of risks 
• selection of underlying funds (geographic focus, team, investment stage, performance)
• focus on top quartile private equity funds/managers 
• optimisation of the balance between risk, IRR and multiple 
• minimal initial investment in comparison to the exposure and access to funds gained
• follow-up of investments and administrative tasks simplified

Large European banking groups, for whom marketing and sales power is a strength, have already chosen multi-management for their traditional stocks and bonds products. They carry on their development with the launch of private equity fund of funds management companies.

This significant move confirms that private equity is an asset class that cannot be neglected and that funds of funds represent, for managers as well as investors, one of the most appropriate vehicles given the current market conditions.

No matter what the investors' abilities or the amount invested, funds of funds are an effective vehicle. They allow the investor to take advantage of private equity while still controlling risks. Furthermore, delegating the management of non-listed assets to a specialised, recognised and experienced team, provides an opportunity to make the best in a difficult environment.

The selection of the best funds of funds is crucial in order to benefit from the most secure opportunities. The quality of the team managing the fund of funds is of prime importance. Two key points are significant when assessing them:

• The length of time actively involved in investment into funds 
• The performance realised by invested funds.

In Europe, and particularly on the continent, very few teams and even fewer people can show such expertise.

Even if the private equity industry has just entered a deceleration period, funds of funds will still continue to offer opportunities to investors :
- On primaries: fund of funds managers will select the teams that have been able to perform well on a long term basis and to manage safely the 1995 to 2000 euphoria.
- On secondaries: fund of funds managers will be able to detect and select the best profitable opportunities that will derive from the turn in the market following that very euphoria.

This article was first published by IPE (Investment & Pensions Europe) in its ‘Private Equity' supplement March 2001

Charles Soulignac is CEO of Fondinvest Capital.

Fondinvest Capital has raised four fund of funds and has over E350m under management. It focuses on primary and secondary investments. The management team has collective expertise of 45 years in private equity investment.

For further information, please contact :
Charles Soulignac, CEO, c.soulignac@fondinvest.com
Ludovic Prevost, client services, l.prevost@fondinvest.com
Phone : + 33 1 58 36 48 00
Fax :    + 33 1 58 36 48 28