Funds of funds struggle under weight of ambition

Financial News - Private Equity News


Investors fear rocketing fund sizes will cut outperformance, writes Jason Corcoran in Moscow

14 January 2008

Institutional investors are growing concerned about the swelling size of funds of private equity funds and whether they can maintain performance levels on investments.


During the past two years, private equity has attracted substantial interest from UK pension funds and the number of new mandates awarded by investment consultants has increased sixfold. While direct investments are becoming more popular, the majority of funds continue to favour the fund-of-funds route.

Jane Welsh, senior investment consultant at Watson Wyatt, said: “I don’t think there is a right limit but you have to wonder whether some of these very large funds of funds can continue to make the money work and generate outperformance to justify the extra layer of fees they charge.”

A recent report by Watson Wyatt identified private equity as the most expensive asset class, with managers’ fees ranging from 5.40% to 11.80% of investors’ returns; and fund of funds’ fees taking an extra cut of between 0.75% and 3.70%, depending on gross investment returns and fee structure. This means investors are paying a minimum of 6.15% a year for their investment to be managed – and anywhere up to 15.5%.

Sanjay Mistry, a principal at consultancy Mercer, feels returns by established fund of funds managers suggest they can identify those who outperform and justify these fees.

He said: “Returns from private equity have, in the past, been in excess of the quoted markets. However, the range of returns among managers varies enormously.

Through due diligence it is possible to select a fund of funds manager who will be able to identify private equity groups with the greatest expectation of being able to deliver returns above those available from the quoted market.”

The established funds of private equity funds attract the lion’s share of pension assets, according to data provider Thomson Financial. The top ten funds attracted more than $61bn of the $128bn raised by more than 150 firms in the past three years.

US fund-of-funds manager HarbourVest Partners tops the table, having attracted $11.6bn in its 12 funds. Adams Street Partners, Axa Private Equity and Goldman Sachs have all brought in in excess of $6bn each over the past three years.

Close to 40% of the $128bn is estimated to come directly from pension funds.

Welsh said there are only a finite number of top-tier underlying managers in the market to absorb new inflows.

“This poses the question whether funds of funds are putting more and more with the big groups such as Blackstone and if that is consistent with generating outperformance. If funds are diversifying, it may be at the expense of quality,” she added.

For venture capital, consultants prefer to see more underlying managers to hedge risk but they question the wisdom of having as many as 60 managers for plain vanilla funds of funds. “In many cases, it looks they are actually running a pure index fund,” said Welsh.

Sam Robinson, director of SVG Capital’s fund advisory business, said some funds of funds are exiting venture capital. He said: “Allocations will be immaterial in a large fund of funds. The exits are legitimate as long as it matches their funds’ strategies and investor expectations.”

With capacity becoming an issue, consultants anticipate funds of funds making more co-investments in companies in which private equity funds already invest. “The effect is that exposure is geared towards a particular investment and diversification is reduced,” said Mistry.

BlackRock Private Equity Partners, which manages $3bn of funds of private equity funds, overcomes potential scalability by using a “warehouse facility” whereby they can make investments at the same time as raising funds.

Roger Pett, head of investor relations for BlackRock Private Equity Partners, said: “We do it in parallel so we don’t have a massive overhang when the fund size is too big.”

Robinson said his firm has relieved overhang problems by creating two fund structures: plain vanilla funds of funds and the leveraged Diamond series of funds of funds.

Leveraged funds benefit from greater diversification and focus on relatively stable performers in the large and mid-market, while the plain vanilla funds offer greater exposure to venture and emerging capital.

Investors, including wealthy individuals and institutional pension funds, have committed €700m of private equity funds to SVG Diamond III, comprising a revolving credit facility or loan worth €420m and €280m of equity.

The Diamond III structure incorporates drawable equity, reinvestment and overcommitment strategies.

The fund has an overcommitment facility of up to 140%, which allows a target investment capacity of €980m.

The fund is focused predominantly on large and mid-market buyouts in Europe and the US and was 41% committed at closing last May, following the expected transfer of a portfolio of 17 funds, representing total commitments of €290m.

Robinson said: “The two programmes have raised nearly €3bn over the past six years and we have invested that without diluting returns.

“A firm’s investment capacity depends on the strategy of the products. I believe we could invest between €500m and €600m per year in vanilla funds of funds without diluting returns, but there is a limit. The leveraged funds we launched in 2004 offer more scalability, allowing us to grow while maintaining our discipline.”