Climate: Current attitudes to the fund-of-funds market

16 January 2003

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Fund-of-funds managers feel that their industry has become increasingly competitive in recent times. This view is almost universal, with 90% of respondents to Initiative Europe's latest research report, European Funds-of-Funds: A Gateway to Private Equity, stating that the market had become more competitive. As a result of the current economic and venture industry downturn, one might suggest that fund-of-funds managers would have a lessened appetite for venture funds. However, this does not seem to be the case and at least 5% of respondents stated that they have actually become more likely to invest in venture funds and more than 50% said their attitude would not change. The largest proportion of fund-of-funds managers expects their industry to continue to grow. However, it should be noted that almost as many respondents expect the industry to enter a period of consolidation; 55% state that they expect the fund-of-funds industry to continue to grow, whilst 40% expect consolidation.

Increased Competition

A large number of new players have entered the fund-of-funds arena in recent years, attracted by the perceived demand for private equity products amongst institutional investors and high-net-worth individuals. The potential high returns to be made have also been an obvious attraction for many. Virtually non-existent barriers to entry in the industry have meant there has been nothing to stop these players setting up funds-of-funds. These new entrants have included both new independent fund-of-funds managers as well as funds from captive institutions either looking to capitalise on the demand for private equity from third party institutions or their own clients.

Views on this increased competition are mixed. On the one hand, some fund-of-funds managers feel that the growth the industry has experienced has been a good thing. The increased number of funds-of-funds has meant that inexperienced institutional investors have been able to access the private equity asset class. This increase in institutional capital for private equity is considered to be a good thing for the industry.

On the other hand, some fund-of-funds managers feel that many of the new entrants are inexperienced players with little or no track record in investing in private equity funds. As a consequence, many are likely to follow unimaginative investment strategies, as they lack the skills and experience to identify and access the top-performing vehicles. Many of these groups have been successful in attracting capital from investors when the market has been buoyant. As investment in private equity funds is a long-term business, their inexperience is not likely to surface for some years. Some fund-of-funds managers feel that these players could do great harm to the industry. If they are poor performers they may drag down the overall performance of the fund-of-funds sector. This could result in institutional investors becoming disillusioned with private equity and leaving the asset class. The majority of fund-of-funds managers also feel that this increased competition has led to a current danger of supply outweighing demand in the fund-of-funds area.

Attitudes To The Venture Market

Although the recent downturn in private equity has hit all areas of investment, it has been the venture capital area that has been hit hardest of all. Both in Europe and in the US, venture capitalists have been returning capital to investors and reducing the sizes of their funds. Furthermore, there has been a significant tail-off in venture capital investment activity, with the volume of deals in Europe having fallen by over 60% since the heyday of the first half of 2000.

It would be expected that, as a result of this downturn, fund-of-funds managers would have a lessened appetite for venture funds. However, this does not seem to be the case. In fact, 5% of respondents to European Funds-of-Funds: A Gateway to Private Equity stated that they have actually become more likely to invest in venture funds. Furthermore, only 28% of fund-of-funds managers report that they have become less likely to invest in venture capital funds recently. The majority of respondents - 54% - reported that their allocation levels to venture vehicles have remained the same, despite the downturn.

In general, fund-of-funds managers state that they need to invest in all types of funds and have a fully diversified investment programme. This means investing in venture capital funds. Although there is, as one fund-of-funds manager stated, 'blood on the street' with regard to venture capital funds and venture portfolios, the majority of fund-of-funds managers continue to see good opportunities in the venture market. The downturn in the venture market has meant that valuations have fallen and there are good investment opportunities for venture capital fund managers. Furthermore, the 'blood on the street' is leading to consolidation among venture capital teams. Fund-of-funds managers regard this consolidation as healthy, as it is weeding out the weaker players.

However, fund-of-funds managers do warn against becoming overexposed to venture capital funds. Furthermore, most of those managers that invest on an international basis state that the best opportunities in venture capital remain within the US market. European venture teams, with some exceptions, are generally less experienced than their US counterparts, who can point to longer histories and stronger track records.

Likelihood Of Consolidation

Although many commentators expect the fund-of-funds industry to undergo a period of consolidation, opinion amongst fund-of-funds managers on this topic is mixed. The largest proportion of fund-of-funds managers actually expects the fund-of-funds industry to continue to grow. However, it should be noted that almost as many respondents expect the industry to enter a period of consolidation; 55% state that they expect the fund-of-funds industry to continue to grow, whilst 40% expect consolidation; the remaining 5% of respondents to European Funds-of-Funds: A Gateway to Private Equity expect growth in the industry to plateau.

Respondents who stated that they expect the fund-of-funds industry to continue to grow pointed to the fact that capital from funds-of-funds still accounts for a relatively small proportion of all capital flowing into private equity and venture capital funds. Furthermore, they also pointed out that institutional investors continue to be attracted to private equity and wish to enter the asset class. For many institutions, particularly smaller pension funds and insurance companies, the best route into private equity remains via an investment in one or more funds-of-funds.

Other respondents felt that the industry is inevitably facing consolidation. Many of the newer entrants to the private equity fund-of-funds business entered the industry having little or no experience of private equity fund investment. Such groups will begin to disappear as they either find it impossible to complete their current fundraising (if still raising their debut vehicle) or fail to raise a follow-on fund due to the poor performance of their debut vehicle.

Some respondents went further and questioned whether the fund-of-funds business is sustainable long-term. For many institutional investors funds-of-funds represent the best way to enter private equity and learn about the asset class. Investment in one or more funds-of-funds can be used by institutions as a way of gaining experience of private equity and moving up the learning curve. Having done so, it becomes tempting for institutions to avoid the additional layer of fees that comes with a fund-of-funds and invest directly into private equity funds.

In reality, however, the situation is not a black and white choice between either growth or consolidation. Several respondents stated that the industry is likely to consolidate in terms of the number of players, but see growth in its amount of funds under management. There will be some consolidation as weaker players exit the market in time. However, longer term the industry will grow as institutional investors continue to increase their allocation to private equity and new institutions enter the asset class. These will need a way to enter private equity and funds-of-funds will remain for many the obvious route. Consequently, the established players will continue to see their funds under management grow.

This is an excerpt from Initiative Europe's latest 146 pages strong research report: European Funds-of-Funds: A Gateway to Private Equity. The survey comprises results of detailed interviews of some 40 separate fund-of-funds managers and 30 European institutional investors conducted in the second half of 2002. The report includes chapters on market developments and statistics, differentiation of funds, evaluation and due diligence as well as current attitudes towards the market. If you wish to learn more about this or other research products produced by Initiative Europe please contact Nicholas Gordon, Senior Research Analyst, Email: nicholas.gordon@initiative-europe.com Tel: +44 1737 784 204.