Market consolidation forcing FOFs to evolve

Once the lifeblood of Europe's powerful mid-market, funds-of-funds may now be its biggest casualty. "Funds-of-funds (FOFs) are high schools for new investors in private equity. After they graduate, it's hard to get them to keep paying tuition," says Kevin Albert, a partner at Pantheon. "But there are fewer of these newcomers nowadays. Every product goes through a lifecycle, and funds-of-funds are in advanced middle age."

The roughly 250 global players are expected to shrink to 100 or 150, according to F Michel Abouchalache, Quilvest's group chief executive. "The likely buyers could be sovereign funds or emerging markets wealth managers - those that want a door into a ‘new' asset class."

So which funds are in danger? It seems you cannot be too big, too small, or too greedy: between $100-500m is the sweet spot, with Abouchalache suggesting this area will deliver superior returns, though dipping below may prohibit sufficient diversification.

Funds above $1bn, he adds, may struggle if they lack requisite returns, given the high fees they command. Nor are pure FOF players safe nowadays.

"There is no future for firms that just raise money to invest in funds,"
says Alan MacKay, chief executive at Hermes GPE. "Firms have to develop revenue streams in other ways."

The last 12 months have seen a handful of European FOFs hold closes: Altamar in Spain held an interim close on €120m (target: €300m); Portfolio Advisors held a final close on €776m for its sixth Swiss vehicle (ahead of target); Unigestion raised €190m for its Secondary Opportunity Fund; and F&C Climate Opportunity Partners hit €30m in a first close. This year, Access Capital Partners closed its fifth fund on €500m, ahead of its €350m target.

Rather than raising pooled funds, Hermes GPE provides bespoke private markets mandates for their clients, the bulk of which are pension funds.
This blend of funds and co-investments is something that erstwhile FOFs have been ramping up, as is bespoke advice: In September 2011 Pantheon was awarded the mandate for Germany's largest pension fund, the $50bn Bayerische Versorgungskammer (BVK), after a four-year courtship. Last year Access Capital Partners also won a €200m mandate from a US institution as well.

"As FOFs become less important, these customised accounts will be a big growth area," says Albert.

With its similar function, Hermes GPE may be an example of a mid-sized firm set to stand the test of time.

"FOFs nowadays also need differentiated attributes - such as lower fees or a higher alignment of interest between GPs and LPs," says Abouchalache.

Hermes GPE's fee structure has captured a lot of attention. While most FOFs charge 70-80 basis points for management fees, Hermes GPE charges around half of that on its bespoke mandates. "We are not philanthropists, we just do not need to charge for 500 sales people," says MacKay.

The fees are higher for Hermes GPE's co-investment origination, which MacKay says is the real value added by his business. His pedigree is well suited to it too, having spent 20 years at 3i. He is adamant that strong co-invest performance requires strong investment judgment, noting, "we do around 15% of the co-invest opportunities we see".

While investors will welcome this - one placement agent describes the team as ‘revolutionary' - it is unlikely sophisticated institutions will base their decisions purely on costs. Even MacKay admits that any wise investor will partner with the firm that offers the best returns and won't be swayed by fees alone.

With 68 investment professionals, Pantheon's workforce is six times that of Hermes GPE's, and so their fees are higher. Says Albert: "Our more expensive infrastructure means we have more gas in our tank."

Diversification
Europe's largest players have been diversifying for some time, with Adams Street Partners, HarbourVest, Pantheon and Partners Group's offerings all wider than pure fund selection. Albert reveals Pantheon's greater value add for many mature investors is in secondaries, co-invest, emerging markets and its small funds programme. At the end of 2010, Pantheon closed its latest secondaries fund, PGSF IV, at $3bn.

"You need a competitive co-investment and secondaries programme nowadays," MacKay admits.

Despite its relative youth - MacKay took over in 2010 to merge the business with Gartmore's PE business - Hermes GPE has already proved adept at reacting swiftly to market swings. "We have refined from a PE business with a bit of infrastructure, to a private markets business that covers PE and infrastructure," MacKay says.

So lucrative is co-investment that Dutch fund manager Forbion raised its second co-investment fund with all existing LPs re-upping to hit $50m in a first and final close in December 2011. The success was on the back of a stellar first fund: Forbion made six investments from its €54m debut vehicle, raised in September 2010. Two have already been sold for a total consideration of $1.1bn, repaying the fund by almost double.

As co-investment is more lucrative, Hermes GPE focuses more on that, with its funds business accounting for just a quarter of the £4.8bn it manages.
"A good investor in funds will deliver net returns to investors of low teens; a good investor in co-invests will deliver high teens. We would be very disappointed if we were not consistently outperforming those figures,"
MacKay says.

The shift away from fund investing puts Hermes GPE on a par with some of the world's largest FOFs. Partners, for example, now attributes roughly a third of its business to FOFs, with secondaries and directs (including infrastructure, real estate and debt) taking an increasing proportion. A source suggests the latter two accounted for 80% of business in the last two years, though the shift has been ongoing for about five years. Adams Street has a dedicated buyout co-investments team which invests $10-30m per deal in North America, Europe and Asia.

Global asset manager Neuberger Berman has been focused on other areas for some time, according to managing director Joseph A Malick: "Our focus on directs and co-investment is not an add-on to our FOF business; it is part of our core offering. We have dedicated funds and senior teams in each area and have been doing this for many years." Neuberger Berman has a listed closed-end fund (NB Private Equity Partners) that managed $528m as of October 2011. Of that, three-quarters were in funds and the remaining quarter in directs and co-investments.

Listed vehicles offer some funds-of-funds another source of funding.
Pantheon launched its investment trust PIP in 1987 on the London Stock Exchange, and it has outperformed the FTSE All-Share and MSCI World since then. HarbourVest's listed vehicle, HVPE, is listed on the Specialist Fund Market in London and Euronext Amsterdam and invests mostly in HarbourVest's funds, but also invests in other funds, secondaries and directs.

Pantheon, HarbourVest and Partners no longer call themselves funds-of-funds - in fact Partners declined to speak for this piece, to avoid being associated with the vehicles.

Family ties
Carlyle Group acquired AlpInvest last year, a deal which illustrates a new concept proving more popular: the colonisation of the asset management industry by large buyout titans. Other successful funds-of-funds are for sale, illustrating the impact of legislation. AXA PE was eyed up by KKR, TPG, 3i and BlackRock last year, though Canadian PE group Onex and a consortium of Caisse de Dépôt et Placement du Québec (Canada's largest pension fund manager) and Government of Singapore Investment Corporation are the bidders now.

Interestingly, AXA beefed up prior to going on the chopping block: last year it completed its $1.7bn purchase of PE assets from Citigroup as well as $740m from Barclays. AlpInvest also made a sizeable investment, buying CalPERS' $800m portfolio - albeit three months after the Carlyle announcement rather than before.

"Large buyout houses should not get involved because there is an inherent conflict of interest," Abouchalache bemoans. "How can Carlyle have access to all the data related to all the funds in which AlpInvest invested in and then compete against these funds? Carlyle and AlpInvest might find themselves precluded from investing from large-cap GPs in the future. It can work during down cycles when LPs call the shots, but it can work against you in up cycles when GPs are kingmakers."

There are other pitfalls to PE ownership. "As an asset management business, being owned by a PE firm can have its downside," says Malick. "Although PE firms are long-term investors, they always have a time frame for their exit, and this introduces uncertainty for the asset manager's clients."

Neuberer Berman, which spent six years as Lehman's asset management division, staved off a PE buyout attempt in the wake of its parent's collapse in 2008 to buy itself out in 2009. The fund manages €183bn, up from €158bn at the time of the MBO. It recently closed a $720m FOF.

Neuberger Berman's previous ownership was problematic, too. "Our experience with Lehman demonstrated the risks that a bank's other operations expose to an asset management business and they ultimately took down all of Lehman. As investment managers, we were not aware of the risks being taken elsewhere in Lehman. Neuberger Berman is a pure-play, full-service asset management firm.
The firm takes no principal or balance sheet risk like you'd have within a bank."

Hermes GPE merged with Gartmore in 2010, giving it new offices and clients (it opened in Boston and Singapore last year) and last month the merged group announced a new ownership structure, with management having bought itself out from a subsidiary of Henderson Group.

As MacKay says: "We now show more stability with our new ownership structure, which should help us to win new clients." He adds that last year was spent with existing clients since any question over ownership would have been difficult to answer. More than one of Hermes GPE's existing clients has opted to scale back their fund-of-funds manager relationships in favour of using just Hermes GPE for their entire programmes. Pantheon is aufait with parentage as well, having had two: Russell and now AMG. "They were very different. Russell, as a generalist consultant, was very hands-on and even invasive. Now, with a financial owner, it is nearly as independent as before the Russell acquisition."

The market will continue to contract, with some players deliberating over whether or not to raise another fund. UFG Siparex in France, for example, came to be in late 2010 through a merger that saw Siparex's managing company Sigefi take a 34% stake in the new entity. A warrant could see this increase to 50% by the end of this year. However, at the moment the outfit's focus seems to be on its directs business, which just announced a €120m final close for its Midcap II fund. Careful steering through today's labyrinth of institutional demands and market opportunities will put innovative firms in good stead.

Standing out in a shrinking crowd
As all of the biggest players in FOFs expand, they are moving into similar areas of business. This opens the question over what differentiates them.

"Track record [excluding Partners, given its shorter history] is not a key differentiator," Pantheon's Albert says. "It is more about personality:
HarbourVest is Boston-centric; Adams Street raises money annually; Partners is marketing-driven; and Pantheon market-driven.

"Partners looks at what LPs want and creates a product to suit it. Pantheon looks at what is a good opportunity and raises that." Therefore, Albert says, "Partners is not raising a Europe fund now as that would be like selling the plague. But we are, as we see great opportunities there. We're the opposite of marketing-driven."

As a result of this, Pantheon markets three different funds, all at different times so they do not compete for investors.

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