Funds-of-funds fight for survival

The appeal of funds-of-funds has been waning for several years now. Alarm bells had sounded in 2013, when consultancy firm Towers Watson surveyed the top 100 alternative investment managers worldwide: although the report placed funds-of-funds as the second most popular investment route for pension funds, it also detected an increasing shift among these LPs towards directly investing in GP funds.

“Private equity has had a good crisis relative to other asset classes. However, as expectations for returns begin again to fall in an ultra-low interest rate environment, investors want to ensure the net returns they get are closer to the gross returns”, explains James Moore, head of private placement at UBS. “There is an increasing pressure on institutional investors to put their money to work in a way that closes that gap, and one way to do that is to disintermediate funds-of-funds and invest directly in the underlying funds themselves,” he adds.

Bound for mid-cap and small-cap
“The decrease in commitments coming from traditional pension funds has been significant. It has not been sudden, but a gradual development stretching across the past seven to eight years,” agrees Olivier Decannière, managing director at Ardian and head of the firm’s UK office. Ardian represents a solid case study within European funds-of-funds, with $30bn currently under management via vehicles such as secondaries-focused $9bn Ardian Fund-of-Funds VI.

According to Decannière, it is those funds-of-funds operating within the large-cap region that have borne the brunt of the fundraising slump. Meanwhile, small- and mid-cap vehicles have done a better job at weathering the storm because of the larger number of participants within those spaces: as the efforts to map the market become more intense, so does the need for a fund-of-funds to step in and help investors sniff out the best opportunities.

UBS’s Moore agrees with this view: “If you are a US state pension plan with a minimum commitment size of $100m and you want exposure to the European lower middle-market, there is real logic to seeking the services of a fund-of-fund to build a diversified portfolio. There are few options to commit on that scale to proven, top-performing funds. When spread across a selection of funds, access constraints are less of an issue.”

Client-based is the name of the game
As the European funds-of-funds community prepares for an uncertain future, a number of managers have shown they can battle against the tide and continue to appeal to larger LPs. Indeed, in May, Access Capital Partners reached a final close on €644m for Access Capital Fund VI Growth Buy-out Europe (ACF VI), its sixth generation of funds-of-funds.

At the time of the first close, which was held on €190m in December 2013, Access claimed all commitments received up to that point were from existing investors. The level of re-ups, attributed by the Paris-headquartered firm to “meaningful” cash returns from earlier exits, is testament to the renewed appetite for a funds-of-funds offer among its LP base. In terms of deploying cash, almost half the capital has been invested to buyout and special situations funds.

Over the past few years, Access reports a surge in the appetite from pension funds for its fund-of-funds offering, having witnessed swelling commitments during fundraising for ACF VI. When questioned about the secret of its success, the firm underlines pricing discipline, controlled levels of leverage and the ability to deliver strong performance.

“Performance is the critical factor”, echoes Peter Wilson, managing partner at HarbourVest Partners. “A fund-of-funds needs to deliver from 200 to 400 basis points above a relevant public pension mark to satisfy most pension funds.” In his experience, once a fund-of-funds has ticked that box it needs three elements to bring a value proposition to the table that is still relevant for the client base: an experienced, cohesive team; proven access to leading managers; and flexible offerings to address evolving client needs.

Through this three-pronged approach, HarbourVest maintains a fund-of-funds network managing $36bn, around $10bn of which was raised over the last three years. The scheme, Wilson explains, is one in which separate accounts play an increasingly dominant role: “Generally speaking, with our funds-of-funds we have gone from a one-size-fits-all strategy 15 years ago to an offer that is tailored to the needs of our institutional investor base. Today, these separate accounts represent roughly 15% of the capital we manage with our funds-of-funds programme.”

In Ardian’s case, the client-based approach also appears to be the name of the game. According to Decannière, the firm has recently received mandates ranging from $200m to $400m from clients including US pension plans and European insurers. The wish list includes requests for a private equity programme to be built in the US market within a number of years and investment schemes in the mid- and large-cap spaces.

Fighting the double fee
The examples above, just a selection of those mentioned by Decannière, illustrate how catering to the appetites of an increasingly selective LP community is becoming a prevalent theme, one also spotted by placement agents. “There is an increasing trend toward single managed accounts, particularly for the largest clients, with some providers having largely withdrawn from raising co-mingled fund of funds”, says UBS’s Moore. “These individual mandates are also much more keenly priced than a traditional fund-of-funds, which has obvious implications for the asset managers’ business plan.”

Given funds-of-funds’ struggles to remain competitive with their traditional double layer of fees, extending flexibility to the fee scheme seems the logical next step. Most players seem to have received the message, as shown by Ardian’s decision to base the management fees calculation on net asset value (NAV) instead of the committed amount, or HarbourVest’s choice to reward long-standing clients with limited discounts. The routes are diverse but all lead all to the same destination: to make sure the intermediary is not sidestepped in favour of more cost-efficient alternatives.

In spite of the challenges ahead, a glance at the market suggests funds-of-funds managers may rest easy, at least in the immediate future. The latest data points to 2014’s healthy performance on the exit side continuing this year, with firms such as HarbourVest reporting a 3.5:1 distribution-to-capital-call ratio in Q1 2015, the highest in the past 15 years. UBS’s Moore mirrors expectations for a strong 2015, but urges caution. “Distributions continue apace but, at the same time, asset prices are high and GPs are understandably wary of re-committing new capital. We may be in this situation for the long-term,” he says.

Expectations for higher returns and lower fees have undoubtedly cornered traditional funds-of-funds into a fight for survival. Resorting to a tailored offering and a focus on harder-to-navigate markets, however, combined with a robust exit landscape appears to be the life line the industry needs to stay afloat in the uncertain waters ahead.

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• Topics
• Fundraising
• UK / Ireland
• France
• Benelux
• Nordics
• CEE
• DACH
• Southern Europe
• Funds-of-Funds
• Top story
• HarbourVest
• Ardian (formerly Axa PE)
• Access Capital Partners
• Unq2015July