Q&A: The role of funds-of-funds

 

1. In a maturing private equity landscape where do you see the fund-of-funds model remaining most relevant?

Firstly, private equity investing requires a significant amount of human capital. There is a considerable amount of data that has been generated over the years but most is hard to find or not readily available. As an investor you need a large team to undertake all the analysis required as well as manage and monitor the investments you have previously made. Very few institutional investors have the capacity to build teams of ten or twenty plus people, so most choose to use a specialist fund-of-funds. Secondly, investing through a funds-of-funds manager enables an investor to achieve superior performance. The best fund-of-funds have developed their selection skills over many years and understand where capital is best allocated. For example, there are over 600 funds in Europe under €500m in size, some of which are very strong performers while others have unfortunately underperformed. The best funds-of-funds are able to select and access the outperformers. We believe an institutionalised fund-of-funds, with a global investment platform combined with experienced local teams, is crucial in enabling the most accurate analysis of the fund universe and ensuring access to the best performing funds.

2. Mega buyouts are expected to produce lacklustre returns. Do you see large-cap buyout funds playing a role in future LP allocations?

Mega buyout funds are a logical first place for new investors to start as these firms are generally highly institutionalised, professional and have a track record of delivering returns over a series of economic cycles. However, there is a mismatch in the capital supply and demand balance for these large groups. Levels of investment and the amount of capital currently being raised are not in line and this poses questions for some of these managers. A handful of the largest funds in Europe are reported to be targeting around €70bn of new fund raising over the next 18 months for their latest offerings, at a time when the investment run-rate is only around €15bn, so substantially more capital is being raised than is able to be invested. Funds in the sub €500m space however are expected to raise €10bn over the same period and the run rate in this segment is €10bn - meaning the capital supply and demand is in balance. Within the universe of 600 managers with funds under €500m in size there are a number positioned to deliver outstanding returns. At the other end of the scale, many of the largest buyout funds are likely to hit their fund targets, but investors should consider the implications of an imbalance between the supply and demand of capital.

3. Given that private equity investment opportunities exist globally, which Western European investment strategies do you consider attractive?

The key to investing in Europe is to target funds that focus on fundamental value creation. By this we mean those funds where the underlying companies can really feel the benefit from the private equity managers' skills and expertise. This is why we avoid generalist managers and focus on value-orientated groups, specialists groups and turnaround managers as we believe they can add real value at a company level. Value orientated managers can demonstrate their ability to acquire companies at lower valuations than comparable transactions. Specialist managers are those groups that specifically follow a clear and concise strategy, such as industry specialisation or investment style specialisation. There are also a number of very strong turnaround funds in Europe that we are excited by.

4. Which elements of upcoming regulation are likely to affect your activities the most?

At a funding level Basel III and Solvency II will affect the amount of capital flowing into the private equity industry and reduce the overall amount available for investment. Some of this drop-off in capital could be off-set by new entrants such as Sovereign Wealth Funds entering the asset class. The other significant piece of legislation which will affect the industry is the Alternative Investment Fund Managers Directive. This was developed in the midst of the crisis in order to protect investors, which is a laudable aim. Unfortunately the original proposition was a ‘one size fits all' approach which failed to take into account the differing models operated by various private equity and venture capital funds as opposed to the approach that hedge funds take. The industry, along with the national trade associations, worked hard to help correct misperceptions held by regulators about how the industry operates, which has resulted in the legislation being significantly amended.

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