Funds of funds hold their own

Date: Wednesday, March 14, 2007
Author: Oliver Smiddy, Financial News

Managers’ returns compare favourably with those of their directly invested rivals

Private equity funds of funds can deliver comparable returns to buyout or venture funds. A report by Private Equity Intelligence suggests top-quartile funds of funds have returns that compare well with directly invested funds.

The report examined the performance of almost 750 funds of funds run by 265 managers. It showed they were a viable alternative to direct fund investments, even for a seasoned investor. Funds of funds generated median returns close behind those of buyout and venture funds, tracking an all-private equity funds benchmark closely.

The traditional perception of funds of funds is of lower returns than direct investments in return for reduced risk. Rainer Ender, a managing director at Swiss fund of funds group Adveq, said: “Funds of funds continue to be a fast and efficient way to gain exposure to the asset class. Importantly, they help avoid beginners’ mistakes.”

Fund of funds managers often argue their relationships with leading firms and selection skills allow them to generate returns that make up for the higher fees, covering the management fee and charges for the funds in which they invest.

Stephan Schaeli, head of private equity investment management at Swiss alternative investments firm Partners Group, said the twin fee was justified by the best managers.

He said: “If an investor devotes as much time and effort to selecting and gaining access to the right managers, then it’s obviously better to invest directly. But investors new to the asset class often underestimate the amount of work involved in that.”

The report supports that contention. Taking a sample of 65 fund of funds managers, it found they generally succeeded in delivering superior performance – 62% of the funds in which these managers invested were either first or second quartile, while only 14% were in the bottom quartile.

Schaeli said fund selection was essential to good returns. He said: “One of the most important features of a good fund of funds manager is that they add alpha. The experience of a gatekeeper or fund of funds manager should translate into a good manager selection capability, along with the ability to identify future top-quartile managers. It’s difficult to spot future top-quality managers without the right level of experience and internal systems in place.”

Gaining access to funds managed by the likes of Kohlberg Kravis Roberts, Blackstone Group or Permira is difficult without a long-standing relationship.

Although fund sizes have mushroomed over the past few years, existing institutional investors have generally provided the capital by increasing their commitments. Experienced fund of funds managers, who have in many cases spent years cultivating relationships with the top private equity firms, can offer a short cut to the best funds.

Schaeli said: “If you have consistently nurtured relationships, you can gain access to the best funds, which a newcomer to the asset class generally wouldn’t be able to achieve.

“Often, people know who the top managers are but that’s different from being able to gain meaningful allocations to their funds. The ability to leverage established relationships and get your foot in the door quickly is important, and funds of funds can provide that.”

Ender said. “If a fund of funds portfolio is well built, it is an efficient means of gaining diversified private equity exposure – even within sub-segments of the asset class.”

However, the report also found that funds of funds’ share of the total raised by private equity had halved from 10% to 5% since 2004. One industry source said that if they continued to decline in importance relative to other investment classes, they were less likely to gain access to the top funds.

Funds of funds mirror the diversity of the funds in which they invest. The report found returns were similar regardless of size, concluding: “Fund size is not a critical criterion affecting the performance of fund of funds managers…it seems that small funds of funds are as likely to produce good returns as larger ones”.

The returns on offer were surprisingly strong. The report found median internal rates of return for the 2001 and 2002 vintage funds were 15.5%, a significant improvement on 1999 and 2000 funds which delivered negative returns in many cases due to over-exposure to venture funds that suffered after the dotcom bubble burst.

The range of returns generated was also smaller for funds of funds than for other ways of investing, because of the effect of averaging the performance of funds in the portfolio. Top-quartile funds generated healthy returns, avoiding the loss of their investors’ capital even during the most difficult vintages for the private equity industry, according to the report.

However, the highest fund of funds returns were well below what the best venture and buyout managers could produce, with returns in the latter case well above 45% and as high as 300%.

These higher returns come with greater risk, which funds of funds seek to reduce through diversification.

Schaeli said: “This is a key attraction. Whereas, with public stocks, exposure to 10 to 12 different stocks is viewed as sufficient diversification, with a direct investment in a single fund you’re exposed to a lot of risk.”