Fund-of-funds: Bespoke solutions

The hollowing out of Australia's leveraged financing market is well documented. In the wake of the global financial crisis and regulations designed to prevent its repetition, foreign banks that once accounted for a significant portion of the debt in private equity-backed deals have retreated. The likes of BOS International, Natixis and Credit Agricole have scaled back or shut their operations in the region.

Domestic banks can be relied upon to provide financing and foreign lenders still active in the market come on board as well. Then it is a case of tapping other institutions to make up the difference - and these range from traditional mezzanine providers to private markets investors to superannuation funds.

The attraction is clear: averaged leveraged margins have more than doubled since 2001 and the 5-7% returns available on first lien debt in a stable market like Australia compare favorably to other fixed income assets, even allowing for the reduced liquidity. For PE fund-of-funds managers, it is also a means of expanding along the capital structure, incorporating equity all the way up to senior debt. Several industry participants are eyeing the opportunity.

"From HarbourVest Partners' perspective, there are push and pull factors," according to a source at the firm with experience in the leveraged market. "We have existing relationships with institutional investors and a number of them are seeking additional products. And then we have existing relationships with the GP sponsors who face reduced liquidity and say to us, ‘Why don't you enter the space?'"

This approach goes to the heart of the information arbitrage that underpins much of what a traditional fund-of-funds provider has to offer. But as the private debt example suggests, fund-of-funds aren't the only product in a manager's portfolio, nor do they satisfy every client's demands. Rather, a manager is tasked with matching opportunities identified in the torrent of information that crosses his desk each day from GPs or other counterparties with the investment objectives of different customers.

This is a global phenomenon, but one with an Asian twist. Some LPs are becoming more familiar with a once opaque region and developing clearer ideas of what they want from it.

"They realize that making money in Asia doesn't happen by itself, and are trying to figure out the best way to allocate capital," says Doug Coulter, head of Asia private equity at LGT Capital Partners. "On the supply side, fund-of-funds and others are providing more structures, vehicles and strategies through which to access the region. It has become more complex but the key question is how are you going to deliver good risk-adjusted returns?"

Alive and kicking

There is an element of fee pressure at work here. On one hand, a fund-of-funds offers exposure to a basket of GPs, which may include a cluster of star managers; on the other, the extra layer of fees could eat into these returns and shift the risk-reward balance. Investors want a suite of services - featuring co-investment, secondaries, separate accounts, and so on - rather than just plain vanilla. This may result in institutional clients graduating from fund-of-funds to advisory mandates and, in some cases, to direct commitments as their familiarity with the asset class grows. But there is no uniform approach.

"Our clients still want fund-of-funds - the model is not dead," says Russ Steenberg, global head of BlackRock Private Equity Partners. "Growth is not as upward as it has been but there will always be a place for them. What you are seeing is more specialization as the institutional asset class matures around the world."

The point is there are investors occupying every segment of this maturity spectrum, and for some, a fund-of-funds still makes sense.

First of all, the resources might not stretch far enough that an LP is emboldened to go solo. A team of four running a global private equity program might have sufficient bandwidth to deal with funds of a certain size directly, but anything below a certain threshold is delegated to a third party. Another category of investor, often small- to mid-size institutions, has no previous exposure to private equity whatsoever and requires support building a program that covers multiple vintages and geographies.

Second, fund-of-funds can form part of a broader strategy. Goldpoint Partners, a PE affiliate of New York Life Investments, revised its approach in 2001 after becoming dissatisfied with the returns it was getting from portfolio GPs in the region. The firm made two discreet fund-of-funds commitments, one in China and one in India, to get a clearer picture of what is happening on the ground.

Ludvig Nilsson, managing director at China-focused fund-of-funds Jade Invest, claims to have a similar relationship with his largest LP, which has more than $100 billion in global assets. "We work tightly with them, sharing information, and when we invest in a fund they often want to have a look at it as well," Nilsson says. "They invested with brand names before but were less than satisfied with the exposure as well as the information sharing."

Reports vary as to the willingness of fund-of-funds to pool manager research with LPs. According to Steenburg, BlackRock is happy to make all the necessary introductions to the point that clients are able to go it alone if they so desire. Some of the of local players - stand-alone Asia or China operations - are said to have been less accommodating, although everyone ultimately has to move with market demand.

There is certainly evidence of LPs shadowing fund-of-funds in the region. Much like Goldpoint, New York State Common Retirement Fund (NYSCRF) started out investing in a string of pan-Asian funds before adopting a more targeted approach. It invested $50 million in each of Asia Alternatives' second and third comingled vehicles and in 2011 put $200 million into two separate accounts with the firm.

Both accounts made small commitments to Hony Capital V and NYSCRF followed up by investing $100 million in the fund, its first direct foray into an indigenous China vehicle.

Separate offerings

Asia Alternatives' third fund, which reached a final close last year, is in certain respects the apogee of its type in the region. The corpus is divided between $908 million in the comingled fund and another $600 million spread across separate accounts for a total of $1.5 billion. The separate accounts have the same fee structure as the comingled vehicle. According to AVCJ Research, it is the largest pool of capital ever raised by an independent Asia-focused fund-of-funds.

The number of separate accounts isn't disclosed but anecdotal evidence suggests that some investors put in far less than NYSCRF's $200 million. Indeed, the standard threshold for a separate account is said to be around $100 million, but many smaller players are willing to compromise on size and fees in order to win market share.

"You offer discounts to big name clients because it helps build out business. It also makes fundraising and reporting processes easier. If someone gives you $100 million in one go you don't have to devote the time and energy to sourcing and looking after 20 clients who each put in $5 million," says one Asia-based manager. "At the same time, if someone commits $100 million they want to be treated differently from everyone else. So a lot of it is about marketing."

This gives rise to a couple of criticisms of fund-of-funds. First, does a smaller manager still have the resources to provide a quality service after making concessions on separate accounts? Second, is there substance behind the marketing? "I think what LPs are finding now in Asia is what they have already found out in the West: All most managers want to do is a separate account that looks like a fund-of-funds," notes Monte Brem, CEO of StepStone.

Needless to say, there are counterarguments. Sebastiaan van den Berg, managing director for HabourVest Partners in Asia, believes there is a misconception surrounding separate accounts in that rising demand for such arrangements is only driven by having more influence over strategy and securing lower fees. In his experience, most separate account clients' primary concern is often confidentiality and the need for a more tailor-made investment program.

The level of discretion afforded to the manager also varies, depending on the mandate. "If it's an Asian LP that wants to invest in North America you typically find the client is less specific. They aren't knowledgeable enough to provide any meaningful direction. If it's a US investor in Asia it's typically the same thing," says van den Berg. "If it's an Asian LP with an Asian mandate, they will have views on what to do."

However, the first criticism does hold true. Numerous industry participants didn't pursue separate accounts to begin with, and even if they now do, a high participation threshold is set in order to keep the numbers down. An LP being told that a fund-of-funds manager already runs 15 separate accounts is akin to a high net worth individual finding out that his private banker is simultaneously handling 30 other relationships. There can also be headache in terms of allocations. If there is a great secondary deal but it's not very big, would it still be divided up among all the clients on a pro rata basis?

The other resource issue is whether the manager has enough people and time to deal with clients individually and to a consistently high standard. While LPs' expectations of a separate account relationship differ, it is a labor-intensive process that goes beyond just doing the investment work. In short, a much greater degree of interaction with the client is required.

Resources are likely to become even more strained as the industry continues down its path towards greater customization. A fund-of-funds may already be sliced and diced so that primary fund exposure is accompanied by co-investment and secondaries in order to address fee and j-curve concerns, respectively. In some cases there are already teams in Asia dedicated to each of these three pillars, and the expectation is they will have to devise and manage more bespoke solutions as relationships with LPs become increasingly granular.

BlackRock bought Swiss Re's fund-of-funds business last year in order to fill some geographic and strategic holes in its product offering, and the company is keen to expand its co-investment capabilities in Asia. As such, the division is no longer referred to as "fund-of-funds" but rather "private equity solutions." Partners Group, which has made plain its preference for direct and co-investment and secondaries, declined to be interviewed for this article on learning that the topic was fund-of-funds.

"StepStone was founded on the concept of doing customized accounts. That comes through portfolio construction and also through how the investment process works," says StepStone's Brem. "When we go in and talk to an LP we don't ask if they want a discretionary manager or an advisor, we ask how they want to relationship to work."

The bulk of StepStone's business is divided between advisory services for large institutions and customized accounts, but clients are now calling for real estate and infrastructure space. Comingled funds tend to be niche offerings, bringing together groups of clients under a particular strategy.

The approach seems broadly comparable to the club structures formed by private banks that enable high net worth clients to participate in a series of single-asset co-investments. According to Roger Bacon, head of managed investments for Asia at Citi Private Bank, the spike in demand for these products, globally and among Asian clients specifically, in the last five years has come at the expense of blind pools.

An off-the-shelf fund-of-funds product is unlikely to get more than a cursory look unless the manager is able to demonstrate a level of expertise and deal access that differentiates them from the rest of the market. These offerings hinge on managers being fleet of foot without neglecting due diligence.

"This a hugely complex area and there are so many ways of skinning so many cats that to try and do it in a scalable way is quite difficult," Bacon explains. "If you do have dedicated resourcing in place then you can be more tactical and opportunistic in the way you look at individual deals and make them available to clients."

The implication is that a fund-of-funds provider with a broad base of resources as its disposal is better equipped to move quickly and deeply into more customized solutions. On a basic level, there is a lot of crossover in terms of the due diligence that is conducted on a primary fund-of-funds mandate and a secondaries program. In addition, creating a new product might not be economically viable without the regulatory, compliance, reporting and information infrastructure that is part and parcel of a global platform.

"At a GP level, it's an advantage being specialized; at a portfolio level, it's an advantage to have a portfolio-level perspective," says StepStone's Brem. "The LPs who work with want not only global access but also the ability to identify opportunities in Asia relative to other opportunities in the world."

Big vs. small

So where does this leave the more specialist regional players? One view is that they face the same fate as their European counterparts: overtaken or absorbed by localizing global asset managers, although it may take some years for this to happen. There have been two mergers in the past 12 months - Asia-focused Squadron Capital and US-based FLAG Capital, and then renminbi fund specialist Diligence Capital and Europe's Capital Dynamics - but the consolidation debate still generates more heat than light.

Two more nuanced, or perhaps cynical, interpretations come from two different industry participants, a global manager and a gatekeeper, respectively: the larger Asia fund-of-funds will be sold during the next China boom; and many won't get picked up at all because they are family offices with aspirations to manage third-party capital rather than fully fledged independent managers and therefore offer little value to larger platforms.

Jade's Nilsson expects to see more mergers and notes that several fund-of-funds providers in the region have already retreated into the investment advisory space because they are unable to raise capital. Yet the trajectory he envisages for the industry is unsurprisingly different from those of global players. As institutional investors realize that Asia isn't as easy as it once appeared they will look for greater value-add and it won't necessarily come in the form of a large-scale provider.

"Back in 2006 you had IPOs left, right and center and high returns everywhere," Nilsson says. "It is only when the market begins to slow down that you come back to fundamentals and realize who has just been following the hype and who has been taking a more fundamental approach all the way through. We feel it's great that now LPs are starting to ask the right questions."

Opinion is also divided as to the prospects for those at the larger end of the scale - the big who are only going to get bigger. Some claim that multi-product asset managers sitting on large distribution networks are out to commoditize the industry, although it is difficult to reconcile this with the resource-intensive and costly nature of the asset class. Under another scenario, asset managers will move up the value spectrum, abandoning fund-of-funds space in favor of sourcing deals directly and operating as GPs. Steenberg says that BlackRock currently has no plans to adopt a this approach, with separate accounts seen as the best fit for the firm's model.

Wherever they end up, the same push and pull factors apply: clients demanding more diversified exposure to the asset class and firms identifying in their information flow ways to create new products and boost sales.

"Fund-of-funds are just like PE firms are diversifying their offerings over time," says LGT's Coulter. "In an Asian context, how many PE firms are there with a global offering of which Asia is a part? Very few. It's no different with fund-of-funds - they have different offerings in response to the market."

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• Topics
• Fund-of-funds
• LPs
• HarbourVest Partners
• Fund-of-funds
• LGT Capital Partners
• BlackRock
• New York State Common Retirement Fund
• Asia Alternatives Management
• Stepstone
• LPs