Fund-of-funds: Creatures great and small

With the launch of its latest fund last month, Australian private equity fund-of-funds Vantage Asset Management is offering a very specific strategy to very specific group of investors. The new vehicle, Vantage Private Equity Growth 2, is targeting A$100 million ($76 million) to back GPs operating in Australia's mid-market buyout space where investees have an enterprise value of A$50-500 million.

Meanwhile, the fund is eschewing traditional institutional LPs in favor of small-scale investors, namely self-managed superannuation funds (SMSFs), endowments, and high net-worth individuals. Vantage CEO Michael Tobin - who spun out with his team from St. George Bank in 2004 - explains that he came to the conclusion early on that it was better go small than try to compete with larger incumbents.

"To be a new player in the game it is difficult to get that critical mass to be able to compete," he says. "So we decided to take it down market and tap into a different segment."

While many global fund-of-funds are busy turning themselves into large-scale, multi-strategy asset management platforms, Vantage is one of a number of smaller players in Asia heading in the opposite direction. Concentration and specialization are their watchwords. Tobin is not the only looking to offer something different.

"I think the day of global fund-of-funds predominantly doing primary funds is over," says Michael Lukin, managing director at ROC Equity Partners, an Asia-focused fund-of-funds that spun out from Macquarie Investment Management last year. "If you are an optimist they are dying, if you are pessimist they are dead."

This market dynamic may be a natural consequence of increased pressure on the conventional fund-of-funds model. On the one hand, LPs have become more sophisticated and considering their options; on the other competition for allocations is intensifying. The focal point is usually fees. It begs the question of where, on the scale from super big generalist to super small specialist, is the best place to be.

Bifurcation point

"There has been an ongoing evolution in the fund-of-funds model over the past few years," says Wen Tan, a partner at FLAG Squadron Asia in Hong Kong. "Really what we are seeing in Asia is a continuation of what has already started occurring with funds-of-funds in the US and Europe which is - broadly speaking - a bifurcation of the industry."

Part of this is down to the fact that, as the market has matured, LPs have become increasingly aware of the need and the possible methods of reducing fee burdens and mitigating the j-curve effect when committing to the asset class.

One way they have done this is to demand more concessions from fund-of-fund managers in return for big ticket commitments, usually structured as separately managed accounts (SMAs). These products can be highly customized, offering a combination of primary, secondary and co-investment exposure. This in turn has put pressure on managers who at best are seeing their margins squeezed and at worst are being passed over by LPs completely.

Industry data suggest that fundraising is indeed a challenge. According to Preqin, there are presently around 156 funds-of-funds in the market - 23 of which are Asia-focused - targeting an aggregate $33.2 billion. By contrast, in 2010, there were 148 funds targeting $44 billion. Looking at capital raised globally, last year $14.2 billion went to 81 fund-of-funds; in 2010, 74 funds received $17 billion.

A snapshot of recent closes - where there will be some degree of exposure to Asia - offers an insight into the nature of this bifurcation: a mixture of global and regional, multi-play and pure-play. Partners Group raised just over $1 billion for its latest global infrastructure fund, which will target a mixture of primary, secondary and direct opportunities, while Hamilton Lane closed its eighth global private equity fund-of-funds at $426 million.

At the other end of the spectrum, Emerald Hill Capital Partners raised $400 million for its third Asian fund-of-funds. As in previous vehicles, endowments and foundations account for the vast majority of LPs and as a result the investment strategy is relatively specific: Emerald Hill prefers concentrated portfolios of smaller-sized funds with high growth strategies that offer the potential for higher net cash-on-cash multiples.

"The two models that work better are the funds-of-funds that are large, scalable, and can provide good services for reasonably low fees as they have significant economies of scale," says Javad Movsoumov, executive director with UBS's private funds group in Singapore. "On the other hand we have the very small, specialist funds-of-funds offering access to highly specialized products in niche geographies."

The first of these - established players with global footprints - have traditionally been able to capture most of the capital. This is important as fund-of-funds pursue greater diversification, particularly away from pure primaries towards secondaries and co-investment where there is often less pressure on margins.

"The private equity market is continuing to grow and you need a global and dedicated investment team to access it," says Josh Jacob, a principal covering relationship management at Hamilton Lane. "The fact that we are one of the largest allocators in the private markets gives better access to all these investment opportunities and manager relationships. Things like having an in-house legal team also help reduce costs."

Increased competition in the fund-of-funds space has also pushed managers into making early commitments GPs so they can hammer out better terms - for example, securing preferential access to more co-investment opportunities - and differentiate themselves from other plain vanilla primary-focused players.

Focused strategies

Emerald Hill, though by no means a boutique operator, occupies the specialist ground. Top Tier Capital Partners is in a similar position, having just collected in excess of $400 million for its latest fund, which will only target venture capital opportunities. The LP base largely comprises more sophisticated groups that effectively want to outsource their North American VC programs to a fund-of-funds manager.

Traditionally, Top Tier's advantage has been rooted in its ability to offer exposure beyond the reach of its LP clients. Many of the more popular North American venture capital firms draw on capital from the same group of LPs each time, which means it is difficult to get an allocation without the right networks. Even if one of these investors successfully makes an inroad, the check size might be too small for it to go in directly.

"Once the argument for funds-of-funds was we can offer access to the big name groups that pension funds don't have," says Jessica Archibald, managing partner with Top Tier. "But that argument - and that model - is changing. Access is still important but so is being able to take larger allocations, being closer to the managers, and having better insights into the industry."

She adds that the cost of outsourcing a venture capital program is less than trying to do the same thing in house. Nevertheless, LPs cutting a larger check still expect concessions in the form of SMAs and customized solutions. Around 20% of Top Tier's LPs are looking to set up SMAs, although this does not necessarily equate to a drag on resources.

"If somebody comes in and says, ‘I only want fund investments under $100 million in fund size,' we are already looking at those investments so we don't need to add more staff, we are just dividing the commitment differently," Archibald explains. "There is no additional work, accept on the reporting side."

However, it is worth noting that SMAs come in many different forms. It may be a vehicle that sits alongside a funds-of-funds providing identical or tailored exposure to the main portfolio at lower cost, or a fully independent mandate. A key issue is the amount of discretion that lies with the manager. The ideal scenario for a fund-of-funds is full discretion, for economic reasons if nothing else.

"Where separate managed accounts turns into more of an advisory relationship is where a fund-of-funds will essentially do the due diligence but the ultimate decision will be made by the investor," UBS' Movsoumov says.

Some smaller players do not offer SMAs. Emerald Hill, for example, is said to have rejected requests for such arrangements. ROC is willing to go down the SMA route, but its niche is similar to those of other Asia-only fund-of-funds - an ability to access, conduct due diligence on, and then manage relationships with smaller single-country GPs. These opportunities are beyond the reach of most North American and European LPs.

The value add is manager selection and the payoff is in the outsize returns that can come from early vintage funds. "There are plenty of people trying to play for volume, but the way we look at our business model is that we are generating premium returns on a smaller amount of capital," ROC's Lukin says.

The downside to this approach is that, in the absence of economies of scale, a fund-of-funds struggles to be flexible on fees. ROC recognizes the amount of capital it can deploy is relatively constrained and is not seeking to raise more than $400-600 million at a time. If performance is strong, fees will not be a concern for LPs, but the firm aims to counterbalance any pressure by offering secondaries and co-investment.

The advantage is the same as on the primary side: ROC can move swiftly in pursuit of opportunities that its clients cannot access on their own.

Squeezed middle

Where the fund-of-funds model has come under the greatest pressure is between these two extremes. These are typically managers that are unable to concentrate on a particular area because of their size, but at the same time are not large enough to offer fee breaks and invest in diversified product offerings.

In many cases, the result has been consolidation. Many of these deals have been outside of the region. Examples include Grosvenor Capital Management's acquisition of Credit Suisse's Customized Fund Investment Group, and US firm Mercer's purchase of Swiss manager SCM Strategic Capital Management. In Asia, while a number of family offices have abandoned plans to raise third-party capital, there has only been one significant M&A transaction - US-based FLAG Capital Management buying Squadron Capital.

"As time goes on we have seen various firms wanting to broaden their product offering and you have seen that consolidation take place," says Tan, of FLAG Squadron Asia, the combined entity. "So some firms are scaling up and getting economies of scale and others are broadening their product offering through consolidation."

Tan cites FLAG Squadron Asia as a beneficiary of mid-size consolidation. The firm has a collection of niche strategies where it still makes sense for LPs to outsource programs but economies of scale are available through a single back-end platform. The key is finding the right balance between skill and scale.

"There will be consolidation and that will be a part of a firm's business development. It all depends on viability of the business, and the positioning of the business, and the ability of the business to adapt," says Mounir Guen, CEO of placement agent MVision. "The larger organizations that have very sophisticated marketing and have the resources for multiple offices will be at an advantage."

There are challenges at both ends of the market. Larger players want to grow their assets under management by offering more products to more investors, yet they cannot afford to this at the expense of quality. For smaller players that don't have the scale to offer discounts on fees, it is a case of explaining why their products merit a premium price.

"The fact that Asia is still an emerging market, and a tricky market for people to understand," says ROC's Lukin. "Getting access is still something people are willing to pay for, particularly if you are a US or European investor and looking to allocate 10% of your capital to Asia."

The bottom line is track record. Managers that have been through several cycles, and have data to back up their story, will have an easier time convincing LPs of their ability to add value. "Very clearly your performance has to be good enough to justify the fees," says Hamilton Lane's Jacob. "If you are going to out-perform the public markets, strategic allocation and portfolio construction are important."

Target market

Another factor worth considering is that the target LP community is also evolving. Just within Asia, the last five years or so have seen an increase in capital entering the asset class from sovereign wealth funds and state-backed pension investors. The next great untapped market is China's insurers and perhaps after that Japan's pension funds. Any of these groups might seek to gradually build their exposure to private equity through a fund-of-funds relationship.

Vantage is also looking to enter virgin LP territory and has turned to a less conventional means of bringing in investors. Its latest fund-of-funds is separated into two closed-ended unit trusts. Trust A is for smaller institutions, such as charitable foundations and university endowments of up to A$1 billion in size. These groups, which have small investment teams and limited knowledge of private equity, are subject to a minimum commitment of A$5 million.

Trust B goes even smaller, targeting high net worth individuals that can put in as little as A$50,000, although all the capital is called on application. They must also meet local qualified investor criteria.. These individuals tend not to be interested in customized solutions or fee competition, just getting into an asset class that was previously inaccessible to them.

Vantage is not the only fund-of-funds reaching out to new classes of investor through a retail-oriented product. And the same challenges apply in terms of providing liquidity to those investors should they choose to exit (the Vantage portfolio includes cash and fixed interest investments as well as PE). But it is an example of a niche offering that goes to great lengths - covering product structure as well as investment strategy - to separate itself from the mainstream.

"We will always look for niche opportunities that are unique and somewhat differentiated from the bigger players," says Vantage's Tobin. "I am not aware of any group that does just Australia, but we are on the ground and have very strong access capability, and we are closer to the newer fund managers."

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• Topics
• Fund-of-funds
• Fundraising
• Fund-of-funds
• Fundraising
• Asia
• FLAG Capital
• ROC Partners
• Hamilton Lane
• Top Tier Capital Partners