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AVCJ
  • Funds

Funds of funds build LP returns

  • Paul Mackintosh
  • 07 September 2010
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Asia Pacific has always possessed the kind of environment that in theory is well tailored for the fund of funds model.

A highly attractive, yet geographically immense and very fragmented region with even less market and cultural continuity than the European Union – as well as many smaller GPs – should offer an ideal proposition for global LPs looking to deploy commitments through trusted and knowledgeable intermediaries. But as Asia and the private equity industry here mature, and as new advisers and partners come into the region, how are fund of funds staying relevant, or are they being forced to evolve?

The case – and place – for fund of funds

Interestingly, funds of funds have more of a market than ever before, according to some, especially in the context of the f-o-f sector worldwide. The Asian head of one prominent global fund of funds sees them as “probably the only part of the business where there is still definitely a need. Under-allocation to emerging markets in general, and to Asia in particular, means that many pension funds are looking for emerging markets product.”

In general, LPs’ relative lack of interest in Asia has worked to the benefit of funds of funds. “Asia is a relatively small part of most LPs’ private equity portfolios and – given the issues with market knowledge and geographical distance - it’s the most logical one to outsource, so to speak,” says Wen Tan, MD at Squadron Capital.

For most LPs, the fact remains that, “the value add of a fund of funds is its experience in looking at a market that is moving so fast and is still so immature,” says Markus Ableitinger, Head of the investment team for Asia at Capital Dynamics. “The benefit is higher than the costs and the risks associated if they would do it for themselves.”

As a result, many new players have been raising money in the Asian fund of funds space, alongside the well-established veteran investors in the region and the newer international players. Philip Bilden, MD for Asia at HarbourVest Partners in Hong Kong, cites some 40-50 f-o-fs in operation region-wide. However, the cost of maintaining the optimum configuration for an Asian investor – a multinational and multicultural team with all the requisite linguistic skills and local market knowledge – in the region means, Tan adds, that, “if you’re committing anything less than $50 million a year in Asia, you are better off going via a fund of funds rather than trying to do so directly.” Needless to say, the economics can also work for larger commitments with a particularly effective fund of funds.

Local presence and access continues to be part of the story. “The fund of funds teams that are working here are interlocked in this region on a daily basis,” affirms Ableitinger. But for Bilden, the case goes further. “Most institutions would be better off with fund of funds programs generally, particularly well-established, well-resourced, credible managers of fiduciary capital. But the challenge in Asia is even more extreme for most investors.”

Competitive pressures

Given the large number of regional funds of funds, many of them of relatively recent vintage, competition and some consolidation is almost inevitable, either at present or in the immediate future. Indeed, Bilden believes that the proliferation of f-o-fs cannot continue. “There can’t remain the trajectory that we’ve had,” he asserts.

One of the peculiarities of the fund of funds space that tends to exacerbate this pressure is its far wider range of terms, allowing for competition on fees and the like to an extent unseen by many primary GPs. As Wen Tan remarks, “unlike GPs, where 2-and-20 is slightly more market standard, in the separate account landscape – and to some extent in the fund of funds – the discrepancy of fees can be quite broad.”

However, in Asia Pacific, the effect has been somewhat mitigated to date by the region’s popularity – and its immaturity. “Asian fund of funds are still being positioned as a premium product, because the price of getting anything wrong is very high,” notes AVCJ’s source. “The competitive pressure is not as high, compared to other more generic plain-vanilla spaces.”

Douglas Coulter, Principal and Head of Asia Pacific at LGT Capital Partners, also feels that his firm’s European pedigree, “which has honed its investment process in the complex patchwork of countries, cultures, languages and legal systems in Europe,” gives it something of an edge in the very different environment of Asia. However, he adds, “we believe that private equity is ultimately a local business, which is why we have a large on-the-ground presence in Asia.”

Competition can manifest itself in slightly more surprising ways. AVCJ’s leading industry source observes: “a very interesting dynamic of regional fund of funds competing to back spinouts and new teams, and making a strong case of wanting to be early investors, be on the advisor board, and claim recognition and credit for helping establish the team.”

There are also new pools of competing capital entering the region, particularly the dedicated account/advisory managers. “It’s a different model, different economics, and different value,” Bilden says. However, he does conclude that the segment has certain business advantages. “Advisors don’t have to live with their long-term performance like funds of funds do. They can dispense advice freely.”

“At the very top end of the market, quantum-wise, there will probably be a shift to more separate accounts, which would probably put more pressure on fees,” avers Tan. But otherwise, he believes, “we’ll probably continue seeing a healthy but competitive landscape.”

Differentiators and advantages

The competitive advantages that a fund of funds brings to the table vary depending on the source. Bilden instances “institutional stability, depth of team, ability to run the business of fund-of-funds – which includes client service, control accounting, fiduciary management, fundraising and investment management.”

With such a broad feature set, some specialization is inevitable. Tan sees some segmentation in the underlying business models taken by different funds of funds.

“At one extreme, the business model of certain f-o-fs is to a large extent asset-gathering,” he suggests, citing the preponderance of management fee income as a percentage of certain f-o-f’s overall income. “At the other end of the spectrum are returns-focused models, which are relatively smaller more disciplined funds, where the name of the game is to deploy to GPs who you think will deliver returns, with the management company profits coming from carry rather than management fees.”

A fund of fund’s pedigree also comes into account when a GP decides whether to take it on board as part of its roster of fund LPs, especially given expectations of that f-o-f being able to raise capital for further investments in future. This can work both ways, in terms of whether a fund of funds can expect capital from certain LPs, and whether a GP will accept that capital.

“There will be distinctions made in the brand value and the professionalism of fund of funds by the GP community,” Bilden argues. And Ableitinger agrees that “the quality of the f-o-f and its reputation will contribute to success … It’s harder for a group not known in the market.”

Track record outside the region can also contribute to a fund of fund’s effectiveness in making the right calls on which GP to back within it. Bilden describes this “having the ability to tap global resources so that you avoid a myopic view of the region.” Ableitinger also believes that “a fund of fudns with a deep pool of investments should be able to work out the strengths and weaknesses of a GP much faster.”

Looking forward though, AVCJ’s fund head source expects that, “there will be a battle to get the headlines on the more subjective side of the business.” However “although there will be a consolidation phase,” it may be a while before this actually has discernible results because of the continuing appetite for Asia.

“There is still a supply/demand mismatch,” he admits. “There are still not enough people to offer products to match all the demand.”

However, others feel that consolidation may hit sooner rather than later, especially as the immediate impact of the GFC recedes. “There’s not unlimited institutional demand for Asian private equity. It has been higher than other markets during the financial crisis,” affirms Bilden. “There’s going to be a significant pressure on all groups to justify their existence.”

Actual performance in-market

Ultimately, the final index of actual fund-of-funds value is the returns they can deliver and the contribution they can make to a portfolio’s overall performance. This always has a somewhat theoretical element, since an LP’s performance if it chose a different strategy to its actual decision is, of course, always an unknown. However, actual returns figures are still the most convincing investment case. “Cash on cash returns matter,” as Bilden says.

“Publicly available data shows that those who have invested through the right funds of funds are comfortably ahead of the mean, while if you’ve invested with the weaker performers, you would have been better off doing it yourself,” says Tan. However, he adds, “there is a large minority of LPs that has a misconception that the f-o-f route will depress returns through a so-called second layer of fees.” Historically, he and other players insist that this is not the case. However, the recent spate of investing into the region could mean, as Bilden points out, that “there’s a lot of digestion that needs to take place” before actual returns and performance are visible.

Coulter maintains that Asia Pacific has actually delivered attractive performance to LPs – but with qualifications that make support in choosing the right GPs even more important. “While there is a wide distribution of returns between first and second-quartile managers, LPs in the right funds in the last few years have benefited from significant cash distributions. This makes manager selection one of the most important considerations in an Asian portfolio.”

To Bilden, the primary determinant remains the quality of the fund of funds itself, rather than the operation of the f-o-f model. “The better funds of funds will have delivered value over time, but there will be many who fail to deliver on that value.”  

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  • Topics
  • Funds
  • Fund-of-funds
  • Performance
  • LPs
  • LGT Capital Partners
  • Doug Coulter
  • Capital Dynamics
  • Markus Ableitinger
  • Squadron Capital Advisors
  • Philip M. Bilden
  • HarbourVest Partners

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