Separate accounts: Special treatment

"We essentially operate as an elongated work bench and view ourselves as an integral part of the institution with which we are working. As much as it is about making good investments it is also about interacting with the client, doing calls on a regular basis, sharing information and educating," says Ralf Jaeger, managing director and portfolio manager of Siguler Guff's emerging markets funds. "That is the essence of the separate account."

Siguler Guff has offered separate accounts alongside its fund-of-funds for years, but they are a particularly prominent feature of the firm's third BRIC opportunities fund. Of the $650 million corpus, approximately two thirds is held in three separate accounts for large institutions.

In return for writing big checks, these groups can to a certain extent choose their own adventure. Exposure is tailored, governed by factors such as strategic imperatives and the level of experience with the asset class in particular geographies. Reporting is customized, based on institutional needs and system requirements. The investor can be hands-off, leaving operations to the manager, but the model Jaeger describes is far more hands-on, with participation from due diligence to decision-making.

"It is a learning experience and it may also be transitory one. After a while these institutions might feel they know the market well enough and want to do it themselves, or they don't and we continue to do the work for them," Jaeger adds. "For the industry as a whole, the separate account component is going to play a larger role."

Critical mass

Few would contest the growing importance of separate accounts; the emergence of large pools of institutional capital is pushing private equity in this direction. LPs are able to make bigger commitments to managers who in turn offer exposure to a portfolio of GPs and they want special treatment in return. It may come through a vehicle that sits alongside a funds-of-funds providing identical or tailored exposure to the main portfolio at lower cost, or through a fully independent mandate.

However, the dynamics of the investor-manager relationship can vary hugely. Indeed, the educational function is generally regarded as the exception rather than rule. As one fund-of-funds manager - whose firm does offer separate accounts - puts it, "The majority of separate accounts are more about the fee breaks and less about the value-added services."

It is not a question of which model works best; as separate accounts proliferate, so will their strategies, based on the needs of the underlying LP. What remains to be seen is whether managers can accommodate the potential conflicts of interest and administrative workload that comes with offering an increasing number of separate accounts, and meet LPs' performance expectations. This is particularly an issue for the smaller pan- and sub-regional operators.

"These structures can get quite complex and raise conflicts issues that are not easily resolved," says David Pierce, an experienced fund-of-funds manager in Asia who also managed separate accounts. "You shouldn't be surprised if you see some unhappy investors coming out of these situations because they weren't on board with the way conflicts got resolved. It isn't easy. We took the view that the key thing was transparency, with all investors knowing what we were doing and why we were doing it."

According to Preqin, $1.83 billion has gone into Asia Pacific-focused PE separate accounts since 2005, with 90% of this capital committed to 10 accounts formed from 2011 onwards. While the numbers are weighted to more recent years, indicating the growth in take-up, they almost certainly offer an incomplete picture.

First, existence of separate accounts is not always publicly disclosed and anecdotal evidence suggests that more than 10 have been formed in the last three-and-a-half years. Asia Alternatives raised $1.5 billion for its third fund-of-funds in 2012, with $600 million coming from separate accounts.

Portfolio Advisors has put $3 billion to work in Asia since 2005, of which only 25% has been through fund-of-funds structures. As Jonathan English, the firm's Hong Kong-based managing director, points out, the total is "skewed by larger mandates that are committed to the region for the long-term."

Size matters

There is no standard commitment threshold above which LPs qualify for special treatment. Sidecar vehicles that invest alongside a fund-of-funds can be as small as $25 million while independent discretionary mandates are often substantially larger than $100 million.

The five largest vehicles Preqin has on record include some predictable names. The State of New Jersey has separate accounts - of $200 million and $100 million - alongside Asia Alternatives last two regional fund-of-funds. New York State Common Retirement Fund also committed $125 million to a separate account linked to Asia Alternatives Capital Partners III.

The top five is completed by Finnish pension fund Keva's $152 million account with Squadron Capital, agreed before the fund-of-funds merged with FLAG Capital in 2012.

Second, even if a separate account is disclosed it may not fit the definition used by others. A global LP survey conducted by Preqin found that 38% of Asia Pacific-based respondents that expressed an interest in separate accounts came from Australia. This hardly surprising given the country's LP base is deeper than most others in the region, but at the same time, the majority of Australian superannuation funds rely on non-discretionary advisory relationships. These are service agreements, not separate accounts.

One Asia-based manager tells of a longstanding pension fund client that hired a new executive who was not content allocating capital to fund-of-funds on a discretionary basis. "The deal we offered him had some non-discretionary elements plus a commitment to the comingled fund," the manager says. "He opted for an advisory relationship instead. The fees are a lot lower for non-discretionary business and we don't want to get into that."

Customization comes in many forms. On a basic level, it reflects preferences in terms of geography and strategy. A European pension fund might use a separate account with an Asian fund-of-funds to carve out exposure to emerging markets managers because this is where it sees the best growth prospects. Similarly, some LPs seek to avoid the higher risks tied to early-stage investing or they are restricted from participating in certain industries, perhaps on religious or regulatory grounds.

In addition to value-added services such as customized reporting and education, managers might offer access to round-the-clock portfolio management analytics systems or sideline advisory relationships. If a separate account covers only a portion of an LP's activities in Asia, the manager could supplement due diligence carried out on other GPs or co-investments that touch upon the region.

Sustainable returns?

For a fund-of-funds, the fee incentive is often structured along the lines of "buy one, get one free" - a commitment is made to the comingled product at standard rates and another goes into the separate account at a discounted rate.

When closing its third fund, Asia Alternatives said that all its separate accounts had the same fee structure and follow the same investment strategy as the co-mingled product. New Jersey disclosed that it was paying an annual management fee of 0.8% on its separate account during the commitment period, falling to 0.5% thereafter, and then zero once an investment has returned 85% of initial capital or run for five years. The manager also receives a 7.15% share of the carried interest.

When New Jersey decided to re-up in 2011, it cited the strong performance of the previous separate account, which was invested in 11 funds and one co-investment, and had outperformed the top quartile Cambridge fund-of-funds index by over 1,300 points. The question some industry participants ask is whether a $200 million account - albeit one divided into two equal tranches covering two two-year periods - can replicate the returns of a $100 million vehicle.

If a separate account is deployed on a pro rata basis alongside the main fund-of-funds, the LP is putting more capital to work but might still be left with a $2.5 million position in a desirable fund because the allocation must be shared. The LP may feel that the size of the commitment warrants larger individual allocations with a view to generating larger cash returns.
"These accounts last as long as the manager can take the pain but it also depends on the investor experience and the returns on the other vehicle," says one fund manager.

The need for larger allocations to satisfy separate account investors also raises the prospect of conflicts of interest. If a fund-of-funds' average check size is $30-40 million, getting additional capacity for separate accounts can be problematic. The danger is that by carving up an allocation in a particular way to accommodate separate accounts, existing investors the fund-of-funds lose out.

Munich Private Equity Partners (MPEP) has yet to introduce separate accounts but accepts they may feature in its future. John Morrison, managing director at MPEP notes that Asia may be particularly suited to individual mandates because of the nuances within individual markets. But he adds that separate accounts must not prejudice the interests of existing clients.

MPEP's commitments in Asia include Hony Capital's fifth US dollar-denominated fund and BVCF's third China life sciences vehicle. The $200 million BVCF fund was not a one-and-done close and Morrison suggests that the GP might have welcomed any request for additional capacity.

Hony, which raised $2.35 billion at short order, was the opposite scenario - massively oversubscribed and MPEP was a comparatively late arrival. It is doubtful there would have been enough capacity to satisfy additional clients in that particular case.

"When a fund continues to be oversubscribed it comes down to your proximity and relationship to the GP," says Morrison. "If you are able to indicate well in advance that you will need more capacity next time around, say going from $15 million to $25 million, managers can usually go some way to accommodating that. It is more of a problem when you are already at $50 million and want to double that."

Even though BVCF did not receive the same level of interest as Hony, achieving allocations of meaningful size in smaller funds can be difficult, unless the separate account is aligned with a fund-of-funds that has agreed to anchor a start-up or spin-out manager.

"A fund that is not oversubscribed can still fill up quickly," says Jonas Lindblad, co-founder and managing director at China-focused fund-of-funds Jade Invest, which does not offer separate accounts. "For funds of $150-300 million there is limited capacity and this creates a clear conflict of interest."

The dangers arguably worsen if allocations to secondaries and co-investments, which tend to be more opportunistic, are also being divided up between different kinds of clients.

Conflict management

Portfolio Advisors' English observes that the best way to avoid conflicts of interest is through allocation policies and providing complete transparency to relevant parties. It is a view shared by other industry participants, who stress that transparency should be reflected in fund documentation drawn up before capital-raising.

Solutions are of course heavily negotiated. A commonly held view is that the pro rata approach, with each investor receiving an allocation proportionate to the capital they put in, regardless of how it is put in, is the only fair approach. Others prioritize the co-mingled fund over the separate account, the latter absorbing any leftover allocation. Furthermore, it is not unknown for managers to establish a pecking order that rewards their most loyal and longstanding clients.

"We have an allocation committee in house that is separate from the investment team," adds Siguler Guff's Jaeger. "It reviews investment recommendations we make to the extent that they fit with the agreed upon allocation policy with clients that are in the co-mingled fund as well as having a separate account."

Another control mechanism is simply not taking on more separate accounts than can reasonably be managed. MPEP's Morrison suggests that relatively few industry participants have the ability to offer these products on an industrial scale as opposed to a small handful of truly special relationships.

The economics have to make sense for the manager - take on too many accounts, plus the extra back office work that comes with them, at low fees and it becomes hard to sustain the business model. And then few LPs would welcome the prospect of being one of many separate accounts sharing an allocation. Not every manager will be able to make it work and not all of them need try.

"We are going to see more customization where the larger LPs are committing larger amounts of money. Also, there will always be new investors in PE and smaller investors for whom fund-of-funds make perfect sense," says Doug Coulter, a partner at LGT Capital Partners.

It points to a division in the market that is already apparent. At one end of the spectrum sit the several-hundred-million-dollar separate accounts that are managed on a discretionary basis, independent of any other vehicle.

These are typically large institutions outsourcing portions of their portfolios that they don't have the bandwidth, experience or risk appetite to manage on their own. In an Asian context, this might involve a state pension fund awarding separate account mandates to cover non-Asian private equity funds. 

There can be an element of education - particularly among Asian groups with realistic ambitions ultimately to handle commitments in house - but Juan Delgado-Moreira, managing director at Hamilton Lane, which focuses on such accounts, says this is not the primary motivation in most cases.

"There is a lot of volume in this space, outsourcing chunks of portfolios. In 90% of separate accounts the investor cannot and is not in pursuit of a seat at the table; it is true outsourcing of due diligence, investment selection and portfolio construction," he says. "Some investors want more understanding and knowledge transfer but they are not necessarily the biggest accounts out there and they often end up as advisory relationships."

Specialized mandates

At the other end of the spectrum are smaller players that eschew separate accounts completely. Jade falls into this category as does Emerald Hill, an Asia-focused manager with a strong following among US endowments. Emerald Hill recently raised $400 million for its third fund-of-funds and is said to have rejected requests for separate accounts.

Axiom Asia, another Asia-focused fund-of-funds but one that operates on a larger scale to the likes of Jade and Emerald Hill, raised $1.15 billion for its third comingled vehicle in 2012 without offering separate accounts. According to sources familiar with the situation, this policy is under review for Fund IV.

Jade tries to convert would-be separate account clients into comingled fund commitments with an understanding that there will be plenty of opportunities for co-investment on a zero-fee basis. The rationale is that the management fee and carried interest paid to the manager is diluted by the co-investment allocation to the extent that it works out cheaper than a separate account.

LPs that have no choice but to operate through a separate account would not be suitable, and Lindblad accepts Jade is not for everyone. The majority of investors the firm works with already have some exposure to Asia and the ability to respond to co-investment opportunities.

"The model works for us but if we were 10 times larger and volume-driven, rather than a carried interest-driven, it would be more challenging," he says. "But then the fund-of-funds industry is becoming more fragmented. It is no longer one size, or one fee, fits all."

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• Topics
• LPs
• Fund-of-funds
• Fundraising
• Fund-of-funds
• LPs
• Fundraising
• Hamilton Lane
• Siguler Guff & Co.
• FLAG Capital
• Hony Capital
• Jade Alternative Investment Advisors
• Emerald Hill Capital Partners