Published: March 12, 2009, Real Deals

Cracks in the foundation

Spreading risk does not eliminate risk, and funds of funds, once deemed the safe route into private equity, are now showing some serious signs of wear and tear.

by  Vicky Meek

Funds of funds have historically been dubbed the “safe” route into private equity. Offering diversification by manager, geography and vintage year, these vehicles provide investors with resource-lite access to an inefficient and opaque asset class.

But spreading risk does not negate risk, and funds of funds are feeling the pressure.

Massive write-downs in buyout portfolios and dwindling distributions are adding strain to the model and listed funds of funds – a bellwether for the industry – are trading at historically high discounts to net asset value – in some cases, as high as 80 per cent.

“One of the issues listed funds of funds face is on the share price separation from net asset values, and that is at inexplicable levels today,” says Bob Long, president and chief executive of listed fund of funds Conversus. “We are seeing discounts in listed vehicles of over two times the historical high.”

These discounts are largely a market reaction to expectations that many private equity firms have still more writedowns to report. They also reflect market sentiment surrounding the aggressive over-commitment strategies employed by many funds of funds.

Over-commitment models worked well in times of plenty, when private equity houses were flinging cash at their LPs faster than they could spend it. Now that the environment has changed, however, they have imposed severe capital constraints, particularly when coupled with leveraged structures.

At a time when leverage is near non-existent, the public markets are understandably sceptical about these funds’ ability to meet future capital calls. “Listed vehicles have generally followed an over-commitment strategy, and this requires sufficient credit lines,” explains Long. “The discount we’re seeing reflects market concerns about liquidity.”

Listed vehicle SVG, whose funding shortfalls were the catalyst for Permira’s decision to shrink its latest fund, has already been in the spotlight for pursuing a rights issue and placement to ensure adequate liquidity going forward. The moves have netted a combined £170m (€191m) for SVG, with an additional £30m being sought.

A number of other listed vehicles have also said they will be slowing down or halting their investment pace for the foreseeable future, including Castle Private Equity, ShaPE Capital and Pantheon.

The reductions in net asset values over the past two quarters have left many with hefty over-commitments. Back in December 2008, ShaPE reported that its commitment ratio had increased from 164 per cent in the previous month to 169 per cent – despite the firm selling off positions in seven funds, offloading SFr45m.

“In some ways, the listed private equity funds of funds are a leading indicator,” says George Anson, managing director at HarbourVest Partners. “They are trading at massive discounts to NAV because of concerns about liquidity caused by over-commitment strategies.”

Commitment fears

Privately held funds of funds did not generally take their over-commitment strategies to the same extremes as their listed counterparts, yet many are facing their own liquidity problems – exemplified by the steady stream of assets being sold by funds of funds on the secondaries market. “Some funds of funds are actively selling holdings in the secondaries market,” says Andrew Musters, head of private equity at Robeco. “Given that this is not an ideal time to sell, they are probably doing so because they had aggressive over-commitment strategies.”

Private funds of funds have an additional layer of complexity in the current market – the need to raise capital from LPs, many of which are struggling with their own over-allocation issues as they have seen the value of other investments plummet.

“Funds of funds have always faced the issue that they have to go out and fundraise on a regular basis, unlike pension funds, endowments or insurance companies, and as a result, some GPs have a preference for the latter,” says Alexander Apponyi, partner at Berchwood Partners. “This issue could be even greater now if fundraising takes longer until they can commit.”

This means that those with limited capital left to commit are holding fire. “All investors are in a different position at the moment,” explains Apponyi. “Listed funds of funds have their own issues because they are being affected by the reduction in public market prices and falls in valuations. Some had over-allocation strategies and those that used leverage too could be feeling some pain right now.

“Private funds of funds are facing different issues,” he adds. “Some are telling me that because they didn’t over-allocate, they have capital to invest and want to gain exposure to today’s market. Others are saying that the last thing they want to do right now is go out fundraising, and so they have slowed down their investment pace to conserve capital.”

But while the consensus is that some kind of shake-out in the fund of funds industry is now inevitable – the first signs of which would be default, either among the funds of funds themselves or their limited partners – to date, examples of visible distress have been limited.

“There’s a lot more discussion in the market about LP defaults than is actually taking place,” says Katharina Lichtner, managing director at Capital Dynamics. “For funds of funds that have not been following over-commitment strategies, there shouldn’t be a problem with meeting capital calls. It’s true that liquidity among investors has been hit because distributions are down so much, but because investment activity has been so low as well, defaults haven’t become an issue.“

However, Lichtner adds that trouble could nonetheless be brewing.

“We may see this becoming an issue in the summer – investment activity is likely to pick up before distributions do.”

Funds of funds that spent time and effort attracting a broad spectrum of limited partners should fare better than those with a concentrated investor base, both in terms of their existing funds and when it comes to raising new capital.

“It is now more important than ever to have a well-diversified LP base,” says Peter Laib, managing director at Adveq. “Those that have put an emphasis on strategically diversifying their investors by region, type of investor, maturity of their programme – you need longer-term LPs that have a mature portfolio, as these are the ones less likely to have denominator effect problems – and by size of investor, should be able to get through the current environment fairly well and should raise funds in the future.”

The current environment plays well to more established funds of funds, as these are most likely to have a deep and stable investor base, as well as a diversified pool of investments across stage and vintage year. “Investors that have been around for a long time – and that includes many funds of funds – will have embedded portfolios across both private equity and venture capital,” says Anson. “They won’t be as hard hit as someone who decided to invest directly and started three years ago, for example, as they will probably only have a large exposure to big buyout funds.”

Anson adds that one of HarbourVest’s underlying funds even reported an uplift in valuations for the final quarter of 2008 because it was a 2003 vintage and “contains underlying portfolios of companies that are further on in their investment life, have de-levered and developed”.

Value-add is vital

There is, nonetheless, no doubt that funds of funds will have to work harder for the added layer of cost they incur for the end-user LP. Those that survive will be those that are able to demonstrate some kind of value-add for investors. In today’s climate, the most important points for limited partners are diversification, plus access to information and analysis on portfolios. “Coming out of this cycle, I believe that LPs will recognise the value of advice and diversification that only a high-quality fund of funds bring,” says Long. “Funds of funds will have to prove that they are delivering value for that extra layer of fees and whether those fees are aligned with LP interests.”

“We will see the knock-on effect of issues such as the Madoff scandal permeate to private equity funds of funds,” adds Apponyi. “Investors will demand a greater degree of accountability and transparency, so this is where the value-added aspects of funds of funds could come to the fore.

“One fund of funds told me recently that it had been preparing for six weeks for its annual meeting and was providing information and analysis on every GP and portfolio company; in the past it would have taken two weeks to prepare, and only the GP level would have been analysed. That’s the kind of area in which funds of funds can provide value-added services to investors – few of them would have the resources to drill down to the portfolio company level.”

Again, the established funds of funds have the advantage of scale and history over smaller and more recently formed managers. “Of the total universe of between 200 and 250 funds of funds, there will be some casualties,” says Laib. “The newer funds of funds that have been established over the last two years will have a tough time. They won’t have a stable investor base and they won’t necessarily have had the time to build the infrastructure and resources essential to doing the analytical work that today’s environment requires.”

So, larger funds of funds that have followed prudent investment policies look set to survive and possibly gather more assets in the future, as investors increasingly look for safe havens for their money. “Most of the established funds of funds should get through this without any defaults, and there is a low likelihood that we will see established names disappear,” says Laib.

Mulling over mergers

If smaller generalist funds of funds encounter difficulties, one possibility could be to merge. The three-way merger between Sal Oppenheim, VCM Capital Management and CAM Private Equity late last year demonstrates that mergers in the industry are possible. Yet there is no suggestion that any of these investors was facing major problems. Instead, the rationale for the combination was more to do with building a business of scale than a forced move: the merged firms, operating under the Sal Oppenheim banner, now comprise one of Germany’s largest fund of funds.

A merger could also be a solution to liquidity problems. “If you have a fund of funds in which the GPs are strong and the underlying portfolio companies are strong, but the investor is having trouble meeting its capital calls, then it may make sense for another player with more stable sources of capital to come in,” says Apponyi.

Yet mergers are incredibly tricky in any investment business, particularly in private equity, where managers invest considerable sums of their personal capital in their funds. The carried interest structure also means that rewards for managers take a long time to come through. Unpicking these issues is notoriously difficult. There also has to be some underlying value in the business that is seeking a merger. “If you’re talking about merging a group with problems in its portfolio, then it will have little if anything to add to another player,” adds Apponyi.

“Historically, you have seen a few funds of funds merge and there may be some managers that will be bought, but it’s a move that needs to be looked at very carefully,” says Laib.

Instead, we’re more likely to see those with issues die a quiet death as fundraising becomes harder in a liquidity-constrained world. The fund of funds landscape is unlikely to change markedly, but most believe we will see the development of a two-pronged industry, with larger and more established funds of funds gathering more assets and a set of smaller niche players offering investors something different to the mainstream (see box-out, above).

“I see the fund of funds universe reducing through either mergers or some disappearances,” says Muster. “That is healthy for the industry as it will clean it up. We will see larger players with the skills to weather the storm gather more assets; but we will also see a lot more niche players that give investors exposure to a particular specialisation.” 

Vicky Meek is a Freelance business journalist.

Liquidity: a solution?

With a number of investors, including some funds of funds, facing liquidity issues, GPs are scratching their heads about how best to work with their limited partners to ensure defaults do not become widespread.

Permira has already offered a commitment reduction to its LPs, and TPG has reduced the size of its fund. But these are solutions that GPs would rather avoid. At the same time, LPs with liquidity problems would often prefer not to be forced to sell assets on the secondary market because of the substantial discounts such transactions are now incurring.

In terms of alternatives, one investor believes there are a couple of means by which GPs could help. The first is to release the value locked in public market investments – the companies that have been sold via IPO in which GPs still hold shares. “Over ten per cent of our portfolio is currently in listed stock held by GPs,” the limited partner says. “Managers don’t want to sell these, but one of the easiest levers they could pull would be to distribute these public securities to LPs so they can hold them in cash. That would create liquidity and enable GPs to take some carry.”

The other would be to take a look at some of the older GP funds. “If I were a GP,” says the investor, “I would not want to reduce the size of my existing fund that I have taken the trouble to raise. I’d look at the unfunded parts of my older funds, on which I am never going to call further capital. It would make sense to release LPs from these commitments to free up some of their capital. A lot of funds of funds would like to see this happen.”

The specialists

Over the past few years, a growing number of specialist funds of funds have emerged. While for some investors, this may go against the grain of committing to a vehicle that provides a high degree of diversification, for others the approach can give them exposure to corners of the private equity industry that they might not otherwise be able to access.

Cleantech is one of the burgeoning specialist areas for funds of funds, and it’s one that is gaining increasing support from investors, many of which are looking for ways of fulfilling socially responsible investment criteria. “Cleantech is a perfect area for specialist funds of funds,” says Alexander Apponyi, partner at Berchwood Partners. “It’s a nascent area, where managers don’t have long track records. Funds of funds can provide an additional overview and have the capability to compare funds against each other.”

There are currently around five funds of funds investing in cleantech, including those raised by Robeco and Unigestion. There is also newcomer Osmosis, which is out on the fundraising trail.

“In some ways, a fund of funds in this space is more relevant to investors than even the generalist funds of funds,” explains Osmosis chairman Jon Bailie. “LPs are committing small absolute amounts to it and yet they would need to use a considerable amount of resource to identify the top teams, particularly as very few have long track records, the space is new and covers the whole gamut from expansion capital through to renewable energy project financings. They also need to gain diversification.”

It’s an area that is really picking up, despite the current difficult investment climate. “The scale of investment opportunity in this space is exponential,” says Sean Gorman, partner at Osmosis. “We are seeing year-on-year growth of 35 to 40 per cent. Last year, $150bn was invested in cleantech; by 2012, that figure is forecast to rise to $450bn. Previously, for some firms, investing in cleantech was not much more than a marketing exercise, but now investors are seeing they can make money out of it and they have the backing of institutions that are not only looking for good returns, but also an SRI wrap-around.”

“Ten years ago, investment in cleantech meant investing in R&D; in 20 years or so, it will be project finance,” says Andrew Musters, head of private equity at Robeco. “At the moment, we are seeing a crossing point as renewables become economically viable as economies of scale and the development of technology lower the prices. Private equity can build companies around these drivers as well as those surrounding issues such as energy security, long-term increases in commodities prices and increasing consumer preference for green products.”

Musters agrees that the fact of the space being so new is a challenge for investors, which is why he believes the fund of funds approach works so well. “The cleantech market is like biotech was 15 years ago,” he says. “It’s a new investment theme. Many of our clients have their own private equity teams and operations, and can make investments in, say, large buyouts themselves, but cleantech is so specialised, especially when it comes to analysing individual portfolio companies, that they feel more comfortable investing via a fund of funds.”

“Track record analysis in cleantech is much more challenging than with a mid-market or large buyout team,” adds Musters. “You have to do your own analysis of the portfolios, which are to a large extent unrealised. You need to form your own judgement on these, and so in some respects it’s more like secondaries analysis than primaries.”