A direct hit on funds of funds

The ranks of private equity funds of funds are thinning, managers and other industry insiders say, with some predicting that close to half of them will disappear over the next several years.

“Many private equity funds of funds will disappear,” said Antoine Drean, founder and CEO at Triago, a Paris-based secondary private equity advisory firm and placement agent.

One reason for the decline, according to industry players, is that investors are shifting their private equity commitments to less traditional funds such as small and midmarket, distressed private equity and secondary markets private equity. Others are simply going direct.

Benoit Verbrugghe, senior managing director and head of the New York office for AXA Private Equity, also said that there could be fewer private equity firms in the future.

AXA Private Equity manages private equity funds of funds and invests directly in private equity deals as well as on the secondary market. Mr. Verbrugghe said firm executives estimate that of the 250 funds of funds currently in existence, up to 150 firms will be gone over the next few years.

“The old mainstream fund-of-funds model seems outdated,” Mr. Drean said. “As LPs become more sophisticated, the fund-of-fund option makes less sense, with its additional layer of fees and carried interest, and the danger of its overallocation model.”

Private equity firms overall are finding fundraising a tough slog right now.

In fact, of the $50.4 billion raised by private equity funds in the first quarter, including private equity real estate and infrastructure funds, only $2 billion was raised by private equity funds of funds, according to data from London-based alternative investment research firm Preqin. As of June 9, one other fund of funds closed with $700 million.

By comparison, in 2009, $7.2 billion was raised in seven funds of funds in the first quarter and $11.3 billion by 25 funds in the second quarter, according to Preqin.

“From our own perspective and I believe from the perspective of almost any fund of fund manager, we are having to work harder to attract investors,” said Beau Hurst, partner, Private Advisors LLC, a Richmond, Va.-based private equity fund-of-funds manager. “We are getting in front of more investors and traveling more. “

Fund-of-funds managers say most of their funds are losing investors because investors prefer direct investment in private equity funds and dislike the added layer of fees in a fund of funds as well as their lackluster performance.

While data on the performance of 2008 and 2009 vintage funds is not yet available, 2007 vintage private equity funds of funds have a median -10.3% internal rate of return, according to Preqin. Moreover, the median internal rate of return for these funds of funds has been below 1% since 2003.

That less-than-stellar performance, combined with the tough fundraising market has forced fund-of-funds managers to show investors they have something special.

“If you are a 'me-too' generalist private equity fund of funds, you are in trouble,” Mr. Verbrugghe said. Instead of having a broad portfolio replicating the market, AXA's private equity funds of funds make larger commitments with fewer firms that have the best talent, he said.

Even the largest managers are having a tough time. For example, after a year on the fundraising trail, the BlackRock Diversified Private Equity Program closed its private equity fund of funds with $790 million in commitments, some 20% shy of its $1 billion target.

And those still committing to private equity — both direct and funds of funds — are assigning less this year, Private Advisors' Mr. Hurst said. A client that had made $150 million private equity commitments per year, for example, may be down to $30 million this year.

While some fund-of-funds managers are expected to close over the next several years, others have put expansion plans on hold.

“Some private equity fund-of-fund groups have not been able to raise funds and groups are pulling back from expansion efforts,” Mr. Hurst said. “That will continue and come to bear in the next 12 to 24 months.”

Shifting investor interest in private equity funds of funds has not helped. Some investors are investing directly with four or five private equity funds rather than in a fund of funds. Others, Mr. Hurst said, don't think funds of funds add diversification and aren't worth the extra fees.

What's more, specialized and general investment consultants are beginning to recommend direct investing as well, he said.

Still, fund-of-funds managers have some fans.

Gary Robertson, senior vice president at investment consulting firm Callan Associates in San Francisco, said his firm is not opposed to private equity funds of funds.

For smaller clients that cannot access the best private equity funds, many funds of funds have delivered good returns, he said.

Private equity funds of funds managers performing in the top quartile have been mostly delivering double-digit returns, according to Preqin. For example, the 2007 vintage top quartile funds of funds are producing an average 18% IRR, compared to the bottom quartile, which is returning a -81.6% IRR.

“In my opinion, many investors under-appreciate the true value add that a quality fund of funds can provide. This is a mistake avoidance business, and superior manager selection is the only way to generate top quartile returns in private equity, Mr. Hurst said. “The highest quality funds of funds have more dedicated resources and do better due diligence than almost any other investor type.“

Mr. Verbrugghe said the problem with some managers is too much diversification. Replicating the private equity universe is no way to provide the higher returns that investors want.

“Too much diversification makes it harder to achieve good performance. For better returns, it is better to have a concentration,” he said. “If you invest in fewer funds but larger ticket, you may have more direct access to the general partner and, could have access, for example to the advisory boards.”