The author is private equity researcher Preqin
Fundraising has been very difficult for fund-of-funds vehicles lately. The number of FoF vehicles that completed fundraising has been shrinking since its peak in 2007, when 163 vehicles closed with an average size of US$371 million per fund. During the first half of this year, the average fund size has dropped to US$292 million.
The proportion of capital raised by FoF vehicles has fallen from 11% in 2009 to 7% in 2011. As of the end of first half of 2013, US$162 billion had been garnered by all private equity funds. But only US$6.4 billion, or 4%, of the total is from FoF.
In addition, performance has been sub-par. As a whole, FoF has not performed as well as other strategies. Ten-year horizon IRR (internal rate of return) as of the end of 2012 indicates that all private equity strategies generated a return of 17.9%, but FoF has only returned an average of 8.6%. As a comparison, buyout funds returned 24.3% during the same period.
We think part of the reason for FoF vehicles’ relatively poor return is its double layer fees structure.
All these have led to a reduction in investor appetite for FoF, driving a wave of consolidations among FoF players. For buyers, consolidation can improve the scale and strength of their product offerings. For sellers, exiting may be a smart choice giving the challenges faced by the industry.
For example, StepStone Group (listen to StepStone Group CEO Monte Brem talking to our host Nina Xiang) acquired private equity FoF manager Parish Capital Advisors in 2012 to expand StepStone’s capabilities in Europe. In the same year, Hong Kong-based Squadron Capital (listen to Squadron Capital CEO David Pierce talking to our host Nina Xiang) was sold to U.S. firm FLAG Capital, in an effort to add Asian presence for FLAG.
So far in 2013, a number of transactions saw companies merging FoF arms of other investment firms into their own operations in order to create a single, larger scale FoF platform. Examples include Aberdeen Asset Management’s acquisition of a majority stake in SVG Advisers and the upcoming integration of Partners Group and Perennius Capital Partners.
Despite a diminished prospect for the industry, well-established names continue to close sizable vehicles. For example, Guochuang Kaiyuan Fund of Funds closed at RMB15 billion in February, 2013. It is part of a joint venture between China Development Bank and Oriza Holdings aimed at providing capital for promising Chinese private equity firms that have difficulty in raising funds.
Fund of funds will always have a place in the industry, particularly for investors looking for lower-risk investments through increased diversification. Others who are looking for exposure to certain niche strategies or geographies that are beyond their realm of expertise will also look to FoF for solutions.
However, perhaps the fund type is not as significant as it once was, given the more challenging fundraising environment and the development of more sophisticated investors. As a result, a consolidation of the FoF industry will intensify across the global in the future.