Tuesday, October 10, 2006

Systematic approach to PE investing - FoF Model

As the march away from stocks and bonds brings new, well-heeled investors into the world of private equity, the positive story continues for Funds of funds (FoF). The asset class is attracting streams of new capital and amid the mushrooming marketplace, Funds of funds have moved to distinguish themselves from the crowd.

Certainly it’s a great time for Funds of funds. The whole private equity industry has so much drawing power right now.

This year, while it seems a bit slower than last, one could still track almost $5 billion in new capital that has rushed into the marketplace in just the first six months. Industry sources even believe anecdotally that the amount of capital raised could be almost double that figure.

It's that old fundraising axiom—you raise money when you can. People are throwing money at private equity and there’s people there to collect it.

Part of the popularity for Funds of funds stems from the arrival of new investors interested in getting into private equity for the first time. Many of these new LPs are often coming from overseas, with a knowledge base of zero. These new groups need a fund of funds to assist them in overcoming the learning curve.

Institutions like to get their feet wet... They'll do one or two Fund of funds over the first five years, and then start to invest directly into PE funds themselves.

However, in the interest of keeping their limited partner base intact, many Funds of funds have developed specialized strategies, which at the same time help Funds of funds distinguish themselves from the growing crowd of rival firms.

For whom does it serve best...

Fund-of-funds investing is not reserved for the greenhorns. To attract institutional investors that have been investing in private equity over decades as opposed to years, there is a growing population of funds of funds that have established specialized vehicles as a way to give the more experienced investors exposure to specific niches.

Specialization is one way to attract both new and experienced LPs. And for an industry that targets the same "top-quartile" GPs, it can also help to distinguish specific fund-of-funds managers from their peers. This is key, as the industry tries to avoid becoming simply an index of the private equity space.

New specialist funds of funds crop up everyday. Among those currently raising capital are Singapore-based Axiom Asia Private Capital, which was raising a $350 million Asia-focused fund. Parish Capital Advisors was raising $550 million for emerging markets only. Piper Jaffray Private Capital, which is raising Piper Jaffray Clean Technology Ventures LP.

Siguler Guff has been a long time proponent of specialization. This year it has raised two such funds, the $1 billion Siguler Guff Distressed Opportunities II and the $600 million Siguler Guff BRIC (Brazil, Russia, India, China) Opportunities Fund. It is also in the market with a $300 million-targeted small market buyout fund, an area that the firm believes is being ignored by most funds of funds.

Specialization's Detractors

Not everyone is necessarily singing specialization's praise. Many pros say that being a successful fund of funds investor still basically comes down to access. When top notch fundraisers can't be reached, it's up to the funds of funds to provide investors with an "in".

Simply put, It all gets back to discipline and access to relationships.

In some cases specialist strategies can get groups into trouble primarily because it creates demand for a market that may not even be there. For example, in looking at the distressed space, one gets a feeling that a lot of capital has already been formed to take advantage of the distressed cycle, but it hasn’t happened.

Is that capital going to be put to work in a suboptimal way ?

With that said, there are also those who believe the industry needs to bill itself on more than simply an "in."

Fund of Funds can't merely play the role of access-provider. A successful Fund of Funds has to cater to larger and more experienced institutional players.

Private equity is about targeted opportunities. It’s about finding areas of capital starvation around the globe. Smarter LPs, endowments and foundations, they aren’t looking for plain vanilla Funds of Funds. They need someone who’s going to bring a cutting edge idea or open up a new market niche.


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