A few years ago, private equity was bread and butter for funds of funds. In a world of cheap leverage and hunger for yield, appetite for the asset class was growing; yet many new limited partners (LPs) lacked the resources to build a diversified a portfolio. Funds of funds could provide the scale, access and expertise needed to source the best managers and lower risk.
Since the financial crisis, however, their plates have looked rather empty. For one, fundraising has become more difficult: new regulation has restricted the amount banks and insurance companies can invest in the asset class, slow distributions have limited the amount of money LPs can put back in, and allocations have become more concentrated.
But particularly threatening for funds of funds have been efforts by investors to cut fees, target exposure and better monitor risk – by picking managers directly. This has made funds of funds rather less in vogue: only $6.2 billion have been raised by co-mingled private equity vehicles since the beginning of 2013, barely more than half of the total collected during the first semester of 2008.
For an increasing number of them, the riposte has consisted in adding new options to their menu – including infrastructure. “Private equity fund of fund managers are looking to diversify away from their traditional model – as this has been a challenging area from a fundraising perspective – and are looking at other strategies,” says Andrew Sealey, managing partner and chief executive of Campbell Lutyens.
But there’s also a ‘pull’, explains Ed Hall, a partner at law firm King & Wood Mallesons SJ Berwin. “Infrastructure is very attractive at the moment, and institutional investors have a growing appetite for it. We’re seeing a lot of infrastructure funds being launched, with a lot of them raising quite successfully.”
A NEW RELEVANCE
The fresh capital being deployed in infrastructure has helped the asset class grow bigger – and created a new role for funds of funds. According to Infrastructure Investor’s Research and Analytics division, no less than 652 primary GPs are currently active in the infrastructure space; 182 of them are also on the fundraising trail. Navigating this increasingly complex universe is where new investors can find benefits from working with a fund of funds, says Jan Mende, a vice president at Swiss advisor and fund manager Capital Dynamics.
This help is all the more valuable as performance varies greatly among existing GPs, adds Richard Clarke-Jervoise, a director at Paris-based fund manager Quartilium. “In the relatively recent universe of infrastructure managers we’re already seeing a number of vehicles that could become zombie funds – with teams that have either jumped ship or managers who have been unable to raise a second fund. One of our most important roles in selecting infrastructure managers is to avoid this kind of situation.”
But perhaps the strongest selling point of funds of funds is their ability to provide exposure to a wide array of vehicles – for a relatively small amount of money. Eric Warner, co-chief executive and head of investor relations at advisory and funds of funds manager Altius Associates, contends that it remains very hard for an LP with an infrastructure allocation of $20 million to build a diversified portfolio of primary commitments – whereas the same amount invested in a co-mingled vehicle could get it into a dozen different funds.
In particular, says Clarke-Jervoise, funds of funds can often provide geographical spread. “For most small or medium-sized investors it remains difficult to access and review European, North American and Asian managers. It not only requires significant resource to identify such managers but the regional specificities of the underlying projects and regulation make it difficult to analyse such opportunities without dedicated teams.”
Funds of funds can also offer access to smaller managers, whose profiles are sometimes better suited to LP needs. “The investor who doesn’t use a fund of funds might go with the largest well-known names to create a large cap portfolio,” says Mende. “A fund of funds should be able to source emerging managers, who offer diversification or a different background than the large cap funds.”
Yet all this doesn’t come for free: as in private equity, funds of funds charge a management fee for their services.
And that’s where the problem really lies. “The fees are tighter in infrastructure than they are in private equity, in particular for brownfield funds,” says Hall. “A lot of these funds reach their preferred returns but they’re not designed to get a 3-4x return on each deal. So adding another layer of fees is harder to justify for a fund of funds model.”
That makes it difficult for funds of funds to focus on the safest strategies, agrees Urs Rieder, a managing director at Capital Dynamics. “Funds of funds that would invest at the lower end of the risk-return profile – say the PPP or PFI funds of the market – may struggle.”
The most valid approach for funds of funds, then, would be to focus on managers at the riskier end of the spectrum. But that is not always possible, cautions Hall. Because investors are looking for a particular type of return, he says, there is a lot of pressure on managers to say upfront what they’re going to invest in. So they rarely have free rein to allocate all their capital to either brownfield or greenfield strategies.
One complicating factor, he adds, is that infrastructure is a far more complex asset class than private equity. “You have funds that look a lot like private equity funds, ones that have a longer life and others that are open-ended or listed. So there is much more variety in the way the fees and the carry will work out. That makes it much harder to create a platform where the fund of funds investor has a certainty of what he’s getting into, while at the same time giving the fund of funds manager the flexibility to invest in the best funds.”
What’s more, argues Matthias Reicherter, head of infrastructure at German fund manager and adviser Golding Capital Partners, picking top managers in infrastructure requires different tools and skills than those used in private equity. “Benchmarking in the traditional sense is quite difficult in infrastructure, because data quality is poor and track records are short. We need to take the analysis to the asset level, understand the details of each transaction, learn how the investment team thinks about deals and what strategy they want to carry out.”
There are a number of things funds of funds managers can do to mitigate these concerns. For one, says Reicherter, they should strive to look at the asset class broadly – by examining various geographies, sectors and risk-return strategies. “If you’re just defining infrastructure as core, regulated assets in Europe, then obviously it is a bit tight. The menu of potential funds is then limited.”
In some instances, this could even encompass a broader spectrum of assets, including renewable energy, metals or commodities. Altius Associates, for instance, is currently raising a $500 million fund dedicated to real assets.
Yet industry participants agree that infrastructure funds of funds need to be dedicated vehicles, rather than blind pools straddling distinct classes of alternatives. “If you do this you have to be mindful of returns,” argues John Gripton, global head of investment management for private equity at Capital Dynamics. “You would be benchmarked against private equity funds of funds and if you put infrastructure in there clearly it’s going to depress returns. So we certainly see them as two separate parts of an alternative assets portfolio.”
But even more crucial to the success of funds of funds, says Sealey, will be their ability to go beyond the pure funds of funds model – by crafting a more personalised yet comprehensive relationship with their LPs. “There’s an opportunity for fund of funds managers to add value to institutions investing in infrastructure. But rather than co-mingled vehicles, growth is more likely to come from larger single client accounts. These can be structured differently, tailoring them to suit the institutions’ investment objectives as well as setting the economics to reflect the scale.”
That’s also the view of Serge Lauper, a managing director at BlackRock’s infrastructure unit. “We do not see funds of funds as just fund investments but as exploiting the relationships we have with GPs beyond the primary side. The concept of ‘multi manager’ probably better pins down the idea: you have a relationship with managers where you provide capital to them and they provide you with opportunities. These include primary fund investments – but also secondaries and, more importantly, co-investments.”
That’s why having people from industry on board will often help, says Fabian Pötter, an investment manager at Golding. LPs often want to work with a team capable of executing occasional co-investment or direct deals.
The relationship between funds of funds and their investors, more often than not, should thus be seen as a dynamic one. “We are following our clients along the infrastructure learning curve,” says Reicherter. “So we expect some of our investors coming back to us saying ‘ok next time I want to go for a managed account and having a more bespoke strategy on my own’; but equally, others might realise that a fund of funds is the product of choice also for the future.”
In the meantime, observes Clarke-Jervoise, convincing them that funds of funds have a role to play may well remain the biggest difficulty. In that respect, he says, “fund of funds face the same challenges in infrastructure as they do in private equity”.
Yet Warner has no doubt that underlying demand for their services remains robust. “Why should it be different in infrastructure than in any other asset class?” he asks. “There’s always going to be a share of investors – those who are starting out, i.e. have not yet invested, or have discreet small amounts to invest – for whom funds of funds have a role to play. For them a third party that can offer due diligence and pick the best managers will remain the best choice.”
Some managers also think the debate over fees is over-hyped. “It’s true that the returns are different for infrastructure funds than for more LBO-type funds. But a lot of investors looking at infrastructure are seeking current yield rather than capital gain,” says Mathias Burghardt, head of infrastructure at Ardian.
All this doesn’t mean the same model is likely to find acceptance everywhere. While a more straightforward fund investment approach can work in Europe, Clarke-Jervoise thinks advisory or direct investing may be better suited to Asia or the US, where ticket sizes are generally larger.
But while their precise role will continue to evolve, it seems unlikely that infrastructure funds of funds are a passing fashion. “For most of our investors, investing directly remains the preferred route,” says Burghardt. “But when we were in the fundraising process we’ve seen some investors, at least [those] at an early stage, go through fund of funds. So they have merits for us: they’re gathering people that for different reasons can’t or don’t want to go direct into a fund.”