THE GuiDE To FunD oF FunDs MAnAGERs Third Edition Practical intelligence on vital trends and strategies Edited by Kelly DePonte Probitas Partners Fund of Funds.indb 1 09/12/2011 17:04:27 Published in December 2011 by PEi second Floor sycamore House sycamore street London EC1Y 0sG united Kingdom Telephone: +44 (0)20 7566 5444 www.peimedia.com © 2011 PEI isBn 978-1-908783-01-1 This publication is not included in the CLA Licence so you must not copy any portion of it without the permission of the publisher. All rights reserved. No parts of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means including electronic, mechanical, photocopy, recording or otherwise, without written permission of the publisher. The views and opinions expressed in the book are solely those of the authors and need not reflect those of their employing institutions. Although every reasonable effort has been made to ensure the accuracy of this publication, the publisher accepts no responsibility for any errors or omissions within this publication or for any expense or other loss alleged to have arisen in any way in connection with a reader’s use of this publication. PEI editor: Helen Lewer Production editor: William Walshe Printed in the UK by: Hobbs the Printers (www.hobbs.uk.com) Fund of Funds.indb 2 09/12/2011 17:04:27 Contents Figures and tables vii About the editor ix Introduction from the editor xi Section I: In-depth chapters 1 Funds of funds – a brief history 3 By Kelly DePonte, Probitas Partners Definition and rationale 3 At the creation: separate accounts 4 The late 1990s explosion: new funds and new structures 5 The last decade 6 Summary 10 2 Why invest via a fund of funds? 13 By Stewart Hay, Richard Chapman and Andrzej Plichta, SL Capital Partners LLP Why invest in funds of funds? 14 Where does fund of funds investing fit into the private equity investment landscape? 16 What is a fund of funds? 17 Attractions of a fund of funds 18 Why is the cash-flow profile of a fund of funds important? 19 What should investors look for in a private equity fund of funds manager? 20 3 Private equity fund of funds investment strategy 23 By Hanneke Smits and Kathy Wanner,Adams Street Partners Introduction 23 Investment strategy and process 23 Organisational stability 30 Conclusion 30 4 Legal issues on structuring a private equity fund of funds 33 By Solomon Wifa, O’Melveny & Myers LLP Introduction 33 iii Fund of Funds.indb 3 09/12/2011 17:04:28 Contents Considerations that influence the choice of a fund of funds structure 33 Common fund of funds structures 34 Regulatory issues 38 Principal terms and conditions 40 Common US tax and regulatory issues 41 5 The growing importance of new and next generation managers in private equity 47 By Kelvin Liu, Invesco Private Capital Introduction 47 Historical strategy of PE investing 47 Transformation of the PE industry demands new approach 48 Seeking alpha through new and next generation managers 51 The art of selecting new and next generation managers 52 Conclusion 52 6 Private equity separate account investment vehicles 55 By Kelly DePonte, Probitas Partners Introduction 55 Evolution of outsourced investing 56 The return of separate accounts 57 Focused separate accounts versus allocated separate accounts 59 Key issues for investors 60 Summary 60 7 Co-investments in funds of funds and separate accounts 63 By Brian Gallagher,Twin Bridge Capital Partners Background 63 History of the co-investment process 63 Current state of co-investment 63 Benefits to the LP 64 Benefits to the equity sponsor 65 The co-investment process 65 Sourcing 66 Myths about co-investing 68 Success factors in co-investing 69 The future of co-investing 69 8 Regional focus: developments in Asian emerging markets 71 By Veronica John and E. Brooke Whitaker, Serasi Capital Current global trends pose challenges for funds of funds, but not in Asia 71 Asia – investors must allocate 72 Asia-focused fund of funds landscape 73 Why do investors prefer the fund of funds route to going direct in Asia? 75 Similarities and differences between Asia-focused funds of funds and the rest of the industry 76 Understanding the different private equity models deployed 77 iv Fund of Funds.indb 4 09/12/2011 17:04:28 Contents What are the prospects for Asian Funds? 78 Conclusion 79 Section II: From the Private Equity International archive Private Equity International coverage on funds of funds 83 Standing out from the crowd 83 Don’t be a JAFOF 87 Survival of the fittest 89 Same rules, different concerns 92 Private equity is going bespoke 95 Albert: LPs will flock to established FoFs 98 News analysis: The FoF phenomenon 100 Section III: The survey Current trends in the fund of funds market: A survey of practitioners 105 Profile of respondents 105 Sectors and geographies of interest 108 Secondaries and co-investments 114 Terms and conditions 114 Greatest fears 115 Summary 116 Section IV: The directory A comprehensive directory of fund of funds practitioners and advisers 121 About PEI 216 v Fund of Funds.indb 5 09/12/2011 17:04:28 Figures and tables Figures Figure 1.1: Global commitments to funds of funds 5 Figure 2.1: Pooled IRR for European buyouts, as at December 31, 2010 14 Figure 2.2: Structure of a fund of funds 18 Figure 2.3: Example cash-flow of a fund of funds 19 Figure 3.1: Market assessment methodology 26 Figure 3.2: Subclass assessment by market 27 Figure 5.1: US venture capital industry – assets under management 48 Figure 5.2: US buyout & mezzanine industry – assets under management 49 Figure 5.3: Average debt/EBITDA–large-cap US leveraged buyouts 49 Figure 6.1: Global private equity raised per annum (1991–2011) 56 Figure 7.1: Sample net cash-flow by year – traditional funds of funds versus fund of funds with co-investment 64 Figure 7.2: The co-investment process 66 Survey figures Figure 1: Location of firms’ headquarters 106 Figure 2: Number of years active in private equity investing 106 Figure 3: Strategies offered by funds of funds 107 Figure 4: Targeted amount of private equity allocations across all funds for 2012 (in US Dollars) 107 Figure 5: Target sectors for investment for 2012 108 vii Fund of Funds.indb 7 09/12/2011 17:04:28 Figures and tables Figure 6: Target sectors for investment in 2012 – North American respondents only 109 Figure 7: Most attractive geographical focus for 2012 110 Figure 8: Most attractive European investment regions for European-focused funds 110 Figure 9: Most attractive markets in Asia 111 Figure 10: Most attractive strategies/sectors in the US mid-market 111 Figure 11: Most attractive sectors/stages in venture capital 112 Figure 12: Most attractive emerging markets 113 Figure 13: Approach to secondary markets 113 Figure 14: Directs and co-investments activity 114 Figure 15: Attitude to the ILPA Private Equity Principles 115 Figure 16: The most important issues regarding terms/structures of a fund 115 Figure 17: Fund of funds managers’ greatest fears about the current private equity market 116 Tables Table 1.1: Ten largest private fund of funds vehicles, 2011 7 Table 1.2: The five largest publicly traded fund of funds vehicles, 2011 8 Table 1.3: Private equity and funds of funds: a timeline 10 viii Fund of Funds.indb 8 09/12/2011 17:04:28 About the editor Kelly DePonte is the head of research and due diligence at Probitas Partners, a leading global provider of integrated, alternative investment solutions including fund placement and portfolio management services. Kelly is based in the firm’s San Francisco office and has over 30 years experience in the industry.Before joining Probitas Partners, Kelly was chief operating officer and a managing director at Pacific Corporate Group,aprivate equity consultancy firm, where he also directed the partnership investment programme. Before that he spent several years with First Interstate Bank where he most recently oversaw its private equity activity and interest rate swap activity.Kelly is also a member of the Editorial Advisory Board of PEI’s quarterly journal The Review of Private Equity.Kelly received an MBA from UCLA and a BA in Communications from Stanford University. ix Fund of Funds.indb 9 09/12/2011 17:04:28 Introduction from the editor When the second edition of AGuide to Private Equity Fund of Funds Managers was published in early 2008 we were unknowingly at the beginning of the Great Financial Crisis (GFC). That crisis dramatically affected the private equity industry and the fund of funds market as well. It accelerated changes that have led to an increased set of targeted product offerings and separate account vehicles taking their place alongside the well- established globally diversified funds that originally started out in the market. While the fundamentals of funds of funds have not radically changed, the market has become more complex and in the coming months the industry will also have to comprehend the raft of regulatory changes emanating from Europe and the US, and assess the impact it might have. The new market dynamics are reflected in this third edition of the guide, which includes an entirely new chapter on the growing importance of new and next generation managers in addition to a number of fully revised and updated chapters from the previous edition. It also includes a new survey of fund of funds managers, which analyses current trends in the market and highlights the market segments, investment strategies and geographic areas that are of most interest to practitioners as well as the challenges they face in doing their business.