A recent trend in European Private Equity has been the emergence of funds of funds. According to our own research, the number of European funds of funds managers with funds between E50m and E1bn under management is approaching 80 and this figure does not even take into consideration the 10 or so US managers with a keen European interest.
From an investor’s point view, they are all aiming at the same target, that is ‘top-quarter performers’, and they all market their products around the same arguments, that is ‘one-stop-shop’, extensive diversification, access to ‘invitation-only funds’, etc.
Performance should therefore be the ultimate criteria for selection. However, most managers currently on the market have insufficient track records to demonstrate their fund selection skills. The real performance of most European funds of funds raised since 1998 will only start to show in the three to four years to come.It is therefore a challenge for institutional investors to pick the right funds of funds managers.

Quality of management teams
At first glance, the barriers of entry to the funds of funds business seem relatively low, hence they are proliferating in Europe as every bank, insurance company or asset management firm has launched or is launching one.
Thanks to their marketing power towards mostly unsophisticated and often captive clients, raising money is not an issue for them. Neither is putting together a team.
Unfortunately, the European private equity market is complex and requires substantial knowledge and analysis. Building a funds of funds management team takes people who:
q understand private equity, having been practitioners themselves;
q have witnessed several market cycles in private equity;
q are connected to a large international network, bringing relevant deal flow;
q demonstrate fund selection skills, having invested in a large number of funds before;
q understand the technique of fund investments, being able to negotiate terms and conditions and to add value in fund structuring.

Geographic focus
For their buy-out allocation, most European funds of funds managers tend to back the same large pan-European funds, most managed out of the UK, and covering France, Germany, the Netherlands and the Nordic countries. Few focus on mid-market, domestic funds.
Managers are usually less focused on Europe for their venture capital allocation as they deploy more money in the US with second-tier funds. Within Europe, technology investing is concentrated on regions within Germany, France, the UK, the Netherlands, Finland and Sweden.
Few players offer a global perspective, covering the US, Europe and Asia. The downside of this strategy is that the wide variance in the level of risk and reward attached to these regions has averaged returns down rather than up.
Consequently, investors should ask themselves whether a European manager investing in the US or Asia has the right market expertise and access to the best funds to do so. They should also question the ability of some of the US managers to cover the European market with a one-man operation out of London or people flying in and out occasionally.

Venture versus buyout
Most funds of funds managers cover both the buy-out and the technology/venture capital segments as they may experience decorrelated cycles: Buyouts attract half of the funding for European private equity as teams are usually long-established and they offer stable return profiles.
The top-performing European technology fund managers are now more seasoned and more able to capture the European technology opportunity.
Nevertheless, there are some clear differences between European funds of funds managers in their allocations to those two segments. For instance, UK managers have long remained private equity traditionalists for whom continental venture funds (and sometimes even UK ones) were clearly not good enough. The only real venture capital for them was the ‘Silicon Valley’ thing. As a consequence, their overall allocation to venture capital is usually around 25% and their European venture capital allocation is below 10%.
Some continental European managers have clearly favoured venture capital in their strategies, allocating up to 70% of their resources to US and European venture capital funds.
Very few managers have offered specialised products that would, for instance only invest in European venture capital funds or specialise in buy-out funds.
According to their own preferences, investors in funds of funds should therefore pay particular attention to the split between buyout and venture capital in the strategy of the managers they will pick. Provided that specialised products are available, they may also pick separate managers to cover the two segments independently.

Fund investments
Investors should select funds of funds managers which, beyond the analysis of past performance, are looking for the differentiating factors between fund managers. In buyout, for instance, build-up and value added-oriented teams as well as those who can help integrating new technologies in the strategy of traditional companies should make a difference. In venture, there should be a premium on those teams with a strong sector focus, investing in companies very early on to avoid over-paying and providing a comprehensive service to their investees (like head-hunting, incubation, PR and marketing, international placement, etc).
Lastly, they should check if funds of funds managers are basing their investment decisions on research or they are just ‘following the herd’ and investing only with ‘blue chip’ names that institutional investors can identify themselves. Considering the inflation in fund sizes and the possible turnover of staff, there is no guarantee that today’s blue chips will continue to perform.
Secondary transactions
Changes in market conditions or in investment strategies may lead some investors to sell their holdings in private equity funds. Although there are specialised players on this market, some funds of funds are also active as secondary purchasers as such transactions can generate appealing rates of return. Unfortunately, this market goes through cycles and the recent period has seen a reduction in the discounts applied to secondary transactions, as there were few large enough transactions available and an increasing number of buyers.
In these conditions, an IRR-driven buyer could probably generate a satisfactory return because of the shortened holding period, but a buyer driven by the overall multiple it can achieve on its investment would probably not have invested much, as the occasions to produce a multiple in excess of two times money have been scarce. When comparing secondary strategies, investors should therefore ask themselves whether the managers they have picked are clearly able to avoid auctions and pay sensible prices that will not only generate a decent IRR but also a good multiple.

Direct investments
When funds of funds managers cannot resist the temptation of making direct investments in companies, they are entering the danger zone.
The recent stock market collapse has clearly demonstrated that being a third round, pre-IPO investor was a risky business.
Direct investments have a higher risk profile which is not coherent with the fund of fund’s objective of delivering superior performance with a minimum level of risk.
From a manager’s perspective, the justification usually comes from the higher level of carried interest on direct investments, as compared to fund investments (15 to 20% on directs against 5 to 10% on fund investments).
From an investor’s perspective, investing in a fund of funds that would also invest directly in companies makes no particular sense. It would simply mean that funds of funds managers can match or exceed the performance of the fund managers in their underlying portfolios, which is rather unlikely.

Conclusion
Selecting managers according to their sector and geographic expertise is probably the best way to maximise the use of funds of funds as part of a strategy to increase the private equity allocation of large or small institutional investors.
Key aspects in the selection of funds of funds managers should also be their policy vis-à-vis direct and secondary investments. The first (direct) should clearly be avoided, whereas the latter (secondary) should take place on an opportunistic basis, to follow market cycles.
Dominique Peninon, Agnès Nahum and Philippe Poggioli have a combined experience of 41 years in private equity. Prior to founding or joining Access, they had collectively invested more than E200m in 52 funds over the last 15 years. With Access, they have committed E197m to 17 funds in France, Germany, Ireland, Italy, the Netherlands, The UK, Spain, Sweden and Israel

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