There were significant increases in the amount pension funds allocated to private equity in 2004 as they continued to understand the long-term benefits of investing in the asset class. The question now has become not when to invest in private equity but by what means.
Charles Soulignac, chairman and chief executive officer at Fondinvest in Paris, which has managed over e1.2bn in various funds of funds and discretionary funds for institutionals since its foundation in 1994, says pension funds now account for some 30% of all investments in private equity, directly or indirectly. “The main reason for getting into private equity is to get superior returns as well as decorrelation with other asset classes,” he says.
Tycho Sneyers, partner at LGT Capital Partners in Pfäffikon, Switzerland, with €3.9bn under management and whose client base is at least two-thirds pension funds, agrees pension funds are continuing to show more than passing interest in private equity. “Though pension funds have regained some confidence in public equities recently, we see a lot of new entrants to the private equity scene as well as increased commitments by those that already invest in it, with a clear trend favouring the fund of funds business as the principal means of doing so.”
Soulignac says funds of funds act as a good starting point before specialisation. “Many pensions opt for funds of funds over specialist funds at the beginning of their private equity programme, since they provide diversification in terms of sector, investment stage, strategy, funds selection and monitoring. Funds of funds act like a school for private equity.”
Sneyers believes fund of funds investing eliminates the potential problems created by high tracking error. “It is important to use the right managers if you want to make money in private equity. European pension funds typically invest through mutual fund structures with small tracking errors. This is difficult in private equity as the tracking error differential can be as high as 15%. Using funds of funds helps keep the right mix of managers and protects their assets,” he says.
Andrew Muster, senior investment manager at Robeco in Rotterdam, says many mid to large pensions often use fund of funds vehicles as a prelude to a more diversified private equity portfolio. “The vast majority of pensions use funds of funds initially to test the water, so to speak, and move to specialist investments once they have built up their private equity portfolios.”
Even then, Muster says, very few pension funds end up running their own private equity programmes. “Of course the very big funds such as ABP and PGGM here in the Netherlands have their own dedicated private equity units and have been actively investing in private equity since 1996 and 1990 respectively. But funds of funds remain the perfect access point for most institutionals, simply because many individual funds are actually oversubscribed.”
For this reason many pension funds split their private equity investments between funds of funds and individual specialised funds, Muster explains. “To what extent they invest in each depends on their overall strategy.”
But access is not the only reason pension funds prefer funds of funds. According to Sneyer, investing in private equity can be expensive, and very few pension funds have the resources to set up dedicated teams or employ people to work solely on due diligence. “Funds of funds create the perfect diversification. Many pensions start out gingerly, investing in local and individual funds. But as their confidence grows and they seek higher returns, the opportunities are typically further afield. This is when funds of funds become most attractive,” he says.
However, Muster believes it is often the other way round. “Most start with funds of funds and begin
looking at their local markets for opportunities to branch out into individual and specialist funds as their confidence grows and their
in-house capabilities become more sophisticated,” he says.
Sneyer claims even the larger funds that have the ability to set up dedicated teams prefer funds of funds to individual or specialised funds as they have trouble retaining personnel. “The in-house fund of funds managers typically end up leaving for fund management firms.”
Soulignac believes most pension funds remain loyal to their fund of funds investments and switch to individual funds once they have built sufficient knowledge to be able to follow their local market evolution. “In general, when pension funds invest in specialist funds away from funds of funds, it is local-based geographic investments. They tend to invest in their local markets or large pan-European funds,” he says.
Muster agrees resources play a part in how pension funds choose to invest in private equity. “Certainly small pension funds remain with external fund of funds managers because they can’t afford to set up specialist in-house teams. But this is also true of some mid to larger schemes. We must not forget that another significant reason funds of funds remain a popular way into private equity is they offer reduced risk, since the dispersion between good and bad performing private equity stocks is much wider than among quoted stocks.” He says funds of funds ensure pensions get the best private equity investment strategy and returns on a consistent basis and make getting out of private equity stocks easier as these are traditionally harder to exit than their public listed equivalents.
Moreover, Muster says it is becoming increasingly popular for pension funds to look at socially responsible investments (SRI) and this is definitely an area funds of funds dominate. “There is definitely a trend towards SRI and sustainable investments but even the very biggest funds would have difficulty building the expertise and knowledge to take this on board themselves. It’s still considered a niche area and so investing in SRI funds is more or less exclusively through fund of funds vehicles.”

Muster believes the trend for pension funds to invest in private equity is set to continue for some time. “It is a slow process but more and more of our pension fund clients are looking at private equity when they conduct their asset liability studies. It is an area of steady growth. We now conduct private equity seminars every six months and the number of applicants is rising,” he says.
Sneyer sees no let up in the trend towards private equity investing either, even among countries, such as Italy, that are traditionally shy of alternatives. “Private equity offers higher return rates than public listed stocks, so pension funds across Europe that have cash to lock up for 10 to 15 years are investing more and more this way. And funds of funds are the clear winners since they offer a greater level of exposure and diversification without the expense of dedicated staff.”
Soulignac says while he appreciates the growth in interest pension funds in Europe have shown in private equity through funds of funds, he fears there are not enough established managers around to see this interest translate into actual investment. “The development of funds of funds is certainly on the increase and whilst pension funds are keen to allocate appropriate assets to the asset class, there appear to be few adequate management teams with a long-term track record to make this reality.”