Why go the funds route
A recognised asset class
Over the past five years, private equity has experienced a growth never seen before, both in terms of capital under management and amount invested. Although the US accounts for two thirds of the industry globally, Europe, after its substantial growth, has raised about e30bn by 2000 with a comparable amount invested. This equates to a sevenfold increase over the past five years.
This recent enthusiasm shown by a number of investors can be explained by several factors:
q limited returns for bond investments
q lack of visibility on equity markets
q a permanently growing economy
The rise of the “new economy” and the development of technologies, such as telecommunication and media technologies, combined with the arrival of various actors (business angels, seed funds), has made private equity unquestionable attractive.
This flow of funds, or supply, triggered the increase in amounts invested, or demand. The situation resulting from this tremendous growth might appear to some as unbalanced and the chances are that the returns witnessed recently will not be sustained over the years to come.
An asset class that remains complex
The comparison of the private equity industry in Europe in 1990 and in 2000 shows the complexity of making an investment:
q the number of teams grew from 200 to 1000.
q average size of fund went from e50m up to e600m, with the launch of mega-funds (more than e3bn funds).
q total number of funds raised per year went from 20–30 up to over 100.
q performance range went from +98.8%/–76.6% to +624.5%/ –84.7% as provided by Venture Economics.
q for a large number of players geographic coverage went from national to European and even global for a few of them.
q passive investment strategies have moved to active shareholding strategies.
q positions in companies have gone from minority to majority.
q realisations of investment have partly gone from sale to the market after IPO to trade sale, particularly for young companies.
All these changes took place gradually and created a patchwork of different situations, turning the private equity industry into a complex asset for investors.
2000, a year of “euphoria” and certainly a year of change for the market.
2000 began in the same euphoria as the previous three years, which were boosted by the strong growth of investments in high tech areas and internet. Investors, being shown IRR returns above 100%, kept on investing massively. A large number of investors, as well as private equity fund managers, forgot some basic fundamentals. First of all, private equity performances have to be measured over a long period of time. Then, an IRR approach only makes sense if it covers a significant enough period, at least five years. Moreover, the notion of return on investment on cash did not seem to be a significant measure.
The stock market turnaround in March 2000 modified the private equity industry for a number of reasons:
q A gradual decrease in allocations directly linked to a mechanical over-allocation due to the downmove in value of stock markets.
q A number of fund managers, particularly those active in early stage investments, realised that a company couldn’t have a long life doing only sales without turning a profit, and with management methods varying too much from conventional methods.
q The myth of liquidity through IPO.
In that sense, 2000 has been the year of a turn in the market, slowing the euphoria of flows of funds into the industry and showing the market the way back to fundamentals. This year will have showed the cycles of private equity evolution.
Private equity, a cyclical industry.
The analysis of 20 years of development of private equity in Europe, shows obvious cycles illustrated by the chart below.
Two periods can be identified:
q Euphoria: 1985 to 1990 and 1995 to 2000.
Carried by the evolution of stock markets, institutional investors enjoy larger financial resources. Looking for diversification, they allocate more funds to private equity. Institutional investors are also attracted by high potential returns on investment of the industry, the performances of which are boosted by high exit values.
Fund managers already active on the market enjoy substantially more financial resources. Thanks to this dynamism they are in a position to offer satisfactory returns. However, they have to face an increase in price for their new acquisitions. At the same time, they also have to face new entrants on the market, less experienced and sometimes not as rigorous in terms of valuation or investment conditions.
q Deceleration: 1990 to 1995 and 2000 to …?
Institutional investors face a slowdown on stockmarkets and therefore have less funds to allocate to private equity. This situation derives from an allocation system which does not rely on risk/reward criteria but on asset classes.
Some fund managers, especially the euphoric ones, have to cope with difficult situations for their portfolios, particularly from a liquidity point of view. In addition to this, some players have decided to withdraw from the industry.
Investors’ returns in the industry decrease and investors are less attracted to private equity.
2001 – 02: the right time to invest
Since the second half of 2000, the private equity industry has been experiencing a slowdown in its expansion. First signs are already showing that the industry is changing and that clients, ie, investors, are now in a stronger position vis-à-vis fund managers.
The fact is that since autumn 2000, it has become significantly more difficult to raise funds from substantial investors. Thorough due diligence is more and more frequent and investment decisions take longer. Generally speaking, fundraising has experienced a serious slowdown since the second half of 2000.
Still, this evolution in raising capital has not changed the private equity business: companies still need to strengthen their equity and large corporations keep on disposing of some of their subsidiaries. The high tech and internet areas still need capital.
A good side of the slowdown is that acquisition prices are decreasing, in some sectors, significantly so. Fund manager teams which have been able to remain cautious, in general professionals who have performed well, and who are not involved in difficult and time consuming investments, will have the means to be active investors further down the road. It lies with the investor to choose the right fund manager teams.
In order to remain active in their market and to achieve attractive new investments, other fund managers will have to reduce their commitments to some investments, particularly those too demanding in terms of both time and money, and for which returns are hard to predict, especially when it comes to timing.
Investors in private equity funds will have to re-assess their asset allocation, partly due to the lack of visibility on some private equity funds’ return and to keep on selecting the best management teams. Furthermore, they will have to sell some of their commitments to get liquidity earlier.
Funds of funds represent undeniable investment opportunities
Today, funds of funds have become popular in the private equity industry and they have a more and more significant impact worldwide:
q their number is growing consistently : 55 in 1998, 66 in 1999 and more than 100 in 2000.
q amounts invested in them are increasing
substantially : $14.1bn in 1998, $ 18.7bn in 1999 and over $25bn in 2000.
q contribution to private equity has been higher each year: 12.1% in 1998, 15.6% in 1999, and over 20% in 2000.
There are a number of reasons for the success of funds of funds managed by Fondinvest :
q syndication and diversification of risks
q selection of underlying funds (geographic focus, team, investment stage, performances,)
q focus on top quartile private equity funds/managers
q optimisation of the balance between risk, IRR and multiple
q minimal initial investment in comparison to the exposure and access to funds gained
q follow up of investments and administrative tasks simplified.
Large European banking groups, for whom marketing and sales power is a strength, have already chosen multi-management for their traditional stocks and bonds products. They carry on their development with the launch of private equity funds of funds management companies.
This significant move confirms that private equity is an asset class that cannot be neglected and that funds of funds represent, for managers as well as investors, the most adequate vehicle given the current market conditions.
No matter what the investors’ abilities and amount invested are, funds of funds are an effective vehicle. They allow the investor to take advantage of private equity while still controlling risks. Further more, to delegate to a specialised, recognised and experienced team, the management of non-listed assets gives the opportunity to make the best in a difficult environment.
The selection of the best funds of funds management teams is crucial to benefit from the most secure opportunities.
The quality of the team managing the fund of funds is of prime importance. Two key points appear significant to them :
q The length of time actively involved in investment in funds
q The performance realised by invested funds.
In Europe, and particularly on the continent, very few teams and even fewer people can show such expertise.
Our firm has raised four funds of funds, representing a total of over e350m under management.
These funds were raised from US and European investors, and sponsored by CDC IXIS Private Equity (formely CDC-Participations), the private equity subsidiary of the AAA/aaa institution Caisse des Dépôts.
Primaries funds of funds, Fondinvest I (e50m) and Fondinvest III (e100m) are focused on Europe.
Secondaries funds of funds, Fondinvest II (e70m) and Fondinvest IV (e130m) are focused worldwide.
The management team has a collective expertise of 60 years in company analysis and 45 years in private equity investment.
Fondinvest Capital funds bring investors results through :
a) Product :
q Investing indirectly in funds with top tier performance
q Obtaining a high degree of asset allocation, because of the diversity of the categories of investments, by industry type, by manager and by country.
q A deep knowledge of the business has allowed the development of a unique methodology in selecting funds for investment.
b) Organisation :
q Avoiding costs of maintaining a team
specialised in the private equity
q Allocating adequate funds in terms of amount and time
c) Return on investments :
q Producing top quartile private equity performance
q Giving quick return on investment
d) Reports :
q Regular and high-quality information.
Because of our seniority and established presence in the market, we can deal with a huge range of funds.
As far as primary funds are concerned, some managers are raising money (only by invitation) because of their seniority and quality of performance. These managers aim to set up a round table of well known investors having ongoing financial resources and a comprehensive understanding of private equity.
Due to our long term and proven expertise in funds investments, we bring to these managers added value. Thus, these funds managers are pleased to have us investing in their funds.
As regards secondaries funds of funds, we have a significant share of the European market.
These investments cover mainly repurchases of stakes in existing funds and portfolios of funds at the end of their lives. Then we entrust selected specialised and autonomous teams to manage the liquidation of these portfolios of shareholdings.
The market of the shares acquisition in existing funds, as in portfolios, is a recurrent market. However, reasons for transfer change down the years – liquid assets, re-allocation of the assets, and the understanding of the private equity.Thus, through our new secondary fund Fondinvest VI and primary fund Fondinvest V, both to be launched in 2001, we can be of interest to investors of all sizes.
Our team has demonstrated through their performance their expertise by investing in over 110 funds, and by managing four funds of funds. Thus, Fondinvest Capital, one of the leaders in private equity funds of funds, can offer high quality and performance to investors. Even if the private equity industry has just entered a less attractive period, Fondinvest Capital will still continue to offer opportunities to investors :
q On primaries: thanks to its thorough and senior knowledge of fund managers, Fondinvest Capital will select the teams which have been able to perform well on a long-term basis and to manage safely the 1998 to 2000 euphoria.
q On secondaries : Fondinvest Capital will be able to detect and select the best profitable opportunities which will derive from the turn in the market following that very euphoria.
Charles Soulignac is chief executive officer of Fondinvest Capital, part of CDC - IXIS Private Equity, in Paris