Over the past six years, private equity has experienced an aggressive growth, both in terms of capital under management and amount invested, and fund of funds with their specific techniques and particularities, especially pure primary and pure secondary funds, have demonstrated their various advantages. Even in such a tricky economic environment, do fund of funds still allow investors to take advantage of private equity ?

1) Update of the private equity fund of funds business in 2002
o Situation of the private equity industry in 2002.
After a five-year period of constant and significant growth, 2000 has been the year of a downturn, reducing the euphoria and slowing the flows of funds into the industry. This is showing the market the way back to fundamentals.
The ‘euphoria’ period lasted around five years, from 1995 to 2000. Carried by the growth of stock markets, institutional investors enjoyed larger resources. Looking for diversification and attracted by high returns on private equity investment, they allocated more capital to the private equity industry.
The ‘deceleration’ period started in 2000 with the slowdown on stock markets. Some fund managers, especially the euphoric ones, have had to cope with difficult situations for their portfolio companies. Investors’ returns in the industry have been decreasing and investors might be less attracted to private equity.
However, private equity has not changed: companies still need to strengthen their equity, and many industrial sectors (biotechnology and high technologies included) still need capital.
Last year has shown the continuation of this deceleration period, with a global slowdown of both raised capital and investments, in the US and in Europe.
In line with the general slowdown in the economic activity and the aggressive decrease of international stock markets, the investors generally remain extremely cautious in their private equity investments, due to the slowdown of distributions in cash and the erosion of net asset values.
The situation of the private equity industry can be compared to the situation of 1991/92: a worldwide economic crisis, weak stock markets and an automatic global overcautiousness of institutional investors.

o Funds of funds are still of interest.
In such a difficult environment, private equity funds of funds remain an effective vehicle: they allow investors to take advantage of private equity while still controlling risks. The delegation to a fund of funds team for managing non-listed assets gives the opportunity to make the best of a complex environment and still provide investors with higher performance than in other asset classes. For some of them there is an optimum risk/diversification ratio and a high selection of underlying funds.
Two major points characterise the private equity fund of funds business:
o Proliferation: on a worldwide basis, the funds of funds underwent important growth over the past five years with now more than 100 vehicles currently under management.
o Heterogeneousness: on a European basis, the funds of funds are extremely different one from the other. The main differences are:
l Type of assets (combination of primaries, secondaries and co-investments in companies)
l Investment mode (guaranteed bonds, non quoted or quoted)
l Sector of activity and geographical focus
l Type of investor
l Size of investee funds
The crucial issue is choosing the right fund of funds management team, the specialised, recognised and experienced team that will be able to offer high performance to investors with risk diversification and quality of reports.
Three major points must be taken into consideration to select a fund of funds manager :
l Performance: the concept of performance deals with four elements that cannot be analysed separately: IRR, multiples, timing and return in cash. Only the synthesis of these elements can show the global performance of a fund of funds manager.
Performance also has to be proven – the point is to demonstrate how the performance is obtained – and sustained on a long-term basis. Only a few teams have demonstrated such proven performance over several private equity cycles.
l Team: the fund of funds management team needs to appear homogeneous and coherent with capital under management. Fund managers also need to have an extensive experience in private equity and in other businesses. Back office departments have to provide investors with useful information and transparent reports. Teams have to be structured as private equity organisations – one manager for one investment – rather than asset management teams with distinct research analysis and trading departments.
l Strategies and deal flow: investment strategies will differ from one fund of funds manager to another but all strategies need to be clearly specified to the investor. On the other hand, the seniority and established presence in the market of the fund of funds manager will provide investors with investment opportunities.
A solid and consistent performance combined with the seniority of the management teams give the investor the opportunity to benefit from the most interesting investments in private equity.
In selecting its fund of funds manager, the investor must choose on the basis of how they do in the race for performance rather than on volume.

2) The primary funds of funds
o Description: Primary funds of funds invest in funds at their inception and such investments are long term investments equivalent to direct investments in private equity funds. Primary funds of funds are able to provide investment institutions with large diversification in terms of geography, industry, interventions (venture, growth, buyout) and investment strategies.
o The reasons for success: Direct investments in private equity funds needs important cash allocations as minimum capital commitments applicable for the best private equity managers have continued to escalate. Moreover, top-quartile funds are often oversubscribed and many of them are accessible by invitation only, even in such a deceleration cycle private equity industry goes through.
This ‘elitism’ in best private equity investment opportunities partly explains the success of recognised fund of funds managers who are able to offer financial institutions with the access to these vehicles while offering diversified and risk-adjusted portfolios.
There are middle-sized private equity management teams, very experienced with a high performance track record, but little known. Only funds of funds are able to select this type of investment opportunities and make their investors take advantage of them.
o The selection of primary funds: Pure primary funds of funds require a very proactive strategy from the fund of funds manager and due diligence and selection process needs to be very rigorous and disciplined.
Investment decisions in primary funds are based upon three main elements :
l As investments in primary funds remain ‘blind’ investments, the primary fund of funds manager focuses on the past and forecasted evolution of the general partners. The due diligence process of the management team is of prime importance and is made on a long period of time. A strict analysis is made on the quality, the experience and the profile of each professional. One of the key issues is to estimate the capacity of the whole management team to work together and to estimate how the renewal of the generations is managed.
l A second emphasis is made on the primary fund manager’s track record. Total performance, breakdown of performance by member of management team, breakdown by vintage of investments are analysed by the fund of funds manager. Then a comparison of past performance with the top quartile and with a certain number of competitors in the same area. Track record needs to be consistent and to provide high performance on a long term basis.
l Any new primary investment opportunity is then analysed considering the investment strategy, the geographical focus in conjunction with the quality of the management team and with the current market conditions. When analysing primary funds, emphasis is made upon the capacity to provide the investors with high performance in terms of IRR (Internal Rate of Return) and multiple. This capacity to provide top quartile performance is of prime importance for the fund of funds managers.

3) The secondary funds of funds
o Description: The secondary markets date back to the global economic crisis of early 1990s, which produced a large lack of liquidity among lots of financial and corporate institutions, especially those with ‘illiquid’ assets such as private equity. This situation created new activities in private equity market: secondary funds of funds.

Different types of intervention. There are two main types of transactions. The first one is based on auctions. The seller or its intermediary organises the sale of a portfolio of interests in private equity approaching a certain number of potential buyers, pre-selected or not. These transactions concern mega transactions involving hundreds of million of euros. These transactions are often linked to mergers, a total change in investment strategy or corporations focusing on their core activities.
The second type of intervention is the detection of secondary investment opportunities. This concerns more limited transactions in size. Thus, Fondinvest Capital, a secondary player specialised in mid-market transactions worldwide, invests in secondary transactions on a proprietary deal flow basis, that is to say with little competition. This requires long experience in investment in funds, technical expertise in valuation transactions, seniority in relationships with general partners, limited partners and a high degree of confidentiality.
o The reasons for success
Acquisition of secondary positions offer the following advantages :
l Secondary market positions can usually be purchased with discount on re-evaluated net assets, especially if the purchaser is experienced and has developed a proprietary deal flow.
l Investments in secondary acquisitions are made in funds with significant amounts already invested, which eliminates the risk of ‘blind’ investments.
l It offers acceleration of financial returns, which gives more liquidity and security to the investor.
o The selection of secondary opportunities.
A secondary fund of funds manager bases its analysis for objectives based on performance – IRR and cash on cash multiple – but also on the notion of return on cash in a shorter period (for example when 100% of the commitment of the fund has already been returned to investors).
Thus secondary acquisitions require a deep analysis of each underlying company, which is made to compare the value with the one communicated by the general partner and allows the evaluation of the possible year of exit and the expected amount of exit.
The quality of the general partner is also of prime importance: the quality and experience of the management teams is estimated, with the profile of each professional, their capacity to work together.
Investment decisions in secondary funds are based on:
l a demonstrated expertise in direct private equity, including a systematic approach to evaluating underlying companies;
l experience in having dealt with a large number of transactions;
l experience in having secured its secondary transactions with a high degree of confidentiality;
l the ability to deliver proposals on a short term basis and proven flexibility in negotiating with the seller.
Confidentiality, expertise in direct investments, flexibility and non-competitive acquisitions are the basis of successful secondary funds of funds.

4) Comparison among primary and secondary funds of funds
Pure primary and pure secondary funds of funds are very different one from the other in terms of philosophy.
The primary markets require long term investments, from eight to 12 years generally. In that case, the fund of funds manager overbids a specific management team, often specialised in a particular market or geographic area, in a specific sector. The investment process requires time and capital calls are spread over a period of four to five years.
On the other hand, the secondary markets can be considered as an opportunist market. Emphasis is put on performance and speed with which cash is returned as investment horizon is generally below eight years. Unlike the primary funds of funds, secondary opportunities require adaptability and quick decision-making. Usually, capital calls are limited to a two to three years period.
In terms of performance, primary funds of funds usually offer high multiple and IRR levels as secondary funds of funds offer high IRR levels with lower multiple levels as emphasis is put on quick returns.

5) Answers to investors’ objectives.
The institutional investor who decides to invest capital in a private equity fund of funds first of all seeks a large diversification of risks. Moreover, he chooses the fund of funds management team able to offer high performance thanks to its seniority, its experience and the consistency of its track record.
Then the investor has to specify a horizon and major objectives in terms of performance: IRR or multiple, and speed with which cash is returned.
If the global asset structure allows long term liquidity (insurance companies or pension funds), the primary funds of funds are able to provide an answer based on a high multiple level.
On the other hand, if the global asset structure privileges a shorter term liquidity (banks for example), the secondary funds of funds are able to provide an answer based on quick returns and high level IRR.
However, a certain number of investors with long term management horizon may mix these two types of funds of funds in order to answer short term priorities.