Should Fund of Funds Pioneer General Solicitation?

The past several years have been difficult for many private equity fund of funds (FOFs). Between the economic downturn and aversion to double-layered fees, traditional LPs have grown weary of the investment vehicle.

The challenges can be seen in FOFs’ diminishing contributions to the private equity asset class. According to a recent Preqin report, 165 private equity FOFs contributed only 5% of the aggregate capital raised in 2012, down from the 11% contributed by 168 FOFs in 2009. The lower market share is likely a consequence of the difficult fundraising environment of late.

The report explained, “fundraising conditions for funds of funds [were] extremely challenging throughout 2012. In addition, as the private equity asset class continues to grow and mature, investors are becoming increasingly sophisticated, with many looking to invest directly in funds to avoid the double layer of fees associated with funds of funds.”

Member Shawn Atkinson of Atkinson Capital and Quidnet HF Fund echoed similar sentiments. “The road ahead will be difficult for funds of funds. While the large ones are getting larger, it is definitely a hard environment to launch a fund of funds,” he said.

With many traditional LPs becoming dissatisfied with the investment model, FOFs are in need of a new pool of investors — and the JOBS Act may be the answer. Once the JOBS Act was enacted earlier this year, a new pool of investors — those wealthy enough to be accredited, but not quite wealthy enough to have a family office — became accessible to managers through the more cost effective means of general solicitation.

Less seasoned investors tend to be drawn to FOFs and similar vehicles like mutual funds. As Preqin explained in its report, “Fund of funds have traditionally played a key role in the private equity industry. When considering an allocation to private equity, many smaller, less experienced investors turn to fund of funds managers to help them access the asset class.” In addition, they require smaller capital commitments and shorter time frames, as shares can be more easily traded on the secondaries market.

The JOBS Act has enabled FOFs to proactively reach out to these highly relevant investors, making the potential pool of capital significantly larger.

While few private equity and venture capital funds have embraced the publicity offered by general solicitation, FOFs may be the more appropriate initial vehicle. Since few of the new investors will feel comfortable managing and selecting viable investments in one or two funds, the FOFs can serve as an ideal entry point to the asset class.

The Preqin report continued, “Fund of funds allow LPs to benefit from the experience and resources of fund of funds managers while requiring smaller commitment sizes and providing exposure to a variety of fund types and geographies. They also provide an important access point for investors looking to invest in strategies or geographies where they may not have previous experience, or where access to top fund managers may be challenging.”

While Atkinson focuses primarily on hedge funds, he has seen similar success with smaller investors. “We have seen a great deal of interest from smaller family offices,” explained Atkinson. “They tend to feel more comfortable in fund of funds because 1) they have difficulty identifying a best fit in a single hedge fund and 2) they appreciate the diversity of funds.” As many new JOBS Act-supported investors enter the alternatives market, funds of funds may appear to be an accessible and logical first step.

As fundraising from institutional investors becomes increasingly difficult, the private equity FOFs that harness the advertising potential of general solicitation will be the ones that can overcome the current fundraising slump and survive natural selection. Since their capital will most likely be deployed in smaller funds, FOFs can become the perfect advertising vehicle for middle market and lower middle market groups.

“I think there will always be a place for fund of funds. With thousands of [private equity and hedge] funds out there – and new ones being formed each day — identifying the best performers that match your investment style is quite difficult,” said Atkinson.