Two recent transactions - Pioneer's purchase of Momentum and Man's acquisition of RMF - have highlighted the issue of valuations of fund of funds companies.
It is tempting to take the view that fund of funds is a temporary phenomenon. If a hedge fund is an instrument for a sophisticated wealthy investor, why pay a double level of fees to get into the underlying investments? Granted you get the benefits of diversification and less administration, all these come at a cost. If you are a sophisticated investor, you should be able to handle a portfolio of single manager hedge funds and cut out the middlemen. Surely, fund of funds is a phenomenon that will get disintermediarised in time.
But our experience tells us that particularly in Asia, this is not the case. Demand for alternatives in Asia is for funds of funds, not hedge funds. Partly this is due to the incipience of the market in Asia. Investors just do not have the technical expertise to evaluate individual hedge funds. Therefore they are getting their alternative exposure by sticking their toes in funds of funds which are perceived as being safer. Certainly from an Asian perspective this will be the case for at least the next five years.
What is the rationale for a fund of funds being worth 10% of AUM compared to say 3-4% for long-only money and 5-6% for specialist funds (i.e. smaller company or tech focused)? The answer lies with the profitability potential of fund of funds, which usually charges approximately 1% management and 10% performance. Simplistically assuming that a hedge fund returns 20% per annum, the fund will gross 3% of AUM being 1% plus 10% of 20%. This figure can be augmented further if any capital introduction fee is charged and gets credited to the fund of funds management company.
Compare that to long-only mandates where fees are now well below 1% and falling. There is little pressure on fees for funds of funds or any alternatives at the moment. Furthermore, looking at the cost side, a fund of funds employs very few people - usually a statistics person, the decision maker and owner, and a marketer. Contrast this to the staff required for a long-only fund or even a hedge fund and it is clear that the operating margins in running a fund of funds is very favourable. Also, funds of funds do not require expensive analysts like other funds. This means they should be worth more than other kinds of funds on a strict measure of value to AUM.
Then there is the overall alternatives versus long-only argument. Currently only 1% of global fund assets are in alternatives. Even if this number is to grow at 25% per annum for the next ten years, alternatives would still only be 5% of the market. Given the conventional wisdom that 15-20% of long-term wealth should be in alternatives, this type of growth supports those valuations.
The problem of valuing funds of funds is they tend to be private companies so it is difficult to put values on them. They are growing so fast that even if one can come up with a percentage of AUM valuation formula, one does not know which year end to apply it to. It is very common now to see funds of funds doubling AUM each year. While this growth is the reason for the high valuations, it also makes pinning down a precise valuation more difficult.
We believe that the factors to take into consideration in the valuation of a fund of funds business are:
- The performance of the fund as measured by annualised returns.
- The length of the track record of the fund. If the fund has actually been invested for five years, it will be more credible than a fund which has been in existence for five months but is claiming a back-tested synthetic track record of five years.
- The underlying hedge funds that the fund of funds owns and whether it has capacity in the "good " hedge funds. Many of the best hedge funds are now closed to new money. A fund of funds that has stakes in closed funds will attract a scarcity premium.
- The size of the fund. Smaller US$50-250m funds of funds are probably worth less than a US$1bn size fund on the basis of value to AUM because of the economies of scale argument. We are seeing a trend for many smaller funds to merge.
- The synergies between the buyer and seller. Something is worth what some one else is willing to pay for it. A long-only house keen to get into alternative investments may be tempted to over pay for a quality fund of funds with a good track record and branding.
- What is interesting from the table above is the valuation on the listed companies. Both Man and Sparx are more hedge fund managers rather than funds of funds. The higher valuations could be the result of a listing effect or proprietary technology and expertise. Alternatively it could be just a reflection that from a valuation point of view, the 2% management and 20% performance fees that hedge funds charge is worth more than the 1% and 10% fees of a fund of funds.
The traditional view is that hedge funds are not worth a lot because the funds are tied to the manager. If he leaves or gets run over by a bus, the fund would collapse. However, if the hedge fund is not a one-man band but a multi-strategy, multi-product and multi-manager organisation with a branded market presence, that would be different. Considerable economies of scale develops in areas like risk management and marketing. If one decision-making manager leaves, another could be slotted in with minimal disruption. No such business currently exists in Asia but they will and potentially be worth more than the 9% level for funds of funds.