Introducing ‘funds of firms’

J-curve mitigation, portfolio analysis and similar terms are some of the similarities between secondaries funds and the strategy of taking stakes in private equity managers.

Not long ago, the secondaries market was a little-known, fledgling part of the alternatives universe. Today, it generates around $40 billion in annual deal volume, with healthy competition for transactions and record levels of dry powder to invest.

An interesting strategy that looks like it may have a similar growth trajectory is “funds of firms”: funds established to acquire stakes in GP businesses. Firms including Goldman Sachs Asset Management, Credit Suisse and Hycroft have set up platforms to take minority stakes in private equity managers themselves.

While the strategy doesn’t compete directly with secondaries, there are a few similarities.

The most obvious is J-curve mitigation. Fund of firms managers I spoke to this week were quick to point out the strategy has a very shallow J-curve, because you’re getting cash back from day one. As with secondaries, you don’t have to wait four or five years before you start getting returns, according to Thomas Morgan, co-founder and managing director of Hycroft Capital.

Another is portfolio analysis. Buying stakes in private equity firms requires evaluation of both the GPs themselves and their portfolios; the due diligence shares many similarities with secondaries, I’m told.

Terms for fund of firms vehicles are also more akin to secondaries funds, which often come with a 1 percent management fee and a 10 percent carry rather than private equity or hedge funds’ traditional two-and-twenty. Dyal Capital Partners III, a fund managed by early fund of firms pioneer Neuberger Berman, has a carry rate of below 15 percent and charges a 2 percent management fee on committed capital, which actually drops to 1.5 percent when the capital is invested and disappears after 15 years, according to documents from the New Jersey’s State Investment Council.

There’s less competition too, a luxury secondaries buyers enjoyed a decade ago when the market was still nascent. To date, there have been as few as four examples of funds of firms taking stakes in private equity GPs, and sources I spoke to pointed to the small handful of firms active in this space.

Of course, there are obvious differences between the strategy and secondaries.

Secondaries funds have finite lives, whereas funds of firms have varying structures: some provide permanent capital vehicles.

The returns are driven by different dynamics – secondaries funds hinge on valuation and purchase price (among others things), whereas funds of firms benefit from the performance of the GP itself and its cashflows, including, importantly, its carry.

Despite these differences, the strategy appears to be pushing new and innovative developments in the private equity market, following in the footsteps of secondaries buyers like Coller Capital and Adams Street Partners, who broke new ground decades ago.

As one manager at a fund of firms hypothetically put it: “I’m not investing in Apollo Fund VII, I’m getting 10 percent of whatever Leon Black puts in his pocket.”

Now who wouldn’t want in on that?

What’s your view on funds of firms? Let me know: