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
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
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
- 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.