“We think that due to the fee structure of alter-native investments, with the incentive fee and alignment of interest and so forth, some of the most talented money managers have migrated to hedge funds or private equity or real estate; so we want to get access to the smartest people in the investment universe,” says John Cox, director of alternative investments at the advisory firm Charles D. Haines LLC in Birmingham, Alabama. “They also have tools available to them that you don’t have in traditional money management.”
Unfortunately, the most desirable alternative investment products are often inaccessible to high-net-worth investors and their advisors because of prohibitive minimum investment levels, funds closed to new investors, and onerous due diligence demands. But other means of access exist. This article will focus on the ways some RIAs gain exposure to private equity, managed futures, and hedge funds for their clients.
A previous article in Investment Advisor (“Behind the Curtain,” April 2007) explored the reasons RIAs use alternative investments. A subsequent article will examine risk factors in these investments and precautions necessary to protect investors.
Private Equity: Funds of Funds
The stellar returns of the past five years are the chief attraction of private equity investments, says Rick Rickertsen, managing partner at Pine Creek Partners, a private equity firm based in Washington, D.C. These investments not only “juice” the portfolio, but also provide important diversification. However, steep minimum investments, in the $5 million to $10 million range, make investments in individual funds prohibitive for all but the wealthiest individuals.
At Charles D. Haines, clients for whom private equity is appropriate have a 6% to 10% allocation, says Cox. Because of the difficulty of getting significant diversification and access to top-tier managers, the firm works exclusively with two funds of funds. One is Park Street Capital in Boston, whose seven principals have been making private equity investments for more than 10 years.
Fort Washington Capital Partners Group in Cincinnati has operated a fund-of-funds program since 1999. It currently manages five national funds of funds, as well as a series of regional ones and a co-invest fund. The firm is the private equity arm of Fort Washington Equity Advisors, an RIA that runs $30 billion for its parent, The Western-Southern Life Insurance Co., and for third-party clients.
FW Capital caters to pensions, foundations, endowments, and some high-net-worth investors, the majority being retired entrepreneurs with assets in the $50 million to $100 million range. It requires a minimum investment of $3 million.
According to managing director Steven Baker, FW Capital invests in best-of-breed venture capital and buyout funds; approximately 80% of its capital is invested domestically, with 20% invested elsewhere. The firm also offers a separate program for individual clients.
Diversification is a key advantage of using funds of funds to gain exposure to private equity (for more on diversification in private equity, see sidebar below). With an FW Capital product, says Baker, investors get access to 15 to 25 venture, buyout, and special situation limited partnership vehicles.
The Due Diligence Issue
Amid so much diversity, finding the best managers in each category puts a very heavy burden on due diligence. Top-tier funds of funds are well equipped to handle this. “The difference between an average venture capital or buyout manager and a top-quartile venture capital or buyout manager is immense–many, many basis points,” says Baker. “Because private equity investments are 10- to 15-year partnerships,” he points out, “a lot of homework upfront is crucial–on the reputation of the firm, its track record, and its standing in the community in terms of what the banks think of it if it’s a buyout shop or what entrepreneurs think of it if it’s a venture capital fund.”
FW Capital for the most part does not invest in the first of a series of funds, says Baker. “We typically try to steer our capital to well-established firms that have been doing this for a long time, and have very solid organizational structures and processes.”
Another huge advantage of a fund of funds is operational simplicity. Even for an investor wealthy enough to be able to invest in a diversified assortment of 15 to 25 funds, allocating to these vehicles involves much complexity. Baker points out that private equity funds are just-in-time vehicles: An investor makes a capital commitment, then funds capital calls on those commitments. Commitments to 15 to 25 funds means funding each of them four or five times a year; operational complexity mounts. Each fund provides a quarterly report, and each provides a Schedule K-1; the timely receipt of these will determine whether the investor will be able to meet certain tax-filing deadlines.
“With a fund of funds, you basically do three or four capital calls a year for the investment period, you get one K-1, and you get one report,” says Baker. “That’s pretty compelling for people who are busy and who have other things they would like to be doing with their time.”
Finally, high-net-worth clients want customer service, something large institutional private equity shops aren’t suited to provide, says Baker. “They’re used to seeing their institutional and limited partners at annual meetings, and they talk to them periodically on the phone, but it’s a very businesslike relationship. High-net-worths sometimes want to understand more about what’s going on in the portfolio or more about the life cycle and details of the investments.”
Managed Futures: How Much to Allocate
Charles D. Haines has been investing in managed futures since 2001. This strategy, to which the firm allocates 5% to 7% of client assets, is “one of the most powerful asset classes in terms of the correlation benefits; sometimes it’s even negatively correlated for long periods,” says Cox.