Fund of Funds
Definition
A fund of funds is a private fund whose investments are limited partnership interests in other private funds rather than companies or assets. Its manager raises commitments from investors, selects underlying funds, commits to ten to thirty of them across managers, strategies and vintage years, manages the capital calls and distributions of the whole portfolio, and reports a single set of returns. For this it charges a management fee, typically 0.5 to 1 percent of commitments, and often an incentive fee of 5 to 10 percent of profits, on top of the 1.5 to 2 percent and 20 percent the underlying funds charge. The product exists because most investors cannot reach top managers directly, cannot meet their minimums, and cannot build a diversified private markets program themselves; the second fee layer is the price of that service and is the reason funds of funds have lost share to direct programs, secondaries and single-fund access vehicles.
Why it matters
The fund of funds is the original solution to the problem every individual investor in private markets has: the good funds are closed, the minimums are large, and one fund is a bet on one manager. It is also the origin of the objection that follows every private markets product sold to individuals since: two layers of fees. The registered funds of funds, interval funds holding fund interests, and single-fund access vehicles on wealth platforms are all descendants of it, and the way to evaluate any of them is the way institutions learned to evaluate a fund of funds: what does the second layer cost, in a worked example, against what it delivers.
Common misconceptions
- •The fees are not simply additive. The fund of funds' incentive fee is charged on profits after the underlying funds' carry, and its management fee is often charged on commitments while the underlying funds' fees are charged on drawn capital, so the effective drag depends on pacing.
- •A fund of funds does not guarantee access to top funds. Many of the most sought-after managers allocate to long-standing direct investors first; a fund of funds' access claim should be checked against the names in its prior portfolios.
- •Diversification across twenty funds does not remove vintage risk. A fund of funds that committed all its capital in 2021 owns twenty funds that bought at 2021 prices.
- •The reported net return is not what the underlying managers earned. It is what remained after the second layer; comparing a fund of funds' IRR to a benchmark of direct funds understates the underlying selection skill and overstates the fee drag only if the benchmark is gross.
Technical details
Worked example: $100,000 through a fund of funds
Underlying funds: 2 percent management fee, 20 percent carry over an 8 percent preferred return; gross return on investments 20 percent a year; net to their investors about 15 percent.
Fund of funds: 1 percent management fee on commitments, 10 percent incentive fee over an 8 percent hurdle.
Year by year, the 1 percent fee reduces the compounding rate from 15 to about 14 percent, and the 10 percent incentive on the profit above the hurdle removes a further half to one point.
After ten years: $100,000 in the underlying funds directly grows to about $405,000; through the fund of funds to about $340,000. The second layer cost about $65,000, or 16 percent of the ending value and 21 percent of the profit.
Whether that was worth paying depends on whether the investor could have reached those funds and built that portfolio alone. For a $100,000 investor, the answer is usually no.
What the second layer buys
Access: commitments to funds closed to new or small investors, secured by the fund of funds' relationships and check size.
Selection: due diligence on managers, including reference calls, track-record attribution and legal review, that an individual cannot replicate.
Diversification: twenty to thirty funds across strategies, geographies and two to three vintage years, narrowing the dispersion of outcomes.
Administration: a single capital call schedule, one K-1, consolidated reporting and the fund of funds' handling of twenty sets of consents and elections.
Cash-flow smoothing: distributions from early funds offset calls to later ones, so the investor's net outlay peaks below the commitment.
The family of structures
Primary fund of funds: commits to new funds as they raise; full J-curve, twelve-to-fifteen-year life.
Secondary fund of funds: buys existing interests at a discount; faster deployment, shorter life, positive early returns from the discount.
Co-investment fund of funds: invests alongside underlying managers in specific deals, usually without the underlying fund's fees, lowering the blended cost.
Registered fund of funds: an interval or tender-offer fund holding private fund interests; 1099 reporting, lower minimums, periodic redemptions at NAV, and a liquidity sleeve.
Access fund or feeder: a single-fund fund of funds; the double layer without the diversification, sold on platforms at $100,000 to $250,000 minimums.
Why institutions moved away from them
Fees: as pension funds and endowments built internal teams, the 1-and-10 became hard to justify for capital they could deploy directly.
Dilution of selection: a fund of funds with thirty positions delivers close to the median of its universe, and the median private equity fund has not beaten public markets by enough to cover two fee layers in many vintages.
Separate accounts: large investors now hire fund-of-funds managers as advisers on customized mandates at lower fees, keeping the selection service and dropping the pooled vehicle.
The retail pivot: the same managers repackaged the product as registered evergreen vehicles for individuals, where the access and administration arguments still hold.
Reading the document
Find both fee layers and the base each is charged on; ask for a total expense ratio that includes the underlying funds' fees, which registered vehicles must disclose as acquired fund fees and expenses.
Find the number of underlying funds, the vintage spread, and the share committed to funds the manager also runs (affiliated funds create a conflict on selection).
Find the incentive fee hurdle and whether it is measured on the fund of funds' whole portfolio or fund by fund.
Find the pacing: how many years commitments will be deployed over, which sets the J-curve and the cash the investor must keep available.
For a registered version, find the liquidity sleeve, the repurchase cap and the valuation policy for the underlying fund interests, which are marked from the underlying managers' quarterly reports with a lag.
Frequently asked questions
- What is a fund of funds?
- A fund that invests in other funds. Instead of buying companies, a private equity fund of funds commits its investors' money to a set of underlying private equity funds, and its investors own a slice of every one of them. The manager's job is selection, access, diversification and administration, and it charges a fee for that on top of what the underlying funds charge.
- How much does the double layer of fees cost?
- Roughly 1 to 1.5 percent a year of additional drag plus 5 to 10 percent of profits. On underlying funds that return 15 percent net, a fund of funds charging 1 percent and 10 percent carry delivers about 12.5 to 13 percent to its investors. Over a ten-year program the second layer commonly consumes a fifth to a quarter of the net return the underlying funds generated.
- Why would anyone pay two layers of fees?
- Access and diversification at small size. A fund of funds with $500 million can commit $25 million to each of twenty funds, several of which would refuse a $1 million direct check. An investor with $1 million gets exposure to all twenty. The manager also handles the calls, distributions, reporting and tax documents of twenty partnerships, and a fund of funds' return dispersion is far narrower than a single fund's.
- Is an access fund a fund of funds?
- Structurally similar, economically narrower. An access fund or feeder commits to one underlying fund and charges its own fees on top, so it has the double layer without the diversification. A fund of funds commits to many. Both are funds whose assets are fund interests; the access fund is the single-fund special case that wealth platforms sell.
- What is a secondary fund of funds?
- A fund of funds that buys existing interests in underlying funds from investors who want out, at a discount to NAV, rather than committing to new funds. It enters funds later in their lives, so it deploys faster, avoids most of the J-curve and can report positive returns early. Many funds of funds now combine primary commitments, secondaries and co-investments in one vehicle.
- How is a fund of funds taxed and reported?
- As a partnership. Investors receive one Schedule K-1 from the fund of funds, which itself receives K-1s from every underlying fund, so the fund of funds' K-1 is often the last to arrive each year and frequently requires an extension. Registered versions, structured as tender-offer or interval funds, issue a 1099 instead and have become the common wrapper for individuals.