Fund of Funds

How a fund of funds works

A fund of funds is an ordinary private fund whose assets happen to be interests in other private funds. It raises committed capital from its own limited partners, is managed by its own general partner, has a stated life, charges a management fee and carried interest, and reports to its investors. The only structural difference is what sits on the asset side of the balance sheet.

The activity divides into three sleeves, and most large programs run all three.

• Primary commitments. The core activity: committing to a manager's new fund at first or final close, on the same terms as any other limited partner.
• Secondaries. Buying an existing limited partner interest from a seller partway through a fund's life, usually at a negotiated price against the reported net asset value. This shortens the cash cycle because the purchased interest is already partly invested and may already be distributing.
• Co-investments. Investing directly alongside an underlying manager in a specific company, usually with reduced or no fees. Co-investment is the main way a fund of funds offsets its second fee layer.

The cash mechanics are the part most people get wrong. A fund of funds does not hold cash waiting to be deployed. It makes commitments, and those commitments are drawn by the underlying managers over their own investment periods. The fund of funds then calls capital from its own investors to meet those calls. The result is a chain: the fund of funds can only call when the underlying funds call, and can only distribute when the underlying funds distribute.

Written as a relationship:

Investor's paid-in capital = sum of the capital calls the fund of funds issues, which in turn equals the calls made by the underlying funds plus the fund-of-funds level fees and expenses

Because of that chain, a fund of funds is normally allowed to over-commit, signing for more underlying commitments than it has capital, on the expectation that early distributions will fund later calls. Over-commitment is managed within a stated limit in the partnership agreement and is the single largest operational risk in the structure.

Fees layer. The underlying funds charge their own management fee and carried interest. ILPA's survey of fund terms reports that a 20 percent carried interest rate remains the norm across 71 percent of funds sampled, with management fee rates stable in the 1.5 to 2.0 percent band. On top of that, the fund of funds charges its own fee and carry, at levels that are negotiated and generally lower than the underlying funds'. Net returns to the end investor are therefore net of two sets of fees, which is the standing objection to the structure and the reason co-investment sleeves exist.

Selection is the thing being bought. Dispersion between top-quartile and bottom-quartile managers in venture is wide, and access to the funds with the strongest records is frequently constrained rather than open. A fund of funds is, in effect, selling three things: access to allocations its investors could not obtain directly, selection judgment across a manager universe its investors cannot cover, and the operational work of running dozens of limited partner relationships.

The J-curve is deeper here than in a single fund. Fees at both levels are charged from the start, underlying marks lag, and the top fund's own fee accrues while the underlying capital is still being called. A fund of funds usually shows negative reported returns for longer than any of the funds it holds.

Worked example

Suppose a fund of funds raises $500,000,000 with a twelve-year life, charges a 0.75 percent annual management fee on commitments and 5 percent carried interest over a preferred return, and commits to 25 underlying venture funds. All figures are hypothetical.

Step one: the fee stack at the end investor's level. Assume the underlying funds average a 2 percent management fee and 20 percent carry. An investor committing $10,000,000 to the fund of funds pays, over the life, roughly $900,000 of top-level fees and an underlying share of management fees that might total another $1,600,000, before any carry is paid at either level.

Step two: over-commitment. The manager commits $600,000,000 across the 25 underlying funds against $500,000,000 of investor commitments, a 120 percent commitment ratio, expecting that distributions from the earliest funds will fund later calls. If the underlying funds call faster than expected and distribute slower, the fund of funds must either draw a credit facility or default on a commitment, which is why the partnership agreement caps the ratio.

Step three: the cash pattern. In years one through three the fund of funds calls roughly $120,000,000 and receives almost nothing back. Its own fee of $3,750,000 a year is part of every call. Reported TVPI in year three might be 0.85x, because paid-in capital includes fees and the underlying marks are still close to cost.

Step four: the turn. By year six, several underlying funds have begun distributing. Suppose cumulative calls reach $420,000,000 and cumulative distributions reach $150,000,000. DPI at the fund-of-funds level is 150 divided by 420, or 0.36x, while the remaining portfolio is marked at $480,000,000, giving RVPI of 1.14x and TVPI of 1.50x.

Step five: the end state. By year twelve, cumulative calls total $500,000,000 and cumulative distributions total $1,050,000,000. Gross TVPI is 2.10x. After the top-level 5 percent carry on profit above the preferred return, the end investor's net multiple is roughly 2.0x. The underlying gross performance that produced it was higher, and the difference is the second fee layer.

Step six: what the co-investment sleeve does. If 25 percent of the fund's capital had been deployed as fee-free co-investment alongside the same managers at the same entry prices, the second fee layer would apply to only three quarters of the portfolio, and the net multiple would rise by roughly the fee saved. This is the entire argument for hybrid funds of funds, and the reason primary-only programs have come under pressure.

Where it shows up

In the fund-of-funds partnership agreement: the commitment period, the over-commitment limit, the diversification policy by manager, stage, vintage and geography, the management fee rate and basis, carried interest and preferred return, the waterfall, and the policy on co-investment and secondary purchases. ILPA's Principles set out limited partner expectations on these terms, including its preference for a whole-of-fund waterfall so that carry is paid only after all contributed capital and any preferred return are returned.

In the subscription documents for each underlying fund, the fund of funds appears as a limited partner like any other, with its own side letter covering most-favored-nation rights, reporting frequency, transfer rights, excuse and exclusion provisions, and advisory committee seats.

In reporting to its own investors, the fund of funds produces a capital account statement, a schedule of underlying fund interests with fair values, and performance multiples. ILPA's Reporting Template standardizes how fees, expenses and offsets are presented, which matters more here than anywhere else because there are two layers to disclose. Invest Europe's guidelines supply the metric definitions: DPI, RVPI and TVPI all measured on a net basis against paid-in capital, where paid-in capital is committed capital that has actually been called.

In benchmarking, funds of funds are usually assessed against the vintage-year benchmarks of the underlying asset class as well as against other funds of funds, since the second fee layer means a fund of funds can select well and still trail the direct benchmark. Cambridge Associates builds its private investment benchmarks from managers' quarterly fund financial statements and ranks within vintage year.

In regulatory data, the manager files Form ADV and, above the threshold, Form PF, and the vehicle is counted in the SEC's quarterly Private Fund Statistics alongside every other private fund.

Common mistakes

Judging a fund of funds only on the fee stack. The relevant comparison is not gross underlying performance versus the fund-of-funds net number, it is the fund-of-funds net number versus what the investor could actually have achieved alone, which for most small institutions is a much narrower and less accessible manager set.

Ignoring over-commitment risk. A program committed at 120 or 130 percent of its capital depends on distributions arriving to fund later calls. In a period when exits stall, that assumption fails first and hardest.

Expecting a normal J-curve. Two fee layers and a lagged call chain make the early years look worse than a direct fund's. Reading a year-three multiple below 1.0x as a selection failure is a misreading of the structure.

Assuming access is the whole product. Access matters where allocations are constrained, but selection across emerging managers, where allocation is usually available, is where a fund of funds either earns its fee or does not.

Confusing a fund of funds with a special purpose vehicle. A special purpose vehicle typically pools investors into one position in one company or one fund. A fund of funds is a discretionary, diversified, multi-year program.

Overlapping exposure. An institution that already commits directly to several managers can end up holding the same underlying funds twice through a fund of funds. The look-through portfolio, not the commitment list, is what needs to be checked.

Related terms

A fund of funds is itself a limited partner in every fund it backs, while acting as a general partner to its own investors, and it is paid through a management fee and carried interest at both levels. Its reported numbers are DPI, TVPI and RVPI, deepened early by the J-curve, and it is one of the main sources of capital for an emerging manager. Co-investments are often structured through an SPV.

Frequently asked questions

What is a fund of funds in venture capital?

A pooled vehicle that commits capital to other venture funds instead of investing directly in companies. Its investors get exposure to many managers, stages and vintages through one commitment, one diligence process and one reporting relationship, with the fund-of-funds manager handling selection, allocation and all the administration.

Why would an investor pay two layers of fees?

Because the alternative is often not direct access at the same quality. Minimum commitments at sought-after funds are large, allocations can be constrained, and covering a wide manager universe requires staff a smaller institution does not have. The question is whether the selection and access are worth the second layer, which is why co-investment and secondary sleeves, which carry reduced or no fees, have become standard.

How does a fund of funds affect the J-curve?

It deepens and lengthens it. Fees are charged at both levels from the beginning, the underlying funds call capital gradually and mark conservatively, and distributions only reach the top fund after the underlying funds distribute. A fund of funds commonly shows a multiple below 1.0x for longer than any single fund it holds.

What is over-commitment?

Signing for more underlying fund commitments than the fund of funds has capital to cover, on the expectation that distributions from earlier commitments will fund later capital calls. It raises deployed exposure and therefore returns, and it is limited in the partnership agreement because a failure to meet a call can put the fund in default at an underlying fund.

Do funds of funds back first-time managers?

Many do, and some run that as an explicit mandate. A fund of funds commitment to a first-time fund is valuable beyond the dollars, because it gives other prospective investors a professional allocator's diligence to point to.

How is a fund of funds different from a secondary fund?

A fund of funds primarily makes new commitments to funds at their formation. A secondary fund buys existing limited partner interests from sellers partway through a fund's life. Many funds of funds do both, since buying secondaries shortens the cash cycle and reduces the blind-pool element of a primary commitment.