Fund of Funds, and Why an Emerging Manager Meets One
A fund of funds is how major public pension emerging-manager programs reach first-time private equity managers. What it underwrites in a first fund, and what it asks for.
By Peleg Chevion, Managing Partner
9 min read · Growth Equity
In this note06 · 9 min
A fund of funds is a pooled vehicle that commits capital to other funds. It is also how major public pension emerging-manager programs reach first-time private equity managers: CalPERS and the New York State Common Retirement Fund both run that work through fund-of-funds advisors and separate accounts. The advisor underwrites the team before a record exists, and asks for the file a later fund will need.
01The Fund of Funds Structure
CalPERS describes funds of funds, which it also calls multimanager investments, as pooled investment funds that invest in other vehicles. The investor commits to the fund of funds; the fund-of-funds manager selects the underlying funds, commits on the investor's behalf and monitors the positions. The structure takes two forms. A commingled fund of funds pools many investors under one partnership agreement. A separately managed account serves a single institution and follows that institution's mandate. The New York State Common Retirement Fund uses both: its Emerging Manager Program invests with emerging managers directly, or with the assistance of other managers or program partners, in separately managed accounts or commingled funds. Family offices that invest as limited partners also reach private equity through funds of funds, as the entry on family offices in private equity notes.
The price of the structure is a second layer of fees. CalPERS states that it uses specialist, external advisors to source, mentor and develop emerging managers, which brings an additional layer of fees. A first-time manager should read every request from a fund of funds against that second layer, because the advisor has to justify its own fee on top of the manager's.
02The Regulatory Frame
The federal rule set for funds that invest in funds starts with section 12(d)(1)(A) of the Investment Company Act of 1940. It makes it unlawful for a registered investment company to acquire securities of any other investment company, and for any investment company to acquire securities of a registered investment company, if the acquirer would then own more than 3 percent of the acquired company's total outstanding voting stock, hold more than 5 percent of its own total assets in that company, or hold more than 10 percent of its own total assets in investment companies generally (15 U.S.C. § 80a-12(d)(1)(A)).
Rule 12d1-4, adopted by the Securities and Exchange Commission in Release Nos. 33-10871 and IC-34045, lets a registered investment company or business development company acquire the securities of another registered investment company or business development company in excess of those limits, subject to conditions on control, mirror or pass-through voting, findings by the advisers, a fund of funds investment agreement between funds that do not share an adviser, and a general prohibition on three-tier structures, with enumerated exceptions.
The same release rescinded rule 12d1-2 and withdrew certain exemptive relief that had permitted fund of funds arrangements. It also declined to let private funds rely on the rule as acquiring funds, so a private fund may acquire no more than 3% of a U.S. registered fund. Sections 3(c)(1) and 3(c)(7) produce that result by deeming a private fund to be an investment company for the limits in section 12(d)(1)(A)(i) and (B)(i) when it buys registered funds (15 U.S.C. § 80a-3(c)(1), (c)(7)).
Section 12(d)(1) and Rule 12d1-4 therefore regulate arrangements in which a registered fund sits on at least one side. When an unregistered fund of funds commits to a first-time private equity fund that is itself unregistered, neither clause of section 12(d)(1)(A) reaches the commitment by its terms.
The provision that does reach it sits inside the private fund exclusion. A first fund relying on section 3(c)(1) must keep its outstanding securities beneficially owned by not more than one hundred persons. Ownership by a company counts as one person, except that when the company owns 10 percent or more of the issuer's outstanding voting securities and is, or but for sections 3(c)(1) or 3(c)(7) would be, an investment company, the holders of the company's securities are counted instead (15 U.S.C. § 80a-3(c)(1)(A)).
A fund-of-funds anchor at that level can carry its own investors into the first fund's count, so the size of an anchor commitment is a structuring question as much as an economic one. A fund relying on section 3(c)(7), whose securities are owned exclusively by qualified purchasers, carries no comparable head count in the statutory text.
03The Emerging-Manager Mandate
CalPERS states three objectives for its program: identifying early-stage funds with strong potential for success, accessing unique investment opportunities that may otherwise be overlooked, and cultivating the next generation of external portfolio management talent. Its private equity program entered the emerging-manager space in 2006 with a mandate to commit through funds of funds to first- and second-time funds in buyout, mezzanine, credit and related strategies, domiciled in the United States. The mandate was later widened to third-time funds and to allow for co-investments and secondaries, with GCM Grosvenor as the fund-of-funds operator and a strategy set of buyout, growth and distressed for control.
Under definitions the CalPERS Board approved in September 2022, a private equity emerging manager is one on its first, second or third institutional fund, with a fund size of $2 billion or less.
CalPERS gives the reason for routing this work through advisors in its own review: emerging-manager investments are small in relation to CalPERS' total portfolio and do not offer fee efficiencies through economies of scale. The New York program describes the advisor's role in similar terms. Its program partners assist in the timely deployment of capital, perform due diligence and recommend managers to participate in the Program. The Comptroller's transaction reports show the mechanism at work: commitments to first- and early-fund managers made through partnership vehicles advised by Emerging Manager Program partners, and a HarbourVest-sponsored closed end, separately managed account that will deploy capital to emerging private equity managers.
For a first-time manager the consequence is direct. At a pension that runs emerging-manager private equity this way, the advisor performs the diligence and makes the recommendation, so the advisor's file is the manager's route into the program.
04The Underwriting Map
The routes below are the ones the public program documents describe. The requests use the section numbering of the ILPA Due Diligence Questionnaire 2.0, the template the Institutional Limited Partners Association publishes to standardize the questions limited partners ask a general partner.
| Fund-of-funds route | What it underwrites in a first fund | What it asks for |
|---|---|---|
| Pension separate account run by a fund-of-funds advisor (the CalPERS and New York structures above) | Fit to the mandate's written rules (fund sequence, fund size, strategy, domicile) and a team that can be underwritten before a fund record exists | The principals' shared work history (DDQ 9.1); how carried interest is allocated and vested (10.1, 10.4); how the general partner's commitment is financed (10.8); the key person provision (3.12); and the manager data the pension must report to its legislature, which CalPERS gathers in part via fund of funds vehicles and partnerships |
| Commingled emerging-manager fund of funds | One commitment among several early-stage funds held in a single pooled vehicle | Fund terms (DDQ 12), accounting and valuation (15) and reporting (16), the sections that feed the advisor's own reporting to its investors, read against the fee layer the advisor already charges |
| Mandate with co-investment and secondaries authority (the widened CalPERS mandate) | The deal flow as well as the fund: whether the manager can produce investments larger than the fund should hold alone | The co-investment policy and how opportunities are allocated (DDQ 5.1); the firm's ability to invest at the fund's targeted size and the implications for co-investing (4.4); whether fees or carried interest are charged to co-investors and whether co-investors receive governance rights (5.4) |
| Transition or annex vehicle (the New York Transition Annex Fund, advised by HarbourVest) | A program manager's next fund, on a manager already in the relationship | The predecessor-fund record: any investments excluded from the track record and why (DDQ 14.4); three to five investments below 1.0x TVPI with what went wrong (14.5); how the carry allocation compares with the predecessor fund (10.2) |
| Graduation out of the fund of funds into the pension's direct portfolio | The firm as a lasting institution rather than a single vehicle | A succession plan (DDQ 3.1); any key person event over the last two predecessor funds (3.11); firm governance, risk and compliance (13) |
Most of the questionnaire presumes predecessor funds, and a first fund has none. LeverVenture's view is that the first-fund answer is attributed history: the deals each principal led, where, with what authority, and with what result, documented well enough that the same file can later serve as the predecessor record the transition and graduation rows ask for.
05The Graduation Path
The fund-of-funds relationship is built to end. CalPERS describes its program as designed to identify and grow the next generation of managers with the goal of potential graduation to a Trust level commitment. The New York State Common Retirement Fund seeks to graduate emerging managers to be direct investments by the Fund each year, and its HarbourVest-advised Transition Annex Fund has committed to the fifth fund of a manager that was an existing relationship, so the transition vehicle reads as a bridge between the emerging-manager account and direct status.
The cost argument points the same way. Among the lessons in its own program review, CalPERS records that costs matter to performance and these can be relatively high in the emerging manager fund of funds structure. Graduation removes the second layer of fees, which is one reason a pension would want it, and it makes the advisor's diligence, in effect, the first chapter of the pension's own.
Two consequences follow for a manager meeting a fund of funds for the first time. The first is that the mandate is defined by strategy and stage rather than by sector. The CalPERS private equity program describes itself in terms of buyout, growth and distressed for control, secondaries and co-investments, and United States geography, so a specialist growth-equity manager in life sciences and healthcare enters as a growth strategy and carries the burden of explaining clinical, regulatory and reimbursement risk to a generalist reader. The second is that nothing given to the advisor is temporary. Every answer in the first-fund file becomes predecessor-fund history that a later questionnaire will test, line by line, against what actually happened.
06Frequently asked questions
What is a fund of funds?
A fund of funds is a pooled vehicle that invests in other funds. Its manager selects, commits to and monitors the underlying funds for its own investors, either through a commingled partnership with many investors or a separately managed account for one institution. The investor pays two layers of fees: the fund-of-funds manager's and the underlying managers'.
Does Rule 12d1-4 govern a fund of funds that backs private equity managers?
Rule 12d1-4 lets registered investment companies and business development companies invest in other registered funds and business development companies beyond the limits of section 12(d)(1), subject to conditions. Private funds cannot rely on it as acquiring funds. When an unregistered fund of funds commits to an unregistered private equity fund, the more relevant provision is the look-through in section 3(c)(1)(A), which counts the holders of an investing company that owns 10 percent or more of a 3(c)(1) fund's outstanding voting securities.
Why do public pensions reach emerging managers through funds of funds?
Emerging-manager commitments are small relative to a large pension's portfolio, so specialist advisors source, diligence and recommend the managers, and the pension pays a second layer of fees for that work. The programs are designed so that successful managers graduate to direct commitments from the pension, which removes that second layer.
Nothing in this piece is investment, legal, tax or accounting advice, and nothing in it is an offer to sell or a solicitation of an offer to buy any security.
Three decades of operational leadership across agriculture, pharmaceuticals, biotechnology, climate, food and defense. He has spent that career doing the work this seat requires: strategic partnerships, licensing and business development, executed transaction by transaction. He sits with a company as an operating partner and a growth strategist rather than as a name on its board. A corporate finance and intellectual property attorney, an INSEAD MBA, and a former Air Force officer in aerospace. He also brings strong private equity experience.