Fund of Funds in Private Equity
A fund of funds is an investment vehicle that pools investor capital and commits it to several underlying private funds, so that investors gain diversified access through one commitment and one layer of manager selection.
Reviewed by José Vasquéz, Managing Partner · Last reviewed
Structure
A fund of funds sits one level above the funds it buys. Investors commit to the fund of funds, which then commits to ten or twenty underlying partnerships. Each underlying fund has its own general partner, its own capital calls and its own distributions. The fund of funds receives those flows, nets its own expenses and passes the remainder to its investors.
Three structures are common. A primary fund of funds commits to new funds as they raise capital. A secondaries fund of funds buys existing interests from sellers, as explained in Private Equity Secondaries. A multi-manager or co-investment program adds direct investments next to fund commitments; see Co-Investment.
The economics follow from the structure. Investors in a fund of funds bear a second layer of cost: the underlying funds charge a management fee and carried interest, and the fund of funds charges its own fee on top. The investor's net multiple is therefore lower than the average multiple of the funds underneath. The formula is:
- Net multiple to the investor equals total proceeds received from underlying funds divided by capital the investor paid in. Fund of funds fees and expenses lower the result because they reduce the capital that reaches underlying funds.
- Capital deployed equals capital paid in minus the fund of funds fee layer.
Worked Example
Consider a hypothetical fund of funds with $100,000,000 of paid-in investor capital. Assume it charges an annual fee of 0.75 percent over a 10-year life, an illustrative figure and not a market quote. Fees total $7,500,000 and the remaining $92,500,000 is deployed across 10 underlying funds. Assume the underlying funds return net multiples after their own fees and carry of 3.0x, 2.5x, 2.0x, 1.8x, 1.5x, 1.3x, 1.1x, 1.0x, 0.8x and 0.5x, with equal allocations of $9,250,000 each.
| Underlying fund | Invested | Net multiple | Proceeds |
|---|---|---|---|
| 1 | $9,250,000 | 3.0x | $27,750,000 |
| 2 | $9,250,000 | 2.5x | $23,125,000 |
| 3 | $9,250,000 | 2.0x | $18,500,000 |
| 4 | $9,250,000 | 1.8x | $16,650,000 |
| 5 | $9,250,000 | 1.5x | $13,875,000 |
| 6 | $9,250,000 | 1.3x | $12,025,000 |
| 7 | $9,250,000 | 1.1x | $10,175,000 |
| 8 | $9,250,000 | 1.0x | $9,250,000 |
| 9 | $9,250,000 | 0.8x | $7,400,000 |
| 10 | $9,250,000 | 0.5x | $4,625,000 |
| Total | $92,500,000 | 1.55x average | $143,375,000 |
The average underlying multiple is 1.55x, but the investor receives $143,375,000 on $100,000,000 paid in, a 1.43x net multiple. The gap of about 0.12x is the cost of the extra layer: $7,500,000 of fees that never reached an underlying fund. The median underlying multiple is 1.4x, and two of the ten funds returned less than their cost, which is why dispersion, not the average, is what the structure is designed to manage.
Dispersion and Manager Selection in a Fund of Funds
A fund of funds earns its fee by selecting managers. Selection matters because private fund returns differ widely between managers. Kaplan and Schoar, in Private Equity Performance: Returns, Persistence and Capital Flows, found that a partnership's performance in one fund is related to its performance in the next, which is why a record of earlier funds is used as evidence. Harris and co-authors, in Has Persistence Persisted in Private Equity?, found that venture capital persistence holds even when measured on the information an investor has at fundraising, while buyout persistence largely disappears on that measure. A selector therefore cannot rely on past rank alone; it has to evaluate team, strategy and terms.
Diversification works in one direction in the example above: it limits the damage from fund 10. It also caps the benefit from fund 1. An investor who could pick the top three funds directly would receive an average of 2.5x before any extra layer, but could not know in advance which three they would be.
What It Means for a Limited Partner
A limited partner chooses between a fund of funds and direct fund commitments by comparing cost with capability. A fund of funds can give a small allocator access to many managers, a diligence team it could not afford and the administrative work of tracking dozens of capital calls. It adds a fee layer and a lag: the investor sees performance only after the fund of funds receives and reports it. A larger allocator with its own staff may prefer direct commitments and use a fund of funds only for areas where it has no expertise, such as an unfamiliar sector or geography. Whichever route it takes, the allocator should ask three questions. What is the total cost of both layers? How concentrated is the portfolio in a few managers? And who at the fund of funds decides, and can that person be replaced? Review of the underlying managers' controls follows the approach in Operational Due Diligence in Private Equity.
In Life Sciences and Healthcare
Specialist life sciences funds are hard for a generalist allocator to judge because the pipelines are technical and the outcomes are binary. A fund of funds with scientific and regulatory expertise can evaluate whether a manager's claimed edge is real. The same expertise should be tested: ask who on the team has reviewed clinical, regulatory or reimbursement evidence, and how many underlying healthcare funds the selector has actually followed through a full cycle. Without that track, a claim of specialist selection is a marketing statement and not evidence.
Frequently Asked Questions
What is a fund of funds?
A fund of funds is a pooled vehicle that invests in other private funds instead of buying companies directly. It gives investors diversification across managers, a single commitment and professional selection, in exchange for a second layer of fees. Its returns come from the underlying funds' distributions, net of its own costs.
Why is a fund of funds net return lower than the average underlying return?
Because the fund of funds charges its own fees and expenses on top of those the underlying funds charge. In the example above, a 1.55x average underlying multiple becomes 1.43x to the investor after $7,500,000 of fees reduces the capital deployed. Selection skill must offset that cost for the structure to beat a single manager.
When does a fund of funds make sense for an allocator?
It makes sense when an allocator lacks the staff to diligence many managers, wants broad exposure from a small commitment, or needs access to a sector it does not know. It makes less sense for a large allocator with an experienced team. Compare with secondaries and co-investment programs.
Related Reference
Manager selection and portfolio construction are part of growth equity. Related entries: Private Equity Secondaries, Co-Investment and Management Fee.