A fund of funds (FOF) is an investment model used to diversify investments. It is particularly useful in private equity investing. In private equity, a fund manager selects several individual investments and invests pooled funds from group of investors on their behalf. The fund thereby decreases the investors’ concentration risk, increases their diversification, and expands their exposure to potentially higher-tiered sponsors. A common criticism of the FOF model is that the fund’s management fees dilute the returns an investor would receive if they had invested directly. Although this may be true for very high-net-worth investors, there are several reasons why those with less than $1 million to invest will benefit from the FOF model—without reducing their returns.
First, an FOF often invests a much larger amount than an individual investor can (or should) put into a single opportunity. When a fund invests millions of dollars, individuals can often participate in higher tiers or classes of shares. For example, a sponsor may offer a 9% preferred return versus an 8%, or an 80%/20% split versus a 70%/30% split (or both) to investments exceeding $1 million. By investing more than $1 million, the fund can achieve the higher preferred return and/or higher investor splits compared to individuals who may only be investing $50,000. By splitting this excess return with the fund investors, the fund can pay for its entire operation while maintaining the investors’ returns.
Second, the FOF may be paid an acquisition fee and/or an asset management fee to participate in the fundraising activities and manage its investors. These fees are usually paid to the sponsor as part of their normal fee structure. The fund manager may be able to negotiate the division of these fees between the sponsor and the investors. This can offset the operating costs that the fund investors would typically pay for the fund’s management and its fundraising activities.
Third, the fund manager may negotiate with the sponsor to split some of the sponsor’s general partner (GP) equity shares. As part of most private equity investments, the sponsor earns a portion of the returns as a split in equity after the preferred return. This is called “carried interest,” as it is represented by the 80%/20% split in returns after the preferred return. A fund manager that can invest a large portion of the capital required for a sponsor’s opportunity may be able to negotiate a split in the 20% of the GP’s equity. The return generated by the fund’s split of the GP shares’ carried interest can offset some, if not all, of the fund’s operating expenses.
In summary, an FOF is not necessarily less economical than a direct, individual investment, nor does it necessarily suffer from double fees. In many circumstances, the fund manager can negotiate with the sponsor to compensate the fund for its operating expenses by splitting a portion of the sponsor’s management fees and carried interest. By participating in an FOF, investors achieve diversification without incurring additional fees that negatively affect returns of a comparable investment made individually.
This is our business model at Cira Capital Group. We strive to curate the best diversified private real estate funds with minimal fees to our investors.