A fund of funds aggregates capital from multiple investors to form a fund that invests in other private capital funds. A fund of funds manager therefore acts as both an LP and a GP, raising capital from investors in the same way as a GP, while making capital commitments to limited partnerships as an LP. The life-cycle for a fund of funds will be similar to that of a commingled fund, the only difference being the types of investments made (in other funds vs. directly in the asset).
Funds of funds allow investors to create a highly diversified and comprehensive portfolio of investments with fewer risks compared to direct investment. They also give smaller investors access to larger private capital funds that would usually be out of reach for them due to capital constraints. We will explore some of the pros and cons of fund of funds vehicles below:
- Higher levels of diversification: investments made by a fund of funds manager give an investor access to several funds consisting of varying underlying assets.
- Lower levels of risk and volatility: risk is reduced through greater diversification.
- Management expertise: a fund of funds manager will provide an investor with professional due diligence, manager selection, and oversight over the funds within its portfolio.
- Access to top funds/managers: by pooling capital alongside other investors through a fund of funds, LPs can access funds or managers that might otherwise be out of reach to smaller LPs due to their high minimum investment thresholds.
- Higher fees: funds of funds charge their own fees, as well as passing on those from the underlying funds being invested in, creating a double layer of fees owed by investors.
- Lack of transparency: visibility of underlying assets of funds invested in is limited for investors.