Key Takeaways

• A fund of funds generally pools capital to invest in multiple private funds rather than directly in individual private companies.
• This structure may provide broader diversification but often involves layered fees.
• Private fund of funds offerings in the United States are typically available to accredited investors and are subject to SEC regulations.

A fund of funds structure is one approach that some investors use to gain diversified exposure to private companies through multiple underlying funds rather than selecting a single private company or fund.

Overall, a fund of funds may offer a structured way to participate in private markets, but it also involves specific risks, costs, and regulatory considerations.

This informational article provides a general overview of how fund of funds structures typically work in private markets, particularly when investing in private companies.

What Is a Fund of Funds?

A fund of funds (FoF) is an investment vehicle that pools capital from investors and allocates that capital into multiple underlying investment funds. In the context of private companies, these underlying funds are often venture capital funds, private equity funds, or other private investment vehicles.

Instead of investing directly in one private company or one private equity fund, an investor gains indirect exposure to a portfolio of funds, each of which may hold stakes in numerous private companies.

This layered approach means the investor’s return is generally influenced by:

• The performance of the underlying private companies
• The performance of each selected fund
• The allocation decisions made by the fund of funds manager

How Fund of Funds Structures Typically Work 

Capital Commitments and Fundraising

Fund of funds vehicles often operate through a capital commitment model. Investors commit a specified amount of capital, which is drawn over time through capital calls as the manager identifies opportunities.

The investment period may last several years, and the overall fund lifecycle often extends 7 to 12 years, depending on the strategy and structure.

Allocation Across Underlying Funds

The fund of funds manager selects multiple private funds based on criteria such as:

• Investment strategy (venture capital, buyout, growth equity)
• Industry focus (technology, healthcare, consumer)
• Geographic exposure
• Track record and experience of the fund managers
   

This approach may provide diversification across stages, sectors, and management teams.

Lifecycle and Liquidity Considerations

Private fund of funds investments are generally illiquid. Investors typically do not have the ability to redeem shares on demand, and transfers may be restricted.

Distributions are usually made as underlying funds exit portfolio companies, which may occur through acquisitions, secondary sales, or public offerings. Timing and outcomes vary and are not guaranteed.

Types of Fund of Funds in Private Companies

Fund of funds structures may focus on different segments of the private market:

• Venture capital fund of funds – invests in early- and growth-stage venture funds.
• Private equity fund of funds – invests in buyout or growth equity funds.
• Secondary-focused fund of funds – acquires interests in existing private funds on the secondary market.
• Sector-specific fund of funds – targets funds within specific industries such as technology or healthcare.

Each structure carries its own risk profile and time horizon.

Potential Advantages of a Fund of Funds Approach

A fund of funds structure may offer certain characteristics that some investors find appealing:

• Broader diversification across multiple private funds
• Access to experienced managers and institutional-quality funds
• Exposure to private companies that may not be directly accessible to individual investors
• Professional due diligence at the fund selection level
   

However, diversification does not eliminate risk, and private market investments generally involve substantial uncertainty.

Cost Structure and Fee Considerations

One of the defining features of a fund of funds is the layered fee structure. Investors typically pay fees at both the fund of funds level and the underlying fund level.

Fees generally include:

• Management fees (often based on committed or invested capital)
• Carried interest (a share of profits above a defined threshold)

Because fees are applied at two levels, overall costs may be higher compared to investing directly in a single private fund.

Regulatory and Compliance Considerations

In the United States, fund of funds offerings are typically structured under exemptions from public registration, such as:

• Regulation D (Rule 506(b) or 506(c))
• Regulation A (in certain cases)

Many private fund of funds offerings are limited to accredited investors, as defined under SEC rules. These offerings generally involve private placement memoranda (PPMs), subscription agreements, and detailed risk disclosures.

Fund managers may be registered with the SEC as investment advisers, depending on assets under management and structure. Broker-dealers involved in the offering process are subject to FINRA regulations.

Investors are generally encouraged to review offering documents carefully and consider consulting qualified financial, legal, and tax professionals before making decisions.

Risks and Limitations

Investing in a fund of funds involves several potential risks:

• Layered fees that may reduce net returns
• Limited transparency into individual portfolio companies
• Long holding periods with limited liquidity
• Dependence on the fund of funds manager’s selection decisions
• Market and economic risks affecting private valuations
   

Private investments are speculative and may result in partial or total loss of capital.

Who Typically Invests in Fund of Funds?

Historically, fund of funds structures have been used by:

• Pension funds
• University endowments
• Foundations
• Family offices
• Accredited individual investors
   

These investors often seek diversified exposure to private markets without allocating significant internal resources to manager selection.

Conclusion

A fund of funds in private companies generally provides indirect exposure to a portfolio of private investment funds, each holding stakes in multiple private companies. This structure may offer diversification and professional fund selection, but it also involves layered fees, long time horizons, and limited liquidity.

Private market investments involve significant risk and are not suitable for all investors. Outcomes vary based on market conditions, manager performance, and portfolio company results.

FAQs

1. Are fund of funds investments available to all investors?

Fund of funds investments in private companies are often offered through private placements that are limited to accredited investors under U.S. securities laws. Eligibility requirements generally depend on the structure of the offering and the applicable exemption, such as Regulation D or Regulation A. Investors should review the specific offering documents to determine qualification criteria and restrictions.

2. How are returns generated in a fund of funds structure?

Returns in a fund of funds structure are generally derived from the performance of the underlying private funds, which in turn depend on the performance and exit outcomes of their portfolio companies. Distributions may occur over an extended time horizon and are not guaranteed. Performance varies based on market conditions, fund selection, and management decisions.

3. What are the primary risks associated with investing in a fund of funds?

Investing in a fund of funds involves risks that may include illiquidity, layered fees, limited transparency into underlying portfolio companies, and reliance on the fund manager’s selection decisions. Private investments are speculative and may result in partial or total loss of capital. Investors should carefully review all risk disclosures and consider consulting qualified financial, legal, or tax professionals before investing.

Disclaimer: This article is provided for informational and educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy any security. The content does not constitute investment, legal, tax, or accounting advice, and should not be relied upon as such. Investments in private companies and fund of funds structures are speculative, involve substantial risk, and are generally illiquid. Past performance does not indicate future results. There is no guarantee that any investment strategy will achieve its objectives or avoid losses