The Fund Of Funds Model Explained

[Justin Moy]

In very simplified terms a fund of fund refers to a sub fund that is investing into another fund, here’s an example:

ABC capital is raising for a syndication and they’re raising $30M.

They have a minimum investment of $50k and the splits would give you a 5% preferred return and a 70% equity split.

But what could happen is someone else who raises money may approach ABC capital and negotiate better terms in exchange for giving them a greater investment amount. Lets say $1M instead of $50k.

So instead of raising $1M from 20 investors each at $50k, this new group will give them one wire of $1M. This is significantly easier for ABC capital to manage 1 investor versus 20, so many times especially in very large capital raises a company like ABC capital may offer an incentive to do this.

So ABC Capital could offer terms of an 8% preferred return and 80% equity split for an investment of $1M instead of $50k.

So now what that operator does is create a fund of funds, and they’ll open up their own fund, lets call it the Main Street Fund, and open up the investment to their investor database to go raise $1M.

Then that fund, the Main Street Fund, raises $1M from investors and may be able to offer better returns to their investors because now they’re taking advantage of a better split by being part of the larger $1M investment.

So in this scenario The Main Street Fund is the fund of funds for ABC Capital’s syndication.

So what are the pros and cons of investing in something like the Main Street Fund in this scenario as opposed to directly with ABC Capital?

Pros

Historically I’ve seen better top line returns with a fund of funds model, because you’re benefiting from the terms of a $1M investment even if you invest just $50k.

The terms may be more flexible as well. ABC Capital may have a $50k minimum but the Main Street Fund may have a $25k minimum. It’s common for large raises to have higher minimums so sometimes the difference in minimum investment can be substantial.

A third benefit is a double layer of due diligence. In this case if we assume both ABC Capital is a solid operating group and the operators of the Main Street Fund are also experienced and great sponsors, they’ve both vetted the deal and have conducted their own due diligence, giving a double layer of these crucial steps.

Cons

The first downside is additional fees. All sponsors have fees and in a scenario like this ABC Capital will have their fees and The Main Street Fund will also have their fees. While the fees may not be double it is likely there will be more as ABC Capital will take their cut then Main Street Fund will also get paid.

These fees for the better and more flexible terms may be worth it, but you want to find out how much of your investment goes to fees.

Another downside you need to be aware of is Main Street Capitals ability to follow through with their minimum investment. If they fall short of the $1M capital raise, will ABC Capital still honor their terms or will the terms be adjusted? Which would impact your returns as an investor.

Overall, a fund of fund model will likely give you access to stronger terms and more flexibility by combining your investment with the investment of others, leveraging having one big investment instead of many smaller ones. It also gives you a double layer of due diligence with both the operating team conducting their due diligence and the fund of funds manager completing theirs as well.

The tradeoff to this is there are likely more fees involved with the investment, you just have to be sure the terms are worth the additional fees, and you’ll want to be sure the fund you’re investing in will hit their minimum investment amount to honor those terms, and if they don’t what’s the recourse to you as an investor.

[Evan Polaski]

@Justin Moy, this is a great example.  

One thing I would add, as this tends to be a big issue with many investors, is the slow down in K-1s.  The Fund of Funds cannot issue a K-1 to its investors until all the holdings have issued their K-1s.  So, if the Fund of Funds went into 4 separate offerings as an LP.  The Fund needs to get all 4 K-1s before the Fund can issue the K-1 to its investors.

The biggest challenge in general is balancing the overall cost benefit.  The Fund of Funds needs to turn a profit for it to be worth the sponsorship team's efforts.  Is the spread available to the Fund of Funds more than offsetting the sponsor's profits?