Fund of Funds
A vehicle that invests in a portfolio of other funds rather than directly in companies, offering LPs diversification and access at the cost of a second layer of fees.
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Fund of Funds · the mechanism
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Say what a fund of funds gives an LP, quantify the second fee layer, and explain why the model has been under pressure.
Where it comes up. An LP committee asks whether a second layer of fees buys anything the team could not do itself.
What it is
A vehicle that commits to a portfolio of other funds rather than to companies. The LP buys one relationship and gets thirty managers, vintage diversification across several years, and access to funds that are closed or oversubscribed to a first-time investor.
What it costs
Fees compound. The underlying managers charge their own, commonly around 2% management and 20% carry, and the fund of funds charges a second layer on top, typically far thinner, perhaps 0.5–1% and 5–10% carry. The LP pays both, and the second layer is charged on gross performance the first layer has already taken a cut of.
Why the model is under pressure
Large LPs have built internal teams and gone direct, which removes the access argument. Continuation vehicles and the secondaries market now offer diversification without a second carry. What survives is where access genuinely cannot be bought: small LPs, emerging managers, venture, specific geographies, and separately-managed accounts that unbundle advice from the fee stack.
Worked through
A fund of funds whose underlying managers gross 18% a year, over a full cycle.
- Gross return at the underlying funds
- 18.0%
- After underlying manager fees (roughly 2 and 20)
- about 13%
- After the fund-of-funds layer (say 0.75 and 7.5)
- about 11.5%
Roughly 6.5 points of an 18% gross return goes to fees, and the second layer costs about 1.5 of them. That layer has to be worth 150 basis points a year of manager selection, which is a demanding bar and the one the whole debate turns on.
Check yourselfWhy might a small pension scheme still pay two layers of fees when a sovereign fund would not?
Answer once you have one →
Because the alternatives are not available to it. A £400m scheme cannot staff a private markets team, cannot write cheques large enough to be welcome in an oversubscribed fund, and cannot diversify across thirty managers with the commitments it can make. The sovereign fund can do all three in-house, so for it the second layer buys nothing.
Be able to say this back next week
- Named what is bought: manager diversification, vintage diversification, and access
- Said the second fee layer is charged on returns already net of the first
- Said the honest case is where access genuinely cannot be bought at any price
Why Fund of Funds matters in interviews
The fund of funds is the standard interview vehicle for testing whether a candidate can reason about fees compounding and about what an intermediary actually adds. It also matters for anyone interviewing on the LP side, in placement, or in private wealth, because the arguments for and against it are the arguments about the whole private markets fee stack.
How it works in practice
Three things are genuinely being bought: diversification across managers and vintages, access to funds that will not take a first-time or small investor, and outsourced diligence for an institution that cannot staff it. Vintage diversification is the most underrated of the three, because returns in private markets vary more by entry year than by manager within a year.
The costs are the second fee layer and an extra layer of illiquidity. Capital is committed to a vehicle that then commits to funds that then call capital, so the money is drawn later and returned later, which lengthens the J-curve. The internal rate of return suffers from that timing even where the multiple does not.
The competitive pressure has come from three directions. Large LPs built internal teams and now go direct. The secondaries market lets an investor buy vintage diversification in one transaction. And separately-managed accounts unbundle the advice from the vehicle, so an investor can pay for manager selection without a second carry on the whole portfolio.
Where the model persists it is usually because access cannot be bought at any price: oversubscribed venture funds, emerging managers with no track record to underwrite alone, and specific geographies where relationships are the whole game. That is the honest case for it, and it is a narrower case than the industry once made.
What candidates get wrong
- Adding the two fee layers arithmetically. The second layer is charged on returns already net of the first, and carry is charged on gains rather than on assets, so the drag is a compounding calculation rather than a sum.
- Ignoring the timing effect on IRR. An extra layer between commitment and deployment delays both calls and distributions.
- Assuming diversification always improves risk-adjusted returns net of fees. Across enough managers the portfolio approaches the asset-class average, and the second fee layer then guarantees underperformance of it.
- Confusing a fund of funds with a secondaries fund. One commits primary capital to new funds; the other buys existing positions from LPs, at a discount and with much of the J-curve already served.
Fund of Funds: frequently asked questions
What is a fund of funds?
A vehicle that invests in a portfolio of other funds rather than directly in companies or securities. An LP makes one commitment and gets exposure to perhaps twenty or thirty underlying managers across several vintage years, together with the manager-selection work behind that portfolio. It is common in private equity, venture capital and hedge funds, and most common among investors too small to build such a portfolio themselves.
What are the disadvantages of a fund of funds?
A second layer of fees charged on returns already net of the underlying managers’ fees, and a second layer of illiquidity that delays both capital calls and distributions and therefore drags on the internal rate of return. Diversification across enough managers also pulls returns toward the asset-class average, at which point the extra fee layer makes underperformance of that average close to arithmetic.
Why do fund of funds still exist?
Because access and capability are not evenly distributed. A small pension scheme cannot staff a private markets team, cannot write cheques large enough to be welcome in an oversubscribed fund, and cannot diversify across thirty managers with the commitments it can make. Where those constraints bind, in smaller institutions, venture capital, emerging managers and unfamiliar geographies, the second layer buys something real. Where they do not, large investors have gone direct.
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