Funds of funds

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Funds of funds

“Funds of funds” is a generic phrase that applies to several investment vehicles. Funds of funds could mean any of the following: 1) funds of mutual funds; 2) funds of private equity funds, also called private equity funds of funds; 3) funds of hedge funds; 4) funds of venture capital funds, also called venture capital funds of funds. Sometimes the phrase “multi-manager funds” is used instead of funds of funds. One can think of a fund of funds as a wrapper around other funds. The other funds are sometimes called the “underlying funds.”

Historically, the first fund of funds was Leveraged Capital Holdings. Leveraged Capital Holdings began operating on November 30, 1969 under the sponsorship – which continues to the present – of the LCF Rothschild Group and Fortis MeesPierson. Currently, the global funds of funds business manages around 400 to 500 Billion Euros in assets. Customers of funds of funds managers are usually institutional investors such as public and private pensions and insurance companies.

Funds of funds solves three problems
The fund of funds innovation evolved to solve three inherent problems within the venture capital, private equity, and hedge fund universe. These three problems are the following: 1) hedge funds, private equity funds, and venture capital funds typically have high investment minimums (250,000 to 1,000,000 Euros); 2) for each fund type, lock-up periods are long (up to ten years), which means reduced liquidity for the investor; 3) the hedge fund, private equity fund, and venture capital fund universe is very large, which makes finding and monitoring management talent difficult. The fund of funds approach solves these three problems.

A larger pool of capital means diversification
A larger pool of capital means a fund of funds manager can spread investments across multiple funds. Therefore, investors can have exposure to multiple funds with the same capital investment, which in the past might have only allowed access to one fund.

A larger pool of capital means greater liquidity
Each underlying fund will have a different lock-up and unlock date. The “staggered” lock-up and unlock dates allow the fund of funds manager to grant redemptions from a fund that has recently become unlocked. The fund of funds manager can also grant redemptions from new capital commitments. We see the fund of funds approach allows investors to avoid the lengthy commitments that would be required if he were investing directly into the underlying funds, i.e., the investor has more liquidity.

Specialized due diligence
The number of hedge funds, private equity funds, and venture capital funds is large. Therefore, it is time consuming to find and monitor new talent within the universe of hedge funds, private equity funds and venture capital funds. Fund of funds firms reduce the time by maintaining databases that contain information on hundreds of underlying funds and their mangers. Within a fund of funds firm, managers often monitor the career of underlying fund managers; they may personally know underlying fund managers. Monitoring underlying funds and managers and maintaining close contacts means the fund of funds firm is in an excellent position to conduct due diligence. Indeed, it is the claim of better due diligence that is the sales pitch of many funds of funds firms.

Problems with fund of funds firms
There have been several problems with funds of funds firms:

Overbearing management
Sometimes there is resentment among the underlying investment funds that the fund of funds manager is overbearing. Indeed funds of funds managers have referred to the underlying funds as “sub funds.” Such resentment has caused many underlying funds to refuse to become the investee of a fund of funds company.

Investment overlap
Sometimes there is a problem of overlap in the holdings of the underlying funds. For example, fund a can have an investment in asset c, and fund b can also have an investment in asset c. The fund of funds company that has an investment in fund a and fund b, therefore has a double investment in asset c.

Due diligence failure
There were some due diligence failures during the Bernie Madoff scandal. The problem was that several funds of funds put investments directly into Madoff’s funds and into secondarily into funds that were invested in Madoff’s funds. Apparently the funds of funds managers were attracted to Madoff’s lack of fees. Also notable is that many funds of funds did not put money into Madoff’s funds.

The cost of funds of funds
A fund of funds has two cost components. The first cost component is a charge of 1% to 2% of fees on assets under management. The second cost component is a 10% to 15% charge of any investment gains. Some funds use something called a hurdle rate before charging for investment gains. A hurdle rate is a minimum investment rate the fund must achieve before it pays itself.

Is the extra cost worth it?
Returns of funds of funds are high; correspondingly the costs are high. Therefore, one must ask: Is the expected return of funds of funds high enough to justify the cost? Research is being done in the area, but the truth is no one knows for sure.

Conclusion
The fund of funds innovation solves practical problems for investors who wish to gain exposure to hedge funds, private equity funds, and venture capital funds. There have been some minor problems with funds of funds. The problems, however, are not really with the fund of funds idea, but with the implementation of the fund of funds idea and a few fund of funds firms.

Data is inconclusive as to whether the return of funds of funds justifies the cost. For now, because of high investment minimums, long lock-up periods, and the difficulty of conducting due diligence in the hedge fund, private equity fund, and venture capital fund universe, the fund of funds approach may be the best and only option for many investors.

With time, it is likely more firms will better execute the excellent fund of funds idea.