In this episode of Fully Invested, Ropes & Gray asset management partners Marc Biamonte and Lindsey Goldstein introduce listeners to the “fund of funds” product, an alternative investment fund designed to invest in other privately offered alternative investment vehicles. They provide an overview of the different types of investments typically made by a fund of funds (primary, secondary and co-investment), the evolution of the fund of funds structure, and what both sponsors and investors should keep in mind when considering providing or investing in a fund of funds product.
Marc Biamonte: Welcome to Fully Invested, a podcast series hosted by Ropes & Gray’s global asset management team. Drawing on the perspectives of over 1,400 attorneys from all areas of our practice, we provide insight into essential considerations associated with current and emerging asset management products. I’m Marc Biamonte, a partner in our asset management group based in New York, and co-head of our institutional investor practice and our buyout practice. Joining me today is one of my asset management partners, Lindsey Goldstein, also based in New York. We’ll start with a brief description of what these products are and how they differ from other privately offered alternative investment products.
Lindsey, would you like to kick off our discussion with a quick overview of what a fund of funds is?
Lindsey Goldstein: Happy to. A typical private fund of funds is an alternative investment fund that invests in other privately offered alternative investment vehicles. A fund of funds often has a specific strategy—for example, it may focus on investing in private equity buyout funds, hedge funds, real estate funds, venture capital funds or credit funds. A fund of funds can really focus on any alternative strategy and be as narrow or broad in its scope as the sponsor likes. Privately offered funds of funds are exempt from registration under the U.S. Securities Act of 1933 and are required to be exempt from registration under the U.S. Investment Company Act of 1940—therefore, investors in funds of funds generally are required to be accredited investors and qualified purchasers as those terms are defined under the U.S. securities laws and their related applicable rules. Some sponsors have formed private equity funds of funds products that are registered investment companies under the Investment Company Act of 1940 which, as a result of increased SEC regulation over such funds, allows them to accept investors that are not qualified purchasers and, therefore, market to a broader investor base. These registered fund of funds products are beyond the scope of this podcast, but will be a topic of future Ropes & Gray podcasts.
Marc, do you want to discuss the different types of investments fund of funds typically make?
Marc Biamonte: Sure. A typical fund of funds will make one or more of three types of investments: 1) a primary fund investment; 2) a secondary fund investment; and/or 3) a direct co-investment. A primary fund investment is an investment in a privately offered fund made by the fund of funds at the time of original issue by the sponsor of such underlying fund investment. The fund of funds will come into such underlying fund investment like any other investor in such private fund. Because the fund of funds is coming in at the time of original issue, the fund of funds has the ability to negotiate the terms of such investment and may be able to include a side letter as part of its investment, in each case depending on the leverage such fund of funds may have in connection with such primary investment.
A secondary investment can take many forms, but the two most typical are referred to as 1) a plain vanilla secondary investment, and 2) a GP-led secondary or recapitalization. A plain vanilla secondary is when a fund of funds buys underlying interests in private funds from other investors in those private funds on the secondary market, rather than directly from the underlying fund as part of such underlying funds’ original issue. Sometimes sellers of secondary interests will hire a placement agent or other financial intermediary to market private funds interests the seller desires to sell. The fund of funds may purchase one interest in a transaction or it can purchase hundreds of interests in a single transaction with values stretching into the billions. Sales of such interests to a secondary buyer require the consent of the underlying fund general partners, and because the fund of funds is buying an existing interest from another investor, the fund of funds typically has limited negotiating power with respect to the sponsor of the fund interest being purchased, which means it is unlikely to be able to obtain any side letter in connection with such investment.
GP-led secondaries or recapitalizations occur when a sponsor sells some or all of its investment in one or more portfolio companies to a continuation vehicle that is managed by the same sponsor, but capitalized by a new investor base. The lead investors in this new investor base are often a fund of funds. On March 30th of this year, Ropes did an entire podcast on fund recapitalizations—for additional information on such transactions, I recommend listening to that March 30th podcast, which can be found on the Ropes & Gray website under podcasts.
Finally, a direct co-investment is a direct, generally minority, investment in a portfolio company of a third-party fund. Many underlying funds in which a fund of funds invests will offer co-investment opportunities to its investors to invest alongside its funds, often on a no-fee and no- carry basis.
Lindsey, do you want to discuss how we typically see a fund of funds structured?
Lindsey Goldstein: Sure. Historically, a fund of funds sponsor would have a flagship co-mingled fund that would be established to make primary investments, secondary investments and co-investments. These funds were designed for investors who wanted to be able to invest in a diversified portfolio of alternative funds, but may or may not have had the ability to make direct investments in each underlying fund on its own given the often very high minimum investment requirements or other restrictions to access. These funds are often structured with a master fund and a feeder fund to allow different investors with different tax attributes to invest efficiently, with U.S. taxable and super-tax exempt investors investing though the master fund that is a partnership for U.S. federal tax purposes, and non-U.S. and tax-exempt investors investing through a feeder fund taxed as a corporation for U.S. federal tax purposes.
Over time, fund of funds sponsors started offering separate accounts to individual investors generally structured as funds of one with a single investor. This allowed the fund of funds sponsor to customize the investment strategy for a single large investor to suit such investor’s particular needs. Perhaps an investor did not want any primary investments or the investor only wanted co-investments. Any combination around strategy and type of investment was now available to a particular investor. Over the past several years, there has been an explosion of these funds of one at fund of funds sponsors. In addition, many fund of funds sponsors now have dedicated secondary programs and co-investment programs and offer co-mingled funds just focusing on that one type of investment.
Marc, do you want to discuss things a sponsor of a fund of funds should keep in mind when forming such a fund?
Marc Biamonte: Yes. Since a fund of funds is investing in other private equity funds, the fund of funds vehicle needs to have broad LP clawback rights since the fund of funds sponsor may not be able to anticipate at the time of its offering what the recall obligations will be for each investment it will make. This is especially true in the secondary investment space where fund of funds are not able to negotiate fund terms at the time of its investment. Similarly, fund of funds sponsors may not be able to negotiate structural protections with underlying fund investments to guard against potential UBTI and ECI, therefore, fund of funds typically will not provide ECI or UBTI covenants to investors, but will offer a structural solution at the fund of funds level that its investors may elect to utilize. Fund of funds sponsors also need to have flexible investment allocation policies, and such policies should be able to be updated without investor consent to ensure that such policy can change as the number and types of fund of funds products are developed and brought to market, including separately managed accounts or funds of one.
Since a fund of funds is generally not taking control positions in underlying operating companies and generally is not receiving management rights in connection with its investments, it may not rely on the “venture capital operating company” exemption most private equity funds rely on to avoid being a fund subject to ERISA. Therefore, a fund of funds must rely on a different ERISA exemption, the so-called “25% test,” which, in order to avoid being an ERISA fund, a fund of funds must have less than 25% of its investors subject to ERISA. Proper counting of the ERISA assets is critical, and acceptance of ERISA investors may need to be staged over time to avoid violating this limitation.
Also, fund of funds sponsors should think carefully about conflicts of interests and their disclosure to investors. As a fund of funds manager grows, conflicts among the various funds they manage may increase—and sometimes, especially with funds of one, one fund may have contractual terms that could be materially different from a commingled fund alongside which it invests—and sponsors want to be sure they have the flexibility to manage those conflicts and differences in ways that do not limit or slow their investment activity.
Lindsey, what should investors think about if they are considering investing in a fund of funds product?
Lindsey Goldstein: A fund of funds offers a number of advantages to investors, including (1) expertise in evaluating investments in underlying funds; (2) relationships with top managers and access to funds which would otherwise be limited to large institutional investors; and (3) diversification. The cost for these benefits is an incremental layer of fees. An investor in a fund of funds will directly be responsible for the fund of funds’ management fee and carried interest, and indirectly responsible for the management fees and carried interest charged by the underlying funds in which the fund of funds invests. However, the management fees and carried interest charged by the fund of funds are less than the fees charged by the funds in which it invests. Given this, a typical fund of funds focused on primary investments generally attracts high-net-worth investors and smaller institutional investors. On the other hand, secondary-only or co-investment-only funds of funds attract sophisticated institutional investors of all types as they add these niche strategies to their portfolio. Also, the separately managed accounts or funds of one are popular with sophisticated investors who are able to commit large amounts of capital to such vehicles to help round out their alternative portfolios.
A fund of funds investor should be prepared to be on the hook for an LP clawback term that could last for multiple years past termination of the fund of funds itself. This is because a fund of funds is often not in a position to move the needle on underlying fund terms, and therefore, the fund of funds’ terms must be broad enough and, in the case of the LP clawback, lengthy enough to cover the broadest and longest corresponding provisions of the underlying funds.
Finally, it can be challenging for an investor in a fund of funds to negotiate specific excuse rights. As noted, a fund of funds may be limited in its negotiating leverage, and therefore, it will often need to adopt one version of its own excuse requests of underlying funds—for instance, related to alcohol, tobacco or weapons—and that version will need to be acceptable to each of its own investors.
Marc Biamonte: There’s a lot to think about when considering launching a fund of funds product or investing in one. With the growth of popularity in secondary investments and co-investments, we’ve seen many alternative asset managers adding fund of funds platforms to their offering.
Thank you, Lindsey, for joining me today for this discussion. Thank you to our listeners. We appreciate you tuning into Ropes & Gray’s Fully Invested podcast series. Please visit our website at www.ropesgray.com/assetmanagement, or feel free to reach out to any of us via email or phone for more information. You can also subscribe to this series wherever you typically listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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