The Double Fee Problem Most Fund of Funds Investors Miss
Two fund managers can mean two layers of fees and carried interest. Your investors need to understand both.
By Seth Bradley, Esq.
If you want a clear, step-by-step framework for structuring your fund, raising private capital, and building a scalable investment platform from initial strategy through execution, download the Fund Founder's Playbook.
Download the Fund Founder's Playbook →A capital partner wants to build a fund of funds.
Instead of buying and operating properties directly, they'll raise capital and invest it with several experienced sponsors.
They'll select the managers, review the deals, and monitor the investments.
But before launching, there's an important question to answer.
How much will investors actually pay across both layers of the structure?
Because the fees don't stop at the underlying fund.
Quick note: This is educational, not legal or investment advice. Fund economics and disclosure obligations depend on the structure and governing documents.
The 3 Things to Understand First
Point 1
Two separate economic arrangements
Fees and carry can apply at the underlying fund and at the fund of funds.
Point 2
Returns flow through both levels
Distribution waterfalls at each layer shape the investor's net return.
Point 3
Disclosure matters
Investors should see the combined economics before they subscribe.
The Most Important Thing You Need to Understand
A fund of funds invests in other funds.
That creates two separate economic arrangements.
At the underlying fund level, the lead sponsor may receive management fees and carried interest.
At the fund of funds level, the capital partner managing the upper-tier fund may charge additional fees and carried interest.
These arrangements can be legitimate. The important issue is how the combined costs affect investor returns.
When presenting a fund of funds, show the full economic structure, including both fee layers and both distribution waterfalls.
Key Takeaway
The important issue is not whether two fee layers exist, but how the combined costs affect investor returns.
Follow the Money Through Both Waterfalls
Suppose a fund of funds invests in three underlying real estate funds.
Each underlying fund has its own agreement governing distributions between the underlying GP and its LPs.
The fund of funds receives distributions according to those agreements.
That money then becomes available for distribution at the fund of funds level, subject to its own expenses and waterfall.
So the investor's ultimate return depends on the economics at both levels.
Management fees may be charged using different calculation bases and at different times. Carried interest is generally tied to the applicable distribution arrangements.
Don't treat these as a single flat fee.
Key Takeaway
An investor's return depends on the economics at both levels, not a single flat fee.
The Upper-Tier Manager Needs to Earn Its Economics
An experienced fund of funds manager can add value through manager selection, investment diligence, monitoring, access, and diversification.
They may also negotiate more favorable investment terms.
For example, a fund of funds making a meaningful commitment could negotiate a reduction in an underlying manager's fees or enhanced reporting rights.
Those benefits can improve the overall economics.
But negotiating leverage depends on the investment size, the manager relationship, and the agreement.
Key Takeaway
The upper-tier economics should be tied to real value the manager delivers, not simply layered on top.
Show Investors the Combined Economics
This is where disclosure becomes important.
Don't show investors only the fund of funds management fee while leaving the underlying fees buried in another document.
Explain the underlying manager compensation, upper-tier compensation, and other material expenses.
Investors should understand how the arrangement works before they subscribe.
Model investor returns after both economic layers, using assumptions consistent with the actual fund agreements.
Key Takeaway
Show investors the full economic picture, including both fee layers, before they subscribe.
Bottom Line
Two layers of fees aren't automatically a problem.
Two layers of fees without sufficient value or adequate disclosure are.
If you're building a fund of funds, understand the economics at both levels.
Show investors how returns flow through the structure.
And be prepared to explain what the additional layer delivers.
Two layers of fees aren't automatically a problem. Two layers without sufficient value or adequate disclosure are.
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DISCLAIMER: This article is provided for educational and informational purposes only. It does not constitute legal, tax, accounting, or investment advice, nor an offer to sell or solicitation of an offer to buy securities. Private investments involve significant risks, including potential loss of capital and limited liquidity. Consult qualified professional advisers regarding your specific circumstances. All information contained in this communication should not be considered investment advice, but education and entertainment only. Seth Bradley, EverSmart LLC and Raise the Bar do not render tax, legal, accounting, investment or other professional advice herein.