Setting Up Fund of Funds: A Step-by-Step Guide

Fund of Funds (FoF) offers a unique investment approach by pooling capital to allocate across a range of other investment funds. It is a lucrative alternative to directly investing in individual securities like stocks or bonds.

This structure is particularly advantageous for real estate investors with robust networks but may lack direct deals, or prefer to leverage the expertise of other fund managers.

Let’s unpack the details of FoF to help you decide whether this type of investment is right for you.

Benefits of the Fund of Funds Structure

Before you dive into an FoF, it’s advisable to know what you can expect so you can arrive at an educated decision:

Diversification

By spreading investments across multiple underlying funds, an FoF reduces the risk associated with any single investment. This diversified exposure allows you to gain from a variety of investment strategies, reducing the volatility that might come from putting all your capital into one type of asset or market.

Simplicity

A Fund of Funds presents a straightforward investment process for participants. Investors do not need to perform the exhaustive due diligence required to select individual securities. Instead, you rely on the FoF managers who conduct thorough research and select the underlying funds based on performance, risk management practices, and potential for returns.

Inclusivity

For smaller investors, an FoF provides access to high-capital or specialized funds that might otherwise be beyond reach due to restrictive entry barriers. This inclusion allows them to participate in broader market opportunities without needing substantial individual capital outlays.

Flexibility

The Fund of Funds structure allows sponsors to capitalize on their network and expertise without the necessity of managing direct investments. It offers a way to harness collective investment knowledge and strategies, making it a strategic choice for those aiming to optimize investment portfolios through diversified, managed models.

Setting Up a Fund as a Sponsor

To do this successfully, you must ensure all fund elements align for optimal performance and compliance. Here’s a concise guide to get you started:

1. Define Your Investment Strategy

Begin by clearly outlining the investment thesis for your Fund of Funds. Decide on the types of funds you wish to include, and balance the anticipated risks and returns.

2. Select the Legal Structure

Choose between a limited partnership (LP) or a limited liability company (LLC). Your choice will impact the Fund’s regulatory obligations and tax considerations. Utilize either a U.S. or offshore legal entity, such as those in the Cayman Islands, based on tax guidance from a separate CPA or a tax attorney with international expertise.

3. Register and Comply with Regulations

This often involves registering with governmental agencies and adhering to specific disclosure and compliance rules of Regulation D, Rule 506(c) exemption for U.S. investors and Regulation S exemption for international investors.

4. Prepare Offering Documents

Draft the Private Placement Memorandum (PPM) detailing the Fund’s strategy, associated risks, and terms for potential investors.

5. Raise Capital

Utilize your network to attract potential investors. Be transparent about the Fund’s objectives and how it aligns with their investment goals. Restrict to fewer than 100 investors to avoid falling under registered investment company regulations.

If the Fund invests in Rule 506(c) offerings, all investors must qualify as Accredited. That is, they should have:

• More than $1 million in net worth, or
• $200+K annual income for an individual or $300+K annual income for married couples or spousal equivalents

Examine each Subscription Agreement to verify that all participants meet your offering’s suitability criteria.

6. Conduct Due Diligence

Select the underlying investment funds by evaluating their past performance, risk management practices, and management expertise. Also, perform thorough anti-money-laundering and bad-actor background checks.

7. Monitor and Manage Investments

Continuously monitor the performance of the selected funds. Make adjustments as needed to stay consistent with your investment strategy.

8. Determine the Fund Manager’s Compensation

This includes a fixed fee that is not tied to the amount of money raised. Additionally, the manager is entitled to a percentage of the Fund’s profits.

Each of these steps requires careful planning and execution. Sponsors must maintain a diligent approach throughout the process to ensure that all regulatory and investor-related aspects are meticulously managed.

Hiring a Securities Attorney for the Fund Setup

A professional legal counsel plays an indispensable role in ensuring your Fund’s compliance with applicable laws and regulations. Without their involvement, sponsors risk non-compliance, which could lead to costly legal disputes or penalties.

Thus, a skilled and knowledgeable securities attorney is recommended to fill this position with the following responsibilities:

1. Establishing Legal Entities

This could be for U.S. entities and/or a collaboration with offshore legal advisors for international legal entities when applicable.

2. Drafting and Reviewing Key Documents

The following relevant paperwork must clearly articulate the Fund’s terms and meet legal requirements:

• PPM, which is mandatory if investors are Non-Accredited, and recommended if you have more than four Accredited Investors or are marketing the Fund
• Operating Agreement for both the Investor entity and the Manager entity (if required)
• Subscription Agreement, which highlights the investment risks if you are not providing a PPM

3. Guidance in Regulatory Compliance

Your lawyer guides you through the registration process with the relevant regulatory bodies. They will also submit required notices to the SEC and state securities agencies, and make sure all necessary filings are completed accurately and on time.

Some lawyers educate the Manager about their specific exemption to guarantee adherence to securities laws. 

4. Strategic Advice on Structuring the Fund

Perhaps the most indispensable service a securities attorney can offer is counseling on optimizing tax benefits and protecting the interests of both sponsors and investors. Their expertise helps mitigate potential legal risks for all stakeholders involved and ensures the Fund operates within the legal framework.

Moving Forward: When to Consider a Fund of Funds

This structure is an appealing option for various types of investors, particularly those looking to diversify their portfolios without the burden of selecting individual securities. By pooling investments into multiple underlying funds, it provides access to a broad range of strategies and asset classes, reducing risk and enhancing potential returns.

For investors with strong networks but without direct deals, a Fund of Funds leverages those connections efficiently and enables them to invest in a diversified portfolio managed by experienced fund managers. It’s an advantage for those who wish to spread their investment across different sectors or markets without hands-on management.

For fund managers, an FoF offers a strategic avenue to capitalize on their investor networks while relying on the expertise of other fund managers. It broadens their investment scope while adding a layer of professional management to each investment, thereby improving the overall performance of the Fund.

Engaging a securities attorney during this process is crucial. Their guidance provides legal safeguards and strategic advantages, and their professional support is invaluable in your Fund’s setup and management.Are you in the process of starting a real estate Fund of Funds? Avoid legal pitfalls and commission an expert property investment legal counsel! Shams Merchant is the leading real estate private equity and syndication lawyer in Texas, representing clients in more award-winning real estate projects in the state than any other lawyer under 35. Specializing in real estate syndications, fund formations, securities law, and private placements for commercial property investments and development, Shams has been featured in publications like Law360, the Austin Business Journal, BisNow, and The Real Deal.