In recent years, the previously rare funds of funds have become more common as a way to create liquidity in close-ended funds. Funds of funds enable the realisation of an investment in such a manner that the fund manager retains control and has the possibility to benefit from a potential future increase in value of the investment object. In this post, I present some central special characteristics of funds of funds that fund managers and investors should keep in mind.
What Are Funds of Funds?
In a typical fund of funds transaction, a fund of funds purchases one or several investment objects in a fund that is managed by the same fund manager and often near the end of its term. Investors of the existing fund have the option to either sell (i.e. redeem) their investment or to transfer it to the fund of funds. Completely new investors pay their commitments to the fund of funds, which provides liquidity for those investors of the existing fund that have decided to withdraw from the investment object. The terms and conditions of the fund of funds are negotiated between the fund manager and the new investors, and they often vary according to the asset categories that are the object of the fund of funds transaction.
When used strategically correctly, a fund of funds can satisfy the interests of the different stakeholders and achieve several targets: it can offer a liquidity window for current investors wishing to withdraw, balance conflicting interests, customise incentives and extend the holding period of the investment objects to maximise their value creation.
Fund of funds transactions are, however, complex transactions, and if the process to arrange them is weak, it often damages the fund manager's reputation. A successful establishment of a fund of funds requires that the investors are provided with a clear business justification, that the transaction structure is created in a manner that solves the main legal and tax challenges and that the legal and commercial process is efficiently managed.
The Main Contradiction
A significant portion of fund of funds transactions facilitated by fund managers is never completed. Common reasons for this are disagreements on the fair value and the grounds justifying the transaction. Some investors may be worried about the justifications: is the fund manager actually trying to hold on to a high-quality investment object or is the ultimate purpose of the transaction to dump to the fund of funds unprofitable investment object that could not be realised at an appropriate price on the normal market? There may also be suspicions that the fund manager might want to use a fund of funds to hold on to the fees relating to the investment objects that they would not get if the object was realised to a third party.
Usually, the dynamics of a fund of funds transaction are more complex than a typical withdrawal from a target company, as in practice the fund manager acts as both parties in the transaction. To create an attractive liquidity alternative, the fund manager must offer the potential buyers an attractive transaction proposal and price.
On the other hand, acting as the seller, the fund manager also has the duty of care towards the existing fund: in practice, the sales cannot be executed unless a sufficient number of existing investors are persuaded to support the sales. Sometimes the fund manager can also ask the buyers for a group commitment to another fund collected by the fund manager, which may increase the complexity of the transaction. When there is a conflict of interests, measures and justifications are necessary to make the transaction credible and satisfactory to both parties.
Starting the Process
If you are an investor considering investing in a fund of funds, we recommend consulting advisors at an early stage. The legal documentation of the existing fund and its investment objects should be carefully reviewed so that any required approvals and potential restrictions, such as regulatory issues or transfer restrictions, can be identified.
Tax advice is necessary for the potentially complex structuring of the transactions, in particular, if the existing investors are to invest in the fund of funds in a tax-neutral manner. Financial advisors are often needed to help with the coordination of marketing, the commercial process and investor relations, as well as with proving the transparency and impartiality of the valuation and sales process to the investors. Sometimes further assessments on whether the transactions are market-based are obtained.
As fund of funds transactions are, as a rule, insider transactions, they typically require an approval by the existing fund's investment committee or investors. The recommendation is that the fund manager hears the investment committee before planning the transaction very far. This helps in demonstrating transparency and increasing the investors' trust, both of which are very important in ensuring a smooth process.
Finding Buyers and Negotiating Terms and Conditions
After forming the team of advisors, the fund manager should identify potential buyers. These could include single investors or a consortium. Buyers will become investors of the fund of funds and thus provide liquidity for the investors of the earlier fund.
The fund manager can find buyers through their contacts or, for example, through a bidding process. The bidding process is usually managed by the financial advisor who assists in determining the fair value and relieves investors' concerns relating to the impacts that the fund manager's conflicts of interests may have on the transaction.
After the potential buyers have been identified, the negotiations that follow can be a significant phase that requires expertise both in funds and in corporate transactions. Even though the terms and conditions of the existing fund can be used as a basis for certain conditions, the central terms and conditions of funds of funds transactions are usually customised. These include financial terms, the fund manager's own investment, conditions on new investor protection, issues concerning uncalled commitments between current and new investors as well as conditions concerning transferable assets and the minimum number of transferring investors. All existing investors' side letters should be reviewed, and fund managers should be prepared in case the investors want to renegotiate their side letters at this stage.
As establishing a fund of funds is ordinary fundraising, fund managers should take into account all provisions that are usually applied, such as applications and approvals relating to the marketing of the funds.
What Should Current Investors Take into Account?
A disclosure memorandum is usually drawn up for the current investors. In addition to the details concerning the transaction, the memorandum includes important legal information and often also a form with which the investors can partially withdraw from the current fund or transfer a part of their holdings to the fund of funds.
Often current investors can also make an additional commitment to the fund of funds increasing their relative indirect part of the transferring investment objects. Any necessary approvals of the investment committee and existing investors are also obtained at this stage.
As a withdrawal arranged through a fund of funds deviates from an ordinary withdrawal, it is quite common for the fund management agreement to require obtaining an approval of the existing investors. This is usually sensible also considering the fund manager's liability risks. However, some fund management agreements determine permissible inside transfers broadly in such a way that the earlier fund can transfer its holdings in an investment object to any fund managed by the fund manager or its subsidiaries, including a fund of funds.
From the investors' and fund managers' point of view, it is recommended that the possibility of establishing a fund of funds is discussed already in conjunction with the fundraising for the original fund in order to avoid surprises towards the end of the fund's term.
Successful Completion of the Transaction
When investors have decided whether they want to withdraw or transfer their holdings and all preconditions have been fulfilled (e.g. authority approvals have been received), the transaction can be completed. Withdrawing investors are distributed profit, the existing fund can realise the investment object and the fund of funds takes responsibility for holding and developing the investment object.
The key to a successful fund of funds transaction is commencing close cooperation with the investors already at an early stage, and a transparent process for determining the price supports such cooperation. Another critical issue is coordinating the interests of the current and new investors in an appropriate and fair manner, which requires thorough consideration of legal, financial and tax matters.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
