Fund of funds

A fund of funds does not pick companies. It picks managers.

It takes an investor's commitment and spreads it across several AIFs, each running its own strategy, so that no single manager's judgement decides the outcome. The workbook is blunt about the motive: such a fund may have no specialised investment theme of its own, because the theme is risk diversification across several thematic funds.

It is also the standard route for capital that cannot manage money in India directly. An offshore investor without a permanent establishment here can commit to an Indian FoF and let the underlying managers do the active work.

The cost of that convenience is arithmetic, and it is the single most examinable thing about the structure: the investor pays a fee at the underlying fund and a fee at the fund of funds.

FoFs appear in the Indian market from both directions. On the private side they are an investor type — the workbook lists funds of funds alongside institutional investors, HNIs, banks, insurers and pension funds as contributors to AIF corpus. On the public side they are policy instruments: the Government of India set up a Rs 10,000 crore fund of funds for start-ups under the DPIIT, managed by SIDBI through Category I and II AIFs, which invests in SEBI-registered AIFs that in turn invest in start-ups, and announced a further Rs 10,000 crore fund in 2025 for emerging technologies, artificial intelligence and machine learning.

The mechanism to understand is fee stacking. Each layer charges its own management fee and its own carried interest, and the second layer charges on a base that has already been reduced by the first. Two consequences follow:

• A gross return that looks comfortably above a hurdle at the portfolio level can arrive at the investor below it.
• The underlying carry is charged fund by fund. A year in which two underlying funds do well and three do badly still pays carry on the two, even though the FoF investor's aggregate position is flat. There is no netting across managers.

Against that, the FoF buys access — to managers who are closed, to vintages an investor cannot time, and to a manager-selection function the investor would otherwise have to staff. Whether it is worth two layers is a judgement about the dispersion of manager returns in the strategy, not a fact.

Value after the underlying layer
  = Gross portfolio value − underlying management fees − underlying carried interest

Net to the FoF investor
  = Value after the underlying layer − FoF management fee − FoF carried interest

Total fee drag = underlying management fee + underlying carry
               + FoF management fee + FoF carry

Carry at each layer is charged only on the profit above that layer's own hurdle, so the two hurdles are tested independently and on different bases.

An Indian fund of funds raises Rs 500 crore and commits Rs 100 crore to each of five Category II AIFs. Fees:

• Underlying funds: 2% a year on committed capital, and 20% carried interest above a 10% hurdle.
• Fund of funds: 1% a year on committed capital, and 5% carried interest above an 8% hurdle.

Over five years the underlying portfolios double: Rs 500 crore of gross value becomes Rs 1,000 crore.

Layer 1 — the underlying funds

Management fee   5 years x 2% x Rs 500 cr      =  Rs  50.00 cr
Value after fee  1,000 − 50                    =  Rs 950.00 cr
Profit after fee 950 − 500                     =  Rs 450.00 cr
Hurdle return    500 x 1.10^5 − 500            =  Rs 305.26 cr
Profit above hurdle 450 − 305.26               =  Rs 144.74 cr
Carried interest 20% x 144.74                  =  Rs  28.95 cr
Value reaching the FoF                         =  Rs 921.05 cr

Layer 2 — the fund of funds

Management fee   5 years x 1% x Rs 500 cr      =  Rs  25.00 cr
Value after fee  921.05 − 25                   =  Rs 896.05 cr
Profit after fee 896.05 − 500                  =  Rs 396.05 cr
Hurdle return    500 x 1.08^5 − 500            =  Rs 234.66 cr
Profit above hurdle 396.05 − 234.66            =  Rs 161.39 cr
Carried interest 5% x 161.39                   =  Rs   8.07 cr
Net to the investor                            =  Rs 887.98 cr

The result

Rs 112.02 crore of the Rs 500 crore of gross profit went to fees — 22% of it. The FoF layer alone took Rs 33.07 crore, about 6.6% of committed capital over five years, for the manager-selection function. The drag is 270 basis points a year, and the investor doubled their money at the portfolio level while receiving 1.78 times at the bank.

Chapter 2 (Types of Investments), section 2.3 introduces FoFs as AIFs that invest in other AIFs rather than in investee companies; Chapter 6 places them in the Category I and II investor profile and carries the DPIIT and 2025 government FoF figures; Chapter 7 treats them as an investor type in the AIF ecosystem. Chapter 9 supplies the fee machinery. Expect a definition question ("an AIF that does not invest directly in investee companies"), a recall question on the Rs 10,000 crore government fund of funds, and a computation that asks what a stated gross return becomes after two layers of fees.

• An FoF invests in other AIFs, not in investee companies. A fund that does both is not what the workbook means by the term.
• Carry does not net across underlying managers. Two winners pay carry even in a year when three losers leave the FoF investor flat overall — which is why stacked structures underperform the arithmetic average of their holdings.
• The FoF hurdle is tested on the FoF's own base, after the underlying layer has already taken its fees. Applying one hurdle to the gross portfolio return is the standard computational error.
• A fund of funds is not automatically a Category I AIF. The government's DPIIT vehicle operates through Category I and II AIFs; the category depends on what the fund does, not on the fact that it invests in other funds.
• An FoF does not escape the AIF minimums. It still needs a Rs 20 crore scheme corpus, still takes Rs 1 crore minimum tickets from non-accredited investors, and still faces the 1,000-investor cap.
• Concentration limits apply through the units too. A Category III AIF's 10% exposure ceiling to one investee company, and the Category I and II ceiling of 25%, are measured directly or through units of other AIFs.