A private equity fund of funds is a vehicle for collective investment that is not available to the public. Normally such funds are restricted to high net worth investors with a high risk tolerance. Minimum investments are usually quite high, often $1 million US Dollars (USD) or more. For funds doing business in the US, these restrictions lessen the amount of oversight by the Securities and Exchange Commission by a very considerable amount.
To be referred to as a private equity fund of funds, the fund must invest in other funds. The investments may include leveraged buy out funds (LBOs), hedge funds, mezzanine lending funds, venture capital funds, or any other sort of fund that the manager of the private equity fund of funds chooses. Each of the listed activities is a potential high risk undertaking.
LBOs are undertakings in which a small group of owners thinks it can profit by buying a publicly owned company, privatizing it, then selling off some or all the individual parts. The buyout is highly leveraged, and if the core owners can manage more than 100% leverage they have an instant profit. Some of main risks in an LBO are that the sale of the parts will net much less than planned, the core business cannot be made as attractive to the stock market as expected, and the stock market or the economy will greatly decline while the restructuring is underway. Any of these can result in a loss to the investors who provided the capital to take the company private.
Hedge funds come in many varieties and look for opportunities that have a history of being low risk. To obtain high returns from low risk positions, the funds have to use a large amount of leverage. For the most part leverage equals risk, but the risks are manageable if the fund managers make only sound assumptions about the nature of reality. The private equity fund of funds manager must know enough about the nature of the hedge fund’s operation to ascertain whether the assumptions are realistic. For him to do that, the hedge fund would have to disclose the algorithms they use for their business.
Mezzanine funds provide debt funding to companies who have already reached the limits of what conventional banks will lend them. In return, the mezzanine funds receive options on stock in the company along with interest on the loan. If the company does not succeed the fund who absorb most of the losses, not the conventional banks. For the mezzanine fund to enjoy a good return on its investment, the stock must trade well above the options price.
Venture capital funds invest in new ideas or a new, better, and patentable way to do something. In return they get stock, stock options and seats on the board of directors. The equity fund of funds will get a pro rata share of the stock and the options that were granted the venture capital fund. If the company is successful at producing and marketing a product, the venture capital fund will take it public. The risks lie in the ability of the venture capital fund to accurately diagnose the probability of success of the companies it finances.
Private equity fund of funds may choose to invest in other funds. A fund of funds won’t seek these investments directly, but could become an investor in them. The private equity fund of funds manager expects that the risks that pay off will outweigh the risks that fail by a substantial margin.