1) What is a fund-of-funds, and how is it structured?
A fund-of-funds (FoF) pools investor capital and allocates it across multiple underlying funds to diversify across strategies, vintages, managers, and geographies. Typical structure:
- Capital flow: Investor → FoF (GP/manager) → Underlying funds (LP interests).
- Fee stack: Investors pay the FoF’s management/administration fees plus the underlying funds’ fees (often partially offset via fee credits).
- Benefits: Diversification, access to top-tier or capacity-constrained managers, professional selection/pacing, smoother cash flows.
- Trade-offs: Extra fee layer, less look-through control, potentially slower deployment; require careful analysis of value-add vs. cost.
2) What red flags should I look for in fund documents or managers?
- Economics & alignment: Weak GP commitment; uncapped org expenses; complex fee waterfall; high use of subscription lines that can inflate IRR without improving MOIC.
- Strategy & process: Style drift; vague sourcing or underwriting; overreliance on leverage; mismatched liquidity (e.g., frequent redemptions against illiquid assets).
- Valuation & reporting: Non-independent valuations; inconsistent fair-value marks; NAV smoothing; limited transparency or tardy reporting/audits.
- Operations & governance: No independent administrator; poor operational due diligence (ODD) responses; key-man risk without protective clauses; compliance gaps.
- Legal docs: Aggressive side-letter terms disadvantaging other LPs; weak key-man/change-of-control protections; limited advisory committee rights.
3) What’s the difference between operational risk and market risk?
- Operational Risk: Losses from people/process/systems failures—e.g., valuation errors, trade breaks, cyber/compliance lapses, inadequate segregation of duties, or fraud. Mitigated via independent admin, SOC reports, audited financials, robust policies, and strong CCO function.
- Market Risk: Losses from economic/market moves—e.g., spread widening, rates, FX, equity beta. Mitigated via position sizing, diversification, stress testing, and hedging.
In diligence, evaluate both: a great strategy can be undone by weak controls; pristine ops can’t save a flawed strategy.