Turn the fee question around: solve for the underlying multiple at which the second layer disappears, then test the manager against it.
Only if the fund of funds picks managers good enough to pay for its own layer. On an illustrative programme where the underlying funds return 1.70x net, a fund of funds charging 0.75 per cent on commitments, 0.15 per cent of expenses and 5 per cent carry cuts the investor's IRR from 11.20 to 9.49 per cent, 171 basis points. To break even, its managers must return 1.83x instead of 1.70x, a 7.9 per cent better selection than the investor would have made alone.
Worked in full in The Private Markets Limited Partner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The question is usually put as "is 0.75 per cent too much?", which cannot be answered. A fee is worth paying if it buys something larger than itself. For a fund of funds, the thing bought is selection, access and the investor's own time, and the only one that can be measured is selection. So the useful calculation runs backwards: given the fee layer, how much better do the underlying funds have to be?
| Input | Value |
|---|---|
| Calls of the underlying funds, years 1 to 5, % of commitment | 25, 25, 20, 15, 15 |
| Distributions, years 4 to 11, % of total returned | 4, 8, 14, 18, 20, 16, 12, 8 |
| Net multiple of the underlying funds | 1.70x |
| Fund of funds management fee, years 1 to 5, on commitments | 0.75% |
| Fund of funds management fee, years 6 to 10 | 0.50% |
| Fund of funds expenses, years 1 to 10 | 0.15% |
| Fund of funds carry, over an 8% preferred return, full catch-up | 5% |
An investor that commits 100 itself, to funds returning 1.70x, pays in 100 and receives 170.0. On the call and distribution profile above, the net cash flows give an IRR of 11.20 per cent. In Excel, with net flows by year in B2:B13, =IRR(B2:B13).
Investor calls = underlying calls + fees + expenses
Fees and expenses: 0.90 a year for five years, 0.65 for five more = 7.75. Paid in: 100 + 7.75 = 107.75.
Investor distributions = underlying distributions − carry
Profit before carry = 170.0 − 107.75 = 62.25. The fund of funds clears its 8% hurdle, so with a full catch-up its carry is 5% of that profit, 3.11. The investor receives 166.89.
Net multiple 166.89 ÷ 107.75 = 1.55x. IRR 9.49%. Gap: 171 basis points and 0.15x.
Put differently, the second layer takes 15.5 per cent of the profit the underlying funds produce. The management fee is charged on commitments, so it runs at its full rate in years when much of the commitment is not yet invested, and keeps running into years when most has been returned.
Now solve for the underlying multiple at which the fund of funds investor earns the same 11.20 per cent as the direct investor. Scale every underlying distribution, keep the timing, and search.
Find m such that IRR(fund of funds flows at m) = IRR(direct flows at 1.70x)
Excel: Goal Seek on the multiple cell, setting the fund of funds IRR cell to 11.20%.
m = 1.83x. Uplift: 0.13x, or 7.9 per cent more value from the same commitment. In IRR terms the underlying funds must earn 12.94 per cent rather than 11.20.
That is the real price of the layer: 1.74 points of underlying IRR, every vintage. Whether a given fund of funds can deliver it is a diligence question about its record of picks against the funds it could have picked, not about its fee level.
| Fund of funds terms | Investor IRR | Gap, bp | Break-even underlying multiple |
|---|---|---|---|
| 0.50% then 0.25%, no carry | 10.24% | 96 | 1.77x |
| 0.75% then 0.50%, no carry | 9.82% | 138 | 1.81x |
| 0.75% then 0.50%, 5% carry | 9.49% | 171 | 1.83x |
| 1.00% then 0.75%, 10% carry | 8.78% | 242 | 1.90x |
Two features stand out. The carry layer is worth 33 basis points of IRR at a 1.70x outcome, and it grows with success: at 2.00x the total gap is 180 basis points, at 1.40x it is 142 because the hurdle is not cleared and no carry is paid. And the fee table matters less than it seems: moving from the cheapest to the dearest structure moves the required uplift from 0.07x to 0.20x, both inside the dispersion between an average and a good manager pick.
Going direct is not free. An investor that builds its own programme pays for a team, legal review and monitoring. At an illustrative 0.30 per cent of commitments a year for ten years, 3.0 in total, the direct IRR falls to 10.68 per cent. Against that, the fund of funds gap narrows to 119 basis points and the break-even multiple to 1.79x, an uplift of 0.09x. For a small allocator whose in-house cost per unit of commitment is higher, the layer can pay for itself on cost alone.
Access is the argument the arithmetic cannot settle. If the fund of funds reaches managers the investor could not get into at all, the comparison is not with the same funds at 1.70x but with whatever the investor would actually have bought. That is a real argument, and it should come with a list of the managers concerned.
The common mistake is to compare the fee rates: 0.75 per cent on top of the underlying funds' 1.5 to 2 per cent looks modest. But the underlying fees are already inside the 1.70x, and the second layer is charged on commitments to an investor whose capital is only partly invested. The number to compare is the IRR gap, 171 basis points here, and the uplift needed to close it.
Do not ask whether the fee is reasonable. Ask what underlying multiple makes it disappear, compare that with the investor's own cost of going direct, and then test whether the manager's past picks beat that bar. The worked programme and the gross-to-net bridge are in the free workbook and documents for this book. For how fees cut a single fund's return, see why net IRR is lower than gross IRR.
In the illustrative case, a 0.75 per cent fee on commitments for five years, 0.50 per cent for five more, 0.15 per cent of expenses and 5 per cent carry over an 8 per cent hurdle cost 171 basis points: 11.20 per cent direct becomes 9.49 per cent. Without the carry the gap is 138 basis points.
Enough to close its own fee gap. Where the investor would earn 1.70x going direct, the fund of funds must select underlying funds returning 1.83x, a 7.9 per cent better outcome, or 12.94 per cent of underlying IRR instead of 11.20.
It can be for a small allocator. If a direct programme costs an illustrative 0.30 per cent of commitments a year, its IRR falls from 11.20 to 10.68 per cent, the fund of funds gap narrows to 119 basis points and the break-even underlying multiple falls to 1.79x.
This article is one calculation from The Private Markets Limited Partner. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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