Investing in Funds, Not Companies
A Fund of Funds (FoF) AIF inverts the typical private capital investment model: instead of deploying capital directly into operating companies, an FoF's portfolio consists primarily of units in other AIFs — giving its own investors diversified exposure across multiple underlying fund managers and strategies through a single commitment. This is a genuinely distinct structuring and diligence exercise from direct-investing AIFs, worth understanding on its own terms.
The Regulatory Basis: Investing in Units of Other AIFs
SEBI's AIF Regulations specifically permit an AIF to invest in units of other AIFs (Regulation 15(1)(c)/(d)) without requiring the investing fund to formally register or label itself as a "fund of funds" — meaning an FoF strategy operates within the standard Category I or Category II framework, with its distinctiveness coming from the investment strategy disclosed in its PPM rather than a separate regulatory sub-category. One specific structural limit worth flagging: an AIF authorised to invest in units of other AIFs cannot itself offer its own units for subscription to other AIFs — preventing the kind of circular, multi-layer fund-of-fund-of-funds chains that would obscure ultimate risk and fee exposure.
The Fee-on-Fee Problem — The Central Economic Question
The single most important thing any investor needs to understand about FoF economics: an FoF investor typically pays two layers of fees — the FoF's own management fee and carried interest, plus indirectly bearing the management fee and carry of each underlying fund the FoF invests in. This "fee on fee" structure means an FoF's net returns to its own investors are mathematically always lower than the blended gross returns of its underlying funds, by the combined fee drag of both layers. This isn't necessarily a reason to avoid FoF investing — diversification and manager-selection value can still justify it — but it's a return-modelling reality every FoF investor needs to price in explicitly, not discover only when comparing net IRRs after the fact.
Why Investors Choose the FoF Route Anyway
- Diversification without the operational burden of multi-manager relationships — a single FoF commitment gives exposure across several underlying managers/strategies without the investor needing to separately diligence, commit to, and manage relationships with each one individually
- Access to managers/funds otherwise hard to access — some high-demand fund managers restrict access to existing relationships or larger institutional tickets; an FoF with an established track record and relationships can sometimes access allocations an individual investor couldn't secure directly
- Manager-selection expertise as a service — a well-run FoF's core value proposition is genuine skill in identifying and selecting strong underlying managers — a distinct expertise from operating-company investment diligence, and one many individual investors reasonably don't have the resources to build in-house
- J-curve mitigation — because an FoF typically deploys into multiple underlying funds across different vintages, its own cash-flow and return profile can be somewhat smoother than a single direct fund's more pronounced early-years J-curve (the initial dip in reported returns before value creation and distributions materialise) — see our companion glossary content on the J-curve effect for the underlying mechanic this smooths
What Manager Selection Discipline Actually Involves
An FoF's core skill is genuine, rigorous underlying-manager diligence — not simply relationship access. This typically involves: evaluating underlying managers' track records with appropriate scrutiny of methodology (see our TVPI/DPI/RVPI/IRR glossary article for the metrics this diligence actually uses), assessing team stability and succession risk within underlying manager organisations, understanding each underlying fund's specific strategy and how it complements (rather than duplicates) other underlying holdings in the FoF's own portfolio, and negotiating access/terms — since larger, more established FoFs often can negotiate more favourable terms (fee breaks, co-investment rights) with underlying managers than an individual investor committing alone could achieve.
Liquidity: A Double Illiquidity Layer
An FoF investor should understand that their capital faces liquidity constraints at two levels — the FoF's own closed-ended structure and tenure, layered on top of the illiquidity of each underlying fund the FoF itself has committed to. This compounds, rather than reduces, the overall illiquidity an FoF investor experiences compared to a single direct fund investment — a point sometimes lost given FoFs' diversification benefits get more marketing attention than this liquidity-compounding reality.
Government-Backed FoF Structures — A Related but Distinct Model
Government-backed fund-of-funds structures — like SIDBI's Fund of Funds for Startups (see our dedicated SIDBI FFS article) — operate on a related but distinct model: rather than pooling third-party investor capital to diversify across many underlying funds for those investors' direct benefit, government FoF schemes act as an anchor limited partner within individual daughter funds, catalysing private capital formation rather than functioning as a commercial FoF product available for investor subscription. Worth understanding as a structurally different use of the "fund of funds" mechanism, even though the underlying regulatory basis (investing in units of other AIFs) overlaps.
Private FoF Platforms in the Indian Market
Beyond government-backed structures, private FoF platforms have increasingly emerged in India, offering investors diversified access to the country's growing venture and private equity fund ecosystem through a single commitment — a genuinely useful entry point for investors newer to private capital allocation who want diversification and manager-selection expertise before building direct, single-manager conviction over time.
Evaluating and Structuring FoF Strategies
We advise both FoF managers on structuring and PPM disclosure of the fee-on-fee economics transparently, and investors evaluating an FoF commitment on modelling realistic net-of-both-fee-layers return expectations before committing capital.
This article is for general informational purposes and does not constitute investment advice specific to any Fund of Funds AIF or underlying fund selection.