Investor Beware: Feeder Funds

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Investor Beware: Feeder Funds

Welcome back! 👋

Today we’re going to talk about a hot topic: feeder funds. Simply said, these are cases where an LP invests through an intermediary (which we’ll refer to as a feeder fund) that pools such capital and invests it with the ultimate GP. As always I would love any feedback and you can contact me anytime at aleksey@hey.com.

When an LP calls me and has an issue on an existing investment, there’s a decent probability that the LP invested through a feeder fund based on my dataset so far. I hope to shed light on what’s going on behind the scenes in order to help LPs make better decisions going forward.

We’ll cover 3 topics today:

• Examples of feeder funds, and their marketing strategies

• Why do feeder funds exist?

• Okay great, but where does it all go wrong?

A shorter version of this article appeared on The Promote earlier this week. It was fun collaborating with Hiten, who was the mastermind behind the meme below (which I am using with permission because I would never be able to come up with such a thing). You’ll see why it’s relevant soon…

Let’s dive in

Examples of feeder funds, and their marketing strategies

Feeder funds are all around us, and they exist in many forms.

Many attempt to use social tactics (successfully, in many cases - see #2 herein for more) to attract people of a similar background.

Some examples would include:

• Occupation based feeder funds: former doctors, engineers, software developers, sales professionals, pilots, veterans, etc that quit their job (or are doing this concurrently) to pursue investing and/or raising capital

• Cultural based feeder funds, which attract investors based on one’s background (e.g. country you’re from) or religious beliefs (e.g. go to same church, synagogue, etc)

Note that although the tactics above are very commonly used by feeder funds, it’s important to note that these same tactics are used by GPs as well. It goes without saying that you should invest in someone based on their investment acumen, experience, and the opportunity in front of you … and not their former profession or cultural upbringing. The latter might have a connection to trusting someone, but in my experience these “trust” associations tend to lead people to over trust and ignore basic diligence and gate keeping.

Let me pause to state the (unfortunately not so) obvious: just because someone looks like you, talks like you, dresses like you, has similar experiences or religious beliefs, doesn’t mean you should give them money.

Why do feeder funds exist?

Feeder funds exist for a good reason, and as such they’re not created equal.

Feeder funds serve as a conduit for limited partners (LPs) aiming to gain two primary advantages:

• Enhanced due diligence and experience

• In a nutshell, you’re not an investment expert.. but the person running the feeder fund (hopefully) is.

• To compensate them for their due diligence expertise, you are typically paying them fees to get “access” to better deals, assuming they’ve discarded ones that are not good. Fees typically include:

• Placement fees that are calculated as % of capital you invested (payable to the feeder fund, and on top of any acquisition fee payable to the GP)

• Asset management fees (again, on top of any property management and asset management fees that are paid to the PG) for them to keep track of the investment for you

• Access to exclusive investment opportunities

• A feeder fund would pool money together in order to get you “special” opportunities that you would otherwise not get .. either because the opportunity wasn’t marketed broadly, or because the amount an LP wants to invest on their own is far less than the minimum required by the GP.

In essence, LPs rely on the expertise of seasoned investors (feeder fund in our example) who conduct thorough vetting on their behalf, while also gaining entry into top-tier deals that wouldn’t otherwise be available to the LP.

Ok great, but where does it all go wrong?

First, the accessibility benefit of feeder funds isn’t always present. LPs end up investing $50,000 through an intermediary, while the GP themselves would gladly take that $50,000 themselves if the LP would have called them directly.

The due diligence (and thereby value proposition) process facilitated by feeder funds warrants some analysis. LPs may discover the limitations of their arrangement only when investments turn sour. It's not uncommon for LPs who call me to realize, often belatedly, that they were dealing with intermediaries rather than the actual sponsors. Unlike conventional joint venture agreements where a partner would have more leverage, feeder funds typically lack the contractual authority to intervene (i.e. replace or remove the GP) if investments underperform.

Communication breakdowns exacerbate the situation during turbulent times as well, with vital information from sponsors reaching LPs through feeder funds in an incomplete or significantly delayed manner.

Regarding alignment of interests, the dynamics are intricate. LPs might assume that feeder funds prioritize selecting the most promising deals based on risk-adjusted returns to the LP (you’re the customer, and the customer is always first…. right?!). However, these deals often entail upfront placement fees (and in some cases management fees as well), in addition to acquisition fees and other costs accrued by sponsors. This requires some thought based on the above, since as an LP you should wonder whether these costs are “worth” the service that’s being provided.

To further complicate matters for the LP, many feeder funds negotiate portions of the promote from sponsors to secure capital for them, potentially influencing their investment choices based on fee structures rather than investment merits. In other words, a feeder fund may choose to show an investment opportunity to an LP just because (1) that’s the only thing they have right now or (2) this particular investment has much more upside for the fund of funds … as opposed to keeping the LP interests in mind.

LPs must understand that the downside for feeder funds is minimal, while the potential upside can be substantial. Ethical considerations aside, from a financial standpoint, feeder funds stand to gain at least the placement fee (on top of GP’s acquisition fee; and possibly a second asset management fee on top of whatever the GP is charging) - this is the worst case scenario (if you lost all of you LP investment!). In a good outcome, the feeder funds can earn a piece of the sponsor's promote as we discussed above. Consequently, if feeder funds prioritize maximizing their own economic gains, it could skew incentives and compromise the risk/reward balance for LPs.

In essence, LPs must be vigilant and fully comprehend the dynamics at play when engaging with feeder funds of any kind, ensuring that their interests are safeguarded and aligned with the investment strategies pursued by these intermediaries.

A quick note on crowdfunding platforms. Crowdfunding platforms are not totally dissimilar to a feeder fund in many cases, depending on their incentive structure - you always need to understand how your counterparty is being compensated (as defined by what would happen in the best case and worst case scenarios).

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