Private credit has become an important area of interest for High-Net-Worth Individuals (HNIs) looking to diversify their investment portfolios beyond traditional asset classes. However, before investing, one of the most important questions is: how do private credit investments generate returns?
To understand this, investors first need to understand the difference between a private credit fund and a private credit Fund of Funds (FoF).
A private credit fund typically lends money to businesses and earns income through interest payments and other contractual arrangements. A Fund of Funds, on the other hand, invests in selected underlying private credit funds rather than lending directly to businesses itself.
This distinction is important because the returns of a Fund of Funds depend on the performance of its underlying investments, the terms governing distributions, and the fees and expenses incurred at different levels.
In this guide, we explain how private credit Fund of Funds generate returns, how income flows from underlying investments to investors, what factors can affect performance, and what HNIs should consider before investing.
What Is a Private Credit Fund of Funds?
A private credit Fund of Funds is an investment structure that allocates capital across multiple underlying private credit funds.
Instead of investing directly in individual loans, the FoF selects and invests in funds managed by specialist investment managers. These underlying funds may provide credit to businesses across different sectors, industries and financing situations.
The objective is to build exposure to private credit through a portfolio of underlying funds rather than relying on a single fund or lending strategy.
For investors, this structure can provide access to multiple credit strategies through one investment vehicle. However, the actual level of diversification depends on the FoF’s portfolio construction, underlying fund selection and concentration limits.
To understand the broader investment structure, read our guide on how Fund of Funds work in India.
How Private Credit Fund of Funds Generate Returns
The return-generation process involves two levels: the underlying private credit funds and the Fund of Funds.
At the first level, underlying private credit funds provide loans to businesses and may earn income through interest, fees and other contractual payments.
At the second level, the Fund of Funds invests in those underlying funds. Its financial performance depends on the performance of these investments and the distributions it receives under the applicable terms.
After accounting for expenses and fees at both levels, the amount available for distribution to FoF investors depends on the fund’s structure, available cash flows and governing documents.
The following sections explain the main sources of income at the underlying fund level and how they contribute to the broader FoF investment structure.
Four Key Sources of Returns in Underlying Private Credit Funds
1. Interest Income
Interest income is a primary source of returns for many private credit strategies.
Underlying private credit funds lend to businesses under negotiated agreements. These agreements specify the loan amount, interest rate, repayment schedule, tenure and other relevant conditions.
Borrowers pay interest according to the agreed terms. Depending on the loan structure, payments may be made monthly, quarterly or at maturity. Some agreements may also provide for deferred interest.
The interest rate generally reflects several factors, including the borrower’s creditworthiness, the security available, the duration of the loan and the overall risk involved.
For a Fund of Funds, the performance of these underlying lending investments can contribute to the returns generated by its portfolio.
However, interest payments are subject to the borrower’s ability to meet its obligations. Delays, defaults or loan restructurings can affect the income and value of the underlying investment.
2. Structuring and Arrangement Fees
Some private credit transactions include fees associated with arranging, structuring and executing loans.
These fees may compensate the relevant parties for activities such as sourcing opportunities, assessing borrowers, negotiating terms and completing transaction documentation.
Depending on the underlying fund’s investment strategy and contractual arrangements, such fees may contribute to the economics of a credit transaction.
However, the treatment of these fees varies. They may accrue to the fund, the investment manager or another party, depending on the relevant agreements.
FoF investors should therefore understand how underlying fund income is generated and how any applicable fees are treated. They should not assume that every fee charged to a borrower becomes income for the underlying fund or the Fund of Funds.
3. Repayment and Prepayment Premiums
Certain private credit agreements include additional payments when a borrower repays a loan, particularly when repayment occurs earlier than scheduled.
These payments may be described as prepayment premiums, repayment premiums or exit-related payments, depending on the agreement.
Such contractual features may help compensate a lender for the shorter investment period or the loss of expected future interest income.
For example, a loan agreement may specify an additional payment if the borrower repays the loan before the agreed maturity date.
Whether the premium is payable depends on the contract and the circumstances of repayment. It should not be treated as guaranteed income.
For a Fund of Funds, these payments can influence the performance and cash distributions of the underlying investment, which may subsequently affect the FoF.
4. Other Structured Pricing Features
Private credit transactions can include negotiated pricing features beyond a standard interest rate.
Examples include step-up interest rates, discounted loan issuance and certain milestone-linked payments. These features depend on the transaction structure and the underlying fund’s strategy.
A step-up interest rate, for instance, may increase after a specified period or when certain contractual conditions are met.
Such features can affect the timing and amount of income earned by an underlying fund. However, the actual outcome depends on the agreement, the borrower’s performance and whether the relevant conditions are satisfied.
For FoF investors, the important consideration is how these features contribute to the underlying fund’s overall performance rather than simply focusing on the headline interest rate.
How Returns Flow from Underlying Funds to FoF Investors
Understanding the flow of money is essential when evaluating a private credit Fund of Funds.
The process can be explained in four stages:
Stage 1: Investors commit capital to the Fund of Funds.
Eligible investors invest in the FoF according to its terms. Capital may be called in stages, depending on the fund structure and investment requirements.
Stage 2: The FoF invests in underlying private credit funds.
The FoF allocates capital to selected underlying funds based on its investment strategy, due diligence and portfolio construction approach.
Stage 3: Underlying funds generate income and distributions.
Underlying funds manage their respective credit investments. Their performance depends on borrower repayments, investment costs, recoveries and other factors. Cash may be distributed to the FoF according to the underlying funds’ terms.
Stage 4: The FoF manages distributions to its investors.
The FoF receives distributions from its underlying investments. After accounting for its own applicable fees, expenses and other obligations, amounts may be distributed to FoF investors according to the fund’s governing documents.
This structure means that the FoF investor’s experience depends on more than the interest rates charged on individual loans.
It also depends on the selection and performance of underlying funds, the timing of their distributions, the FoF’s own costs and the terms under which investors receive proceeds.
Understanding Gross Returns and Net Returns
Gross returns and net returns are not the same.
Gross returns generally refer to investment performance before certain fees and expenses, although the precise calculation depends on the reporting methodology.
Net returns reflect the impact of applicable costs and fees. For a Fund of Funds, these costs may arise at both the underlying fund level and the FoF level.
Consider a simplified illustration in which an underlying investment generates income. Some of that income may be used to cover the underlying fund’s expenses and fees before proceeds reach the FoF. The FoF then accounts for its own applicable expenses and fees before determining the amount available to investors.
This example explains the process rather than representing the expected performance of any particular fund.
When comparing investment opportunities, HNIs should review the reported performance methodology and understand whether figures are gross or net, what expenses are included, and whether the figures relate to an underlying fund or the FoF itself.
A headline return at the underlying fund level should not automatically be interpreted as the return an FoF investor will receive.
What Factors Can Affect Private Credit Fund of Funds Returns?
Several factors can influence the performance of a private credit Fund of Funds.
Borrower Defaults and Payment Delays
Underlying funds depend on borrowers meeting their repayment obligations. If borrowers default or delay payments, the underlying funds may experience lower income, reduced recoveries or losses.
These outcomes can affect the performance of the FoF’s investments.
Underlying Fund Selection
The quality of the underlying portfolio is an important consideration. Differences in investment strategy, underwriting standards, manager experience and risk management can influence results.
Thorough due diligence is therefore important when selecting underlying funds.
Diversification and Concentration
Investing across multiple underlying funds may help spread exposure across managers, borrowers, sectors and investment strategies.
However, diversification does not eliminate risk. If multiple underlying funds have exposure to similar borrowers, industries or economic conditions, their performance may be affected by the same adverse developments.
Capital Deployment and Cash Flow Timing
A FoF may take time to deploy committed capital across its underlying investments. Capital that remains uninvested may generate a different level of income from capital that has been deployed.
The timing of distributions also matters. Underlying funds may distribute proceeds at different stages, depending on repayments, exits and their respective fund terms.
Consequently, investor cash flows may not be uniform throughout the investment period.
Fees and Expenses at Two Levels
Both underlying funds and the FoF may incur management fees, performance-related fees and operating expenses, depending on their respective terms.
These costs can affect the returns ultimately available to FoF investors. Understanding the combined cost structure is therefore an important part of investment due diligence.
Liquidity and Fund Tenure
Private credit Fund of Funds investments are generally designed for investors who can accommodate limited liquidity.
The ability to withdraw capital or transfer an investment depends on the fund’s governing documents and applicable restrictions. Investors should understand the tenure, exit provisions and distribution terms before committing capital.
Returns are not guaranteed, and the possibility of capital loss should be considered.
Private Credit Fund of Funds vs Equity and Direct Property
Private credit Fund of Funds investments differ from equity and direct property investments in how they generate returns and the risks they involve.
| Comparison factor | Private Credit Fund of Funds | Equity | Direct Property |
|---|---|---|---|
| Investment approach | Invests in underlying private credit funds | Invests in shares | Invests directly in property |
| Potential sources of returns | Performance and distributions from underlying funds | Dividends and share price appreciation | Rental income and property appreciation |
| Primary risks | Credit losses, underlying fund performance, concentration and layered fees | Business performance and market volatility | Vacancy, maintenance costs and changes in property values |
| Liquidity | Generally limited and subject to fund terms | Listed shares are generally more liquid | Often requires time to sell |
| Return characteristics | Influenced by underlying credit strategies and cash flows | Influenced by company performance and market prices | Influenced by rental demand and property market conditions |
No investment category is universally superior. Suitability depends on an investor’s financial objectives, risk tolerance, liquidity requirements and overall portfolio.
What HNIs Should Evaluate Before Investing
Before investing in a private credit Fund of Funds, HNIs should look beyond the headline return and understand the investment structure.
Important questions include:
- Which underlying funds does the FoF invest in, and what is the rationale for selecting them?
- What investment strategies and credit exposures do those funds follow?
- How diversified is the portfolio across managers, borrowers, sectors and investment vintages?
- How does the investment manager conduct due diligence and monitor underlying fund performance?
- What are the management fees, performance-related fees and other expenses at both levels?
- How are distributions received from underlying funds passed through to FoF investors?
- What are the fund’s tenure, liquidity restrictions and exit provisions?
- What reporting is available to help investors monitor performance and risk?
Investors should review the Private Placement Memorandum (PPM), relevant disclosures and other fund documents carefully. These materials help explain the strategy, fee structure, risks and terms applicable to the investment.
A clear understanding of the investment process and potential downside is more useful than evaluating a fund solely on an advertised return figure.
Regulatory Context for AIF Investors in India
Alternative Investment Funds in India operate within the regulatory framework established by the Securities and Exchange Board of India (SEBI).
The applicable regulatory requirements and fund documents govern matters such as fund categorisation, disclosures, investor eligibility and reporting. The specific requirements applicable to a fund depend on its structure, category and circumstances.
Investors should review the fund’s PPM and relevant disclosures to understand its investment strategy, expenses, tenure and risk factors.
For further information, refer to the official SEBI website.
Final Thoughts
Private credit Fund of Funds provide a way to access private credit through investments in selected underlying funds rather than lending directly to businesses.
The underlying funds generate returns through their respective credit strategies, which may include interest income, fees and other contractual payments. The FoF’s performance depends on how those underlying investments perform and how distributions flow through the structure.
For HNIs, evaluating a private credit Fund of Funds involves understanding the underlying portfolio, manager selection, diversification, fees at both levels, liquidity and potential risks.
A well-informed investment decision begins with looking beyond headline returns and understanding how the investment works, how cash flows are distributed and what could affect the final outcome.
If you would like to learn more about ElementOne Alternatives and its private credit Fund of Funds approach, contact our team to explore the investment strategy and available information.
Frequently Asked Questions
1. How does a private credit Fund of Funds generate returns?
A private credit Fund of Funds invests in underlying private credit funds. Those funds lend to businesses and may generate income through interest payments, fees and other contractual arrangements. The FoF’s performance depends on its underlying investments, applicable expenses and the terms governing distributions.
2. Does a Fund of Funds lend money directly to businesses?
Not necessarily. In a conventional private credit Fund of Funds structure, the FoF invests in other private credit funds, and those underlying funds make the loans. The exact structure should be confirmed from the relevant fund documents.
3. What is the difference between a private credit fund and a private credit Fund of Funds?
A direct lending private credit fund generally lends to borrowers and earns income from its credit investments. A Fund of Funds invests in underlying funds and participates in their performance through its investments in those funds.
4. Are private credit Fund of Funds returns guaranteed?
No. Returns depend on the performance of the underlying investments, borrower repayments, fees, expenses and other factors. Investors may experience lower-than-expected returns or a loss of capital.
5. How do fees affect Fund of Funds returns?
Fees and expenses may arise at both the underlying fund level and the FoF level. These costs can reduce the amount ultimately available to FoF investors. Investors should review the relevant fund documents to understand the combined fee structure.
6. Why is diversification important in a private credit Fund of Funds?
Diversification can help spread exposure across multiple managers, strategies, sectors and borrowers. However, its effectiveness depends on the actual portfolio, and it cannot eliminate credit risk or guarantee positive returns.
7. What should HNIs check before investing in a private credit Fund of Funds?
HNIs should evaluate underlying fund selection, manager due diligence, portfolio diversification, fee structures, distribution policies, liquidity restrictions, fund tenure and risk disclosures. Reviewing the PPM and other relevant documents is an important part of this process.
