What Is a Private Investment Fund?

Below we answer some fundamental questions about how private funds work. This broad overview lays the groundwork for our series of private fund explainers that will dive deeper into the economics and legal structure of private funds for new fund sponsors, managers, and other industry professionals.

What is the basic definition of a private investment fund?

A private investment fund (or private fund) is a vehicle that raises capital from qualified investors and invests it according to the strategy specified in the fund’s documents.

Private funds are not open to retail or general investors, and they are not as strictly regulated as funds that are open to the public, such as mutual funds. As a result, they have more flexibility to pursue a wider range of investment strategies, including higher-risk strategies that may have the potential for outsize returns.

There are many types of private funds, including private equity (PE), venture capital (VC), real estate (RE), and hedge funds, each focusing on particular types of assets. These funds are typically run by managers with expertise in investing and in the area or areas of focus specified in their fund documents.

What regulatory requirements must a private fund meet to raise capital?

Private funds often raise capital through “exempt offerings,” or securities sales that don’t require registration with the U.S. Securities and Exchange Commission (SEC). Regulation D in the Securities Act of 1933 outlines specific conditions that a fund must satisfy to qualify for this exemption, including the types of investors to whom they can sell securities (e.g., limited to “accredited investors”).

What criteria must a fund meet to be classified as a private investment fund?

Under the Investment Company Act of 1940, a private fund is required to meet certain criteria to qualify for exemptions from certain types of SEC registrations for investment companies.

The two primary exceptions, laid out in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act, relate to the number and type of investors who participate in the fund.

To qualify for a 3(c)(1) exemption, a private fund must have 100 or fewer “accredited investors” (the standard to qualify for a safe harbor to avoid registration under the Securities Act noted above) or “knowledgeable employees” (and a VC fund 250 or fewer). To qualify for a 3(c)(7) exemption, a fund must have 2,000 or fewer “qualified purchasers” or “knowledgeable employees.” To qualify as an accredited investor or qualified purchaser, an individual or institution must show it meets certain wealth thresholds set by the SEC, ensuring it has the financial means to handle the risk associated with investing in private funds.

Funds that qualify are subject to less regulatory scrutiny and are allowed to pursue high-risk investments without the need for public disclosure, which not only reduces compliance costs but also minimizes the potential for investor lawsuits and the likelihood that their investment strategies will be revealed to competitors.

How are private investment funds structured?

Starting a private fund involves establishing a legal structure. We explain fund structures in more depth in a separate article, but here is a quick overview:

Some funds are structured as limited liability companies or corporations.

Many funds are structured as limited partnerships. Under this model, the key players are the general partner and limited partners. A general partner (which can be a person or a firm) is legally responsible for the fund and makes final decisions on investments, or “manages” the fund. The general partner is also known as the “fund sponsor.” The limited partners are the investors who contribute capital to the fund.

Funds need legal documents to define the relationship between the funds’ managers and their investors. A limited partnership agreement, for example, might outline the terms for capital commitments, profit allocation, and the conditions under which limited partners can withdraw from the fund.

How do different types of private funds raise and invest capital?

Below we provide some basic details on three types of private funds: venture capital, private equity, and hedge funds. It’s important to note that private fund types and investment strategies extend beyond these categories.

Venture capital is considered a form of private equity, with the two fund types sharing some similarities. However, they are also different in important ways.

• Fund investments: PE funds usually invest in mature companies, often by acquiring them. VC funds, on the other hand, typically invest in start-ups or early-stage companies and do not acquire companies.
• Raising capital: Both VC and PE funds accept capital commitments from investors and draw on this capital over time to make investments.
• Relationship with portfolio companies: PE funds often actively manage the companies they acquire to enhance their value before seeking a sale or IPO. Some VC funds are engaged in the day-to-day management of their portfolio companies. They tend to serve as advisers, helping their portfolio companies grow to the point that they can be sold or taken public.
• Fund term: Both VC and PE funds typically have a 10-12 year term with options for 2-3 years of extensions. Investors have limited options for liquidity during the term of the fund.

Hedge funds are another common type of private fund.

• Fund investments: Hedge funds often invest in assets such as stocks, bonds, and currencies, using high-risk strategies such as short selling. These investments are typically more liquid than private company investments.
• Raising capital: Hedge funds typically require initial capital contributions that they invest immediately.
• Relationship with portfolio companies: Although hedge funds typically don’t have portfolio companies, some that take a hybrid investment approach might invest larger stakes in public or private companies. In these cases, the hedge funds could engage in activist investing, seeking to influence the strategic direction of the companies in which they invest.
• Fund term: Hedge funds are typically open ended and offer investors periodic redemption rights.

How does a private fund distribute profits?

The profits that a private fund generates are allocated between a fund sponsor and investors according to a predefined structure outlined in the fund’s legal documents. One common structure is called a “distribution waterfall.”

What is a distribution waterfall?

The term “waterfall” in a distribution structure describes profits flowing step-by-step, like water down levels. Each level must meet specific thresholds before moving to the next,
ensuring all participants (such as limited or general partners) receive their share before remaining profits flow to the next level.

The exact process varies by fund and its negotiated terms, but these are the basic components of a limited partnership’s distribution waterfall:

• Return of capital: Profits are initially distributed entirely to investors until they’ve fully recovered their original investment.
• Preferred return (or hurdle rate): After recouping their original contribution, investors continue to receive 100% of profits until they reach a minimum expected return known as the “preferred return” or “hurdle rate,” which is typically between 7% and 9% of their original investment.
• Catch-up: At this stage, the fund sponsor receives all or most of the returns until they reach a predetermined share of profits (typically 20%), which helps them “catch up” with the returns investors have already received. This prespecified profit share is known as “carried interest” and typically qualifies for treatment as long-term capital gains, which are taxed at a lower rate compared to ordinary income.
• Remaining split: Any remaining profits after the catch-up phase are divided between the investors and fund sponsor, often with investors receiving 80% and the fund sponsor receiving 20% in carried interest.

We explain these methods for sharing returns — including the ins and outs of carried interest — in more depth in a separate article.

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee similar outcomes.