How Are Private Investment Funds Structured?

Private investment funds have investors and managers (or "sponsors"). Many private funds use partnership structures such as limited partnerships or limited liability companies (LLCs) taxed as partnerships to attract capital while protecting investors from personal financial risk. In certain circumstances, for tax and regulatory reasons, funds might use a corporate structure as well.

A US-based private fund commonly uses either a Delaware limited partnership or a Delaware LLC as its legal entity. However, it's typical to see a nested structure in which the fund is a limited partnership and the fund's general partner and management company are LLCs.

Is the limited partnership or LLC the same thing as the fund?

While technically the limited partnership or LLC is the legal structure and the fund is the pool of capital, in practice, the terms “limited partnership” or “LLC” and “fund” are frequently used interchangeably. It might be helpful to think about this relationship like a water bottle:

• The bottle itself (the container) represents the limited partnership or LLC. It is the legal structure of the fund, defining the roles and relationships of the fund manager and investors.
• The water inside the bottle represents the actual pool of money that investors contribute and the subsequent purchased assets or portfolio company interests. This is the fund.

In practice, when industry professionals talk about the “limited partnership” or the “LLC,” they are often referring to both the bottle and the water together — the legal structure and the money within it. This is why the terms “limited partnership” and “fund” (or “LLC” and “fund”) are often used interchangeably in the investment world. Once the “fund” starts to make investments, the limited partnership entity, or the LLC entity, is the legal owner of those investment interests.

What is a limited partnership?

A limited partnership is a business structure with at least one general partner and one or more limited partners. General partners and limited partners can be either individuals or entities themselves.

Here is a basic breakdown of the roles and legal liabilities of players within a limited partnership:

• General partners: In a limited partnership, the general partner is legally responsible for the private investment fund and makes final decisions on investments, or “manages” the fund. The general partner is also known as the “fund sponsor.” The general partner can be a person or a legal entity but is most often an LLC. In most structures, the general partner delegates investment authority to the “investment manager” (who then often receives the management fee from the fund).
  
  The LLC structure of the general partner allows the general partner — who would otherwise bear unlimited liabilities — to limit their personal exposure to assets held within the LLC. That means if the limited partnership incurs debts or faces legal issues, each individual general partner’s personal assets — such as their home, savings, or other investments — are protected.
• Limited partners: Limited partners are the investors who provide capital to the fund but do not participate in its management. They are often institutional investors such as university endowments, pension funds, and insurance companies or individuals who can bear the high risks of private fund investing. Their liability is limited to their investment amount, protecting their personal assets from any debts beyond their initial contribution.

Is the general partner part of the limited partnership or separate from it?

The general partner is part of the limited partnership in the sense that it is one of the required partners and it manages the partnership. The general partner often invests capital in the limited partnership; this is referred to as the general partner’s commitment or “skin in the game.” The general partner is legally separate from the limited partnership.

What is an LLC?

A limited liability company is a business structure created by statute with members that own interests of the LLC. LLCs are most often used as the legal entity responsible for managing the private investment fund. They can also be the fund entity itself. (Think back to our water bottle analogy.)

LLCs can be “member-managed” — involving all or some members of a class in management — or “manager-managed,” which delegates authority to specific individuals that are not also members. In either case, when an LLC is used as the primary fund entity, the manager acts as the “sponsor” of the fund. The manager is almost always another LLC, resulting in a nested structure that is similar to that of limited partnership funds.

Like a limited partnership, an LLC offers pass-through tax benefits (unless otherwise elected), ease of setup, and profit-sharing abilities. However, unlike a limited partnership, an LLC provides limited liability protection for all its members, managers, and investors (including its manager).

What is a management company?

Funds often include a third-party management company to oversee investments and manage day-to-day operations, and that entity is often structured as an LLC or a corporation. Typically, an LLC is used when a fund wants to use a partnership tax structure (a single level of tax), and a corporation is used when a fund prefers that the management company be taxed as a corporation, or a double level of tax (entity and employees are taxed).

Under the laws regulating the management company, it is often referred to as the “investment adviser” or “investment manager.”

What is the management company’s relationship with the general partner?

The management company is frequently a legal entity separate from the general partner and employs the investment professionals who work on behalf of the fund sponsor. This structure allows the management company to support multiple funds while providing continuity in management and expertise.

(For background, many funds have a set investment period and term of life [these are so-called “closed-end funds”], and once those end, the fund sponsor or management company can start a new fund with either a similar or entirely new investment strategy. These funds often overlap at least for a time, with the management company supporting multiple funds at once. Often, management companies may advise multiple funds with different strategies or across different asset classes as well.)

Though the general partner and management company often operate as separate LLCs, the same individuals can be involved in both LLCs. Because of this, members of the management company and the general partner LLC are often both referred to as “general partners,” or “GPs.” This can be particularly confusing for industry newcomers.

Why would a limited partnership separate the general partner and management company into two entities?

One of the main reasons to separate the two is for tax purposes. The management fee (which the management company receives) is taxed as ordinary income, while carried interest (which the general partner or fund sponsor receives) may get long-term capital gains treatment. Establishing two entities helps prevent the IRS from taxing all this as ordinary income, thereby reducing overall taxes for those receiving the income and capital gains.

Having a separate management company also allows for continuity of employment for individual investment managers and back-office staff as closed-end fund entities reach the end of their terms (legal life) and are liquidated and dissolved.

For cases in which the management company is separate from the general partner or fund sponsor, the fund will enter into a management agreement with the management company. This agreement ensures that the fund pays fees to the management company for its services.

What legal documents are required?

Private investment funds need legal documents to define the relationship between the fund’s managers and its investors. A limited partnership agreement (LPA), for example, defines the roles of the general partner and the limited partners and outlines the terms for capital commitments, profit allocation, and the conditions under which limited partners can withdraw from the fund.

In an LLC, an operating agreement defines the types of members of the entity, which has management rights and outlines the economic rights of each member class along with describing the purpose of the LLC, fee schedules, etc. (similar to an LPA).

Both types of documents include the profit allocation among partners in a limited partnership and among the members of an LLC. When a fund’s investments turn a profit, the money is distributed between the fund’s general partner or sponsor and the limited partners or other members.

These are a couple of important terms typically included in the LPA or operating agreement:

• Management fees: The management fee compensates the management company for its role and typically ranges from 1.5% to 2.5%, depending on the fund type, stage, and strategy. Fee calculations vary and may be based on committed capital, net asset value (NAV), or a multi-stage approach, such as using committed capital during the investment period and transitioning to net equity invested thereafter. If there is no separate management company, then that fee is paid to the general partner or sponsor of the fund.
• Distribution waterfall: The distribution waterfall describes how proceeds from liquidated fund investments are distributed and usually consists of multiple stages that determine the order of profit or loss allocation between the fund sponsor and investors. This waterfall includes carried interest, which is the primary form of profit sharing for the sponsor. Carried interest usually represents 20% of the profits left after the investor receives distributions equaling their initial capital contributions plus, in some waterfalls that don’t have a “catch-up,” a defined preferred return.

Why Delaware?

Many private investment funds choose to form in Delaware because of its extensive history with business law. The state’s courts offer well-defined legal interpretations, giving fund managers more certainty than they might find in other state courts. Additionally, Delaware makes it easy to form entities such as limited partnerships and LLCs.

If a US fund expects to attract non-US investors, it may form additional related entities in non-US jurisdictions and/or as corporations to accommodate those investors for tax and regulatory purposes.

 

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.