Structuring Private Investment Funds: A Comprehensive Guide

Private investment funds are a popular way to facilitate company acquisitions, mergers, and taking companies public or private. Private equity funds are a type of private investment fund that pools capital from multiple investors to invest in private companies. Private equity funds are structured as limited partnerships, with a general partner (GP) and limited partners (LPs). The GP is the fund manager and makes investment decisions, while the LPs provide the capital. The fund itself is a separate legal entity, usually a limited liability company (LLC) or a limited partnership (LP). This structure provides tax advantages and limits the liability of the LPs. The GP earns management and performance fees, while the LPs get returns on their investments when the fund is liquidated.

General and Limited Partners

Private equity funds are typically structured as limited partnerships, with two distinct roles: General Partners (GP) and Limited Partners (LP).

General Partners

The General Partner is the entity with the legal authority to make decisions for the fund and assume all legal liability. They are actively involved in the decision-making process, from sourcing and evaluating investment opportunities to selecting portfolio companies, conducting due diligence, and overseeing the implementation of the fund strategy. GPs are responsible for raising capital from investors and investing that capital in line with the fund's strategy. They work closely with the management teams of the portfolio companies to drive growth and enhance business value. GPs are also in charge of managing the sale of assets at the most opportune time and distributing proceeds to investors.

General Partners contribute their own capital to the fund, aligning their interests with those of the limited partners. They earn management fees, typically around 2% of the total assets under management (AUM), and performance fees, usually 20% of the gross profit.

Limited Partners

Limited Partners are the investors who provide the capital required to execute the fund's strategy. They are passive investors and rely on the expertise of the General Partner to make investment decisions. LPs have limited liability, meaning their financial exposure is limited to the amount they have invested in the fund. In the event of a loss, they only lose what they invested, while any difference is the responsibility of the GP.

Limited Partners can include institutional investors, such as pension funds, insurance companies, sovereign wealth funds, and university endowments, as well as high-net-worth individuals and family offices.

The relationship between the General Partner and Limited Partners is outlined in a Limited Partnership Agreement (LPA), which stipulates the investment terms, roles, risks, liabilities, fund duration, management fees, and payout structure.

Investment Adviser Considerations

The fund may have a separate investment adviser that provides investment advice. The investment adviser is a separate legal entity that will need to be formed and will have its own underlying partners or members. An investment adviser is required to register with either the SEC or its applicable state securities regulator as a registered investment adviser unless exempt or prohibited from doing so. For example, exempt reporting advisors are exempt from registering with the SEC but are still subject to certain reporting requirements.

Documentation often includes an investment management agreement that governs the responsibilities of the investment adviser. If the investment adviser comprises more than one person, consider documenting the arrangements between the applicable parties, such as how to split management responsibilities and compensation between those persons and/or any employees.

The investment adviser will need to be involved in the capital-raising process. This includes knowing the types of assets or companies the fund plans to invest in, whether there is a geographic focus, and whether any co-founders have a personal track record. The fundraise will be subject to federal and state securities laws. Private funds raise capital from investors through exempt offerings, which means any offering must fall within an exemption from registration under the Securities Act.

Documentation for the capital raise may include an offering document, frequently called a private placement memorandum, which acts as a detailed disclosure document for potential investors. It may also include a subscription agreement through which investors contract to invest in the private fund.

Management Fees

The management company or General Partner is responsible for identifying, executing, and managing investments. They have the legal authority to make decisions and assume all legal liability for the fund. The management fee compensates them for their expertise and time spent on these tasks.

It is worth noting that the management fee structure may vary depending on the fund's size, strategy, prevailing market norms, past performance of the manager, and incentives for early investors. The fee structure should aim to align the interests of the fund managers and investors.

In addition to the management fee, fund managers may also charge a performance fee, also known as carried interest. This fee is typically calculated as a percentage of the profits generated by the fund and is paid to the General Partner (GP) only if the fund is profitable. The performance fee provides an incentive for fund managers to maximise returns and make sound investment decisions.

When establishing a private investment fund, it is crucial to clearly outline the management fee structure in the fund's documentation, such as the Limited Partnership Agreement (LPA). This agreement stipulates the rights and responsibilities of the General Partner and Limited Partners, including any management fees, distribution waterfalls, and profit distribution mechanisms.

Fund Term

The "Fund Term" is a critical aspect of a private equity fund's structure, defining the time horizons available for investment and divestment. Typically, private equity funds have a finite duration of 10 years, consisting of distinct stages: organisation and formation, fundraising, deal-sourcing and investing, portfolio management, and exiting investments.

The commitment to the fund, known as the "capital commitment", is made through a partnership agreement, which stipulates the return of invested capital or resulting assets within a fixed period, usually 10 years. This agreement outlines the fund term, providing clarity on the investment and divestment horizons.

During the fund term, the General Partner (GP) actively manages the fund, sources investment opportunities, and makes decisions on capital utilisation. The GP also contributes their own capital to the fund, aligning their interests with those of the limited partners (LPs). The LPs are the investors who provide capital and have limited liability, meaning their risk is restricted to their investment amount.

The fund term is a crucial element in structuring a private equity fund, offering a defined timeframe for the GP to identify investment prospects, make investments, and ultimately generate returns for the LPs.

Harvesting Period

The harvesting period is a critical phase in the lifecycle of a private investment fund, and it typically begins after the investment period. During this phase, the fund manager, also known as the General Partner (GP), focuses on improving the performance and increasing the value of the portfolio companies. The goal is to ultimately sell these companies for a profit. This process may involve implementing strategic changes, improving operational efficiency, and restructuring the businesses to enhance their overall performance and make them more attractive to potential buyers.

The harvesting period can last for several years, and it is a time when the GP actively works with the portfolio companies to maximise their potential. This may include providing operational and strategic advice, making connections, and even serving on the board of the portfolio companies. The GP's expertise and active management play a crucial role in identifying growth opportunities, improving operations, and enhancing the overall performance of these businesses.

During the harvesting period, the GP will also start arranging exits from the portfolio companies. This can be done through various exit strategies, such as initial public offerings (IPOs), strategic sales or trade sales, secondary sales to other private equity firms, recapitalisation, or management buyouts (MBOs). The choice of exit strategy depends on factors such as market conditions, the performance of the portfolio company, and the overall investment objectives.

The profits generated from the sale of portfolio companies during the harvesting period are then distributed among the investors, known as Limited Partners (LPs). Typically, the GP also receives a share of the profits, often in the form of carried interest or performance fees. This performance fee is usually a percentage of the fund's profits and is designed to reward the GP for their successful management of the fund and to align their interests with those of the LPs.

Overall, the harvesting period is a crucial phase in the private investment fund lifecycle, where the fund manager works closely with the portfolio companies to improve their performance, increase their value, and ultimately sell them for a profit. This period involves active management, strategic decision-making, and exit planning to maximise returns for the investors.

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