Let’s look at each of these in turn.

Fund Structure

The most common form of business organization used by private equity funds in the United States and most other parts of the world is the limited partnership. In a limited partnership, at least one partner—called the general partner—is responsible for managing the business of the partnership, while the other partners—called limited partners—are merely investors with no responsibility for managing the business of the partnership. In fact, to preserve their limited liability (similar to shareholders in a corporation), the limited partners are actually not allowed to manage the business of the partnership. The general partner is, however, personally liable for the debts and obligations of the limited partnership, as a consequence of being the partner responsible for managing the business of the partnership.

In the case of a private equity or venture capital fund, investors—called limited partners—subscribe for limited partnership interests in the fund. The fund sponsor—called the general partner—is then responsible for sourcing, evaluating, making, and managing investments for the fund. When the fund sells one of its investments, the investors receive distributions from the sale proceeds, and the fund sponsor may receive distributions from the sale proceeds if the proceeds exceed a certain threshold. (Bear with me, we’ll get to the distribution waterfall, as it is called in private equity and venture capital, in a bit.)

This relationship among the investors and the fund sponsor is governed by a combination of partnership law in the state or country where the limited partnership is established and a limited partnership agreement, often abbreviated LPA, entered into among the investors and the fund sponsor.

Why did the private equity industry settle on the limited partnership as the standard form for private equity funds? There were several reasons.

The most obvious was the pass-through nature of the limited partnership for US federal income tax purposes. (Non-US investors may know this by the terms “fiscally-transparent”, “tax transparent”, or “flow-through”.) The limited partnership does not pay taxes upon the income, capital gains, expenses, or capital losses from its investments. Instead, the income, capital gains, expenses or capital losses are divided among the partners in proportion to their limited partnership interests and the partners are separately responsible for recording these amounts on their income tax returns and paying taxes on these amounts. For investors, this sidesteps—at the expense of creating other complications for foreign and tax-exempt investors (a lengthy and complicated topic that we won’t discuss here)—the issue of double taxation on the same item of income or capital gain. (By way of illustration, consider a corporation that receives income of $10 million from investments it made in other corporations. This corporation would pay corporate income tax on this $10 million, at approximately 35%. When the corporation distributes the net proceeds of $6.5 million by way of dividends, its shareholders would pay income taxes on the dividends they receive. In the case of a limited partnership, the $10 million in investment income would be taxed once, when it is distributed to the partners.)

The second reason for choosing the limited partnership is the flexibility of the limited partnership. The partnership laws of most states and countries tend to be flexible default rules that the partners can override in their limited partnership agreements. This allows the fund sponsor and investors to tailor their agreement to fit their needs.

Restrictions

The limited partnership agreement will impose certain restrictions on investors and fund sponsors. The reasons for having restrictions on the fund sponsor are fairly obvious, but why are there restrictions on investors?

Well, a lot of that has to do with some of my favorite topics (no, not really, do I look crazy): United States securities laws, bank holding company laws, and employee benefit plan laws. These are highly complex topics, and definitely beyond the scope of this introduction. If you are thinking of starting a fund, my advice would be to find a very good funds lawyer with experience forming private equity or venture capital funds. He will be worth his weight in gold when you’re up to your eyeballs in these issues (and you will be up to your eyeballs in these issues at the start of fundraising).

One further restriction that fund sponsors impose on investors is a minimum investment size. This restriction helps the fund avoid being classified as a “publicly traded partnership” for US federal income tax purposes, and also reduces the administrative burden of dealing with too many investors.

Investors, in turn, will seek to impose a range of restrictions on the fund sponsor. First, investors will seek to prevent the fund from either exceeding a maximum fund size (the “hard cap”) or falling below a minimum fund size. The professional investors at the fund sponsor will have developed expertise in making investments of a particular size, known as the “bite size”. The maximum fund size will usually be a function of roughly how many investments the fund is expected to make during its investment period and the typical “bite size” that the fund sponsor has expertise in making. This ensures that the fund does not grow so large that the fund sponsor is either forced to target investments that are significantly larger than the “bite size” they have historically taken, or is forced to make significantly more investments than they have historically made.

Second, investors will impose a range of investment limitations on the fund sponsor. These include limits on the maximum size of an investment in any portfolio company, typically expressed as a percentage of the fund size, e.g. 20%. This limit serves to manage the “concentration risk”, i.e. the risk that the firm invests too much of its capital into a single portfolio company.

Third, investors will often specify geographic, sectoral, or asset limitations. These limitations help ensure that the fund sponsor stays within its area of investment expertise.

Fourth, investors will limit the ability of the fund sponsor to raise debt financing. This is less common in real estate funds, where there are often fairly generous provisions permitting the use of some amount of leverage and guarantees of the debt of portfolio projects.

Fifth, if the fund sponsor has already raised other private equity or venture capital funds (which we shall call “predecessor funds”, investors will seek to limit the fund’s ability to co-invest alongside or acquire portfolio companies from such predecessor funds. This limits the ability a fund sponsor to have a new fund “rescue” an investment made by an older fund.

Sixth, investors will limit the ability of the fund to reinvest the proceeds from successful exits. These limits are very carefully crafted, and can include requirements that the exit have happened within a short period of time from the date of the original investment, limits on the amount (typically only the amount of the original capital contributed) that can be reinvested, or a fixed time limit after which such reinvestments are no longer permitted.

Seventh, investors will limit the period of time during which the fund sponsor can call capital to make investments, the “investment period”. This is typically a period of around five years (in more aggressive markets like China this can sometimes be as short as three years). After the investment period ends, the fund may no longer call capital from the investors to make new investments.

Alignment of Interest

The relationship between investors and the private equity or venture capital fund sponsor inevitably create an agency problem; the fund sponsor is empowered to make investment decisions on behalf of the private equity or venture capital fund, but the capital at risk from those decisions is that of the investors. Furthermore, there is information asymmetry as the fund sponsor has more information regarding the investment decisions and day-to-day operations of the fund than the investors.

To overcome the agency problem, investors will demand certain terms that act to—in theory—align the interests of investors and fund sponsor.

The first such term is the general partner’s (or fund sponsor’s) contribution. The general partner’s contribution is a limited partnership investment of between 1 — 5% of the total fund. This ensures that the fund sponsor has “skin in the game” and will suffer a loss of capital (alongside the investors) if the fund fails to perform well enough to return all the contributed capital.

The second term is more controversial. By convention, private equity and venture capital fund sponsors are compensated for managing the fund in accordance with the 2 and 20 rule. The fund sponsor typically receives a management fee of 2% per annum (calculated on the basis of the total fund size during the investment period, and thereafter calculated on the basis of the amount the fund has invested and not yet divested). This management fee can vary: some venture capital funds have received management fees of around 2.5%, while some larger buyout funds may charge only 1.5% (but on a fund size that can easily reach a few billion dollars).

It also receives a performance fee, known as “carried interest”, of approximately 20%, if the fund manages to achieve certain performance targets.

The 2 and 20 rule is a bit of a historical accident; to the best of my knowledge there are no rational principles underpinning it. It just happens to be the terms that were agreed in the early venture capital industry in the 1960s, and which have since become the accepted norm in the industry.

Conclusion

This post has become almost as long as some of the contracts I negotiated in my old job. Let’s end this post here, with a recap. Private equity and venture capital funds are typically governed by a limited partnership agreement. Because of the agent-principal problem, the investors will generally seek to impose certain restrictions on the fund sponsor’s ability to take certain actions that might be detrimental to the investors’ interests, and require certain steps to be taken to, in theory, align the interest of the fund sponsor and the investors. These terms can be quite heavily negotiated, but there are certain industry norms that have developed over the years and which are generally accepted by both fund sponsors and investors.