Structuring and Licensing
[This is the third article in a 4-part series on fundraising] Read the previous chapter on fund strategy.
If you aren’t an investment professional, a lawyer or a banker, fund set up and the mechanics of how LP-GP structures work can be somewhat challenging to understand.
The majority of the business community are familiar with corporate entities limited by shares. But market practice and conventional wisdom seem to dictate that most funds be structured as partnerships. It happens to be the most common and most widely acceptable structure in the PE/VC world.
If this seems complicated, just remember:
At the crux of every commercial entity—be it a corporation or a partnership — is decision making.
Playing by the rules of the game. A typical PE fund structured as a partnership looks something like this:
In the above structure, the main responsibility of operating the fund on a day-to-day basis lies with the General Partner. The Limited Partner (being “limited” by definition) contributes capital but does not have any decision-making rights (much akin to the notion of preference shares in a corporation).
The ‘rules of the game’ — so to speak — are being defined in the Limited Partnership Agreement (“LPA”). Comparatively speaking, instead of the usual board of directors in a corporation, decision making resides in the Investment Committee, which is a group of people nominated by the GP and LPs (the same way shareholders nominate the board of directors). Naturally, those who contribute a larger share of the economics get a larger say in terms of who sits on the board or in this case, the investment committee.
There are many comprehensive resources detailing the mechanics of both partnerships and corporations, but below is an extremely simplified table outlining the few key commercial ‘equivalents’ which illustrates how partnerships in funds operate as contrasted to a typical corporate entity:
The process of ‘receiving’ investors (LPs) into the fund is all about defining the ‘rules of the game’ i.e. Formalizing them in the LPA. A fund formation lawyer can help do this, but as the fund manager, you will need to provide them the game plan, as well as the ‘boundaries’ of the playing field.
Amongst a ton of many things to consider here, some of the key commercial items to take note include:
(i) Amount of management fees and carried interest (profits from exiting an investment)
(ii) When the carried interest will be paid
(iii) Redemption — if, how and when limited partners can withdraw their capital
GPs may carve out special arrangements or preferential economics for different LPs in a side letter. Nothing is stopping you from including these clauses in the main LPA but eventually, it’s really all about how generic you want this to be.
Fund structures and LPAs — being legally drafted — are pretty much predicated on market precedents, which is ultimately driven by demand, i.e. the investor pool. If a structure has been tried and tested in the market, an LP is more likely to use it. This partly explains also why the popular 2–20 fee arrangement has not really changed significantly in the last three decades.
Ultimately, it boils down to managing risk and uncertainty. Most investors (LPs) will try to be more conservative and stand by something which is easier to justify — for a good reason because huge amounts of institutional capital are at stake here.
Is there a need to be regulated / licensed? Broadly speaking, any regulator, fund formation lawyer or sponsor will always advise you to be licensed, for a good reason: to provide more credibility, as well as to protect the interests of the most important stakeholders (the LPs) in your fund, which again in turn, drives credibility.
If you are receiving money from ‘mom and pop’ investors, the answer to being regulated is always yes. In most mature fund jurisdictions, the general rule is: As long as you take monies from any institution (including accredited investors), you need to be regulated / licensed.
What if I just raise capital from people I know? In the eyes of the external parties, getting a fund properly licensed puts the fund manager in good publicity, and is also synonymous with endorsement by the local regulatory authorities. Investors are generally get more comfort that if a fund is licensed, the basic regulatory checks have been done.
In theory, you could even operate a “fund” without being licensed or regulated if you have an extensive proprietary network of individuals who are ready to commit capital with you. The key risk or consideration here is whether or not these investors can seek adequate recourse in the event you screw up.
In reality, most funds are set up for the purposes of taking in institutional money for long periods of time. Therefore, regulation and licensing not only allows for proper governance but paves the way for raising more third party capital in the future.
One of the biggest financial hurdles with getting licensed is of course the upfront expenses (potentially up to $1 million paid-up capital required). Most first-time fund managers may not be willing to part with such a huge amount of capital especially if there is no certainty in raising the fund.
[This is the third article in a 4-part series on fundraising] Read the final chapter on the fundraising process here.