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Private Capital Fund Terms

In this article

The lesson What Is Private Capital? outlined the basics of the commingled fund structure and introduced the main players involved in the limited partnership – the GP and LP. The terms of the partnership between these two parties is documented in a limited partnership agreement, which outlines key details such as the types of investments to be made, the duration of the fund, and the fees to be awarded to the fund manager. We'll explore their partnership further in this section.

The LP/GP Relationship

When entering into a limited partnership agreement, balance must be struck between the GP and the LP to ensure their interests are aligned on a wide range of issues, from fee levels and transparency to responsible investment. As competition in the fundraising market increases, investors have become more demanding regarding the fund terms they expect to see from private capital fund managers. This has made it more important than ever for GPs to get the balance right in the terms offered to LPs.

As shown in the infographic, terms and conditions can be crucial in an investor’s decision to commit capital to a fund. It is important for GPs to pay attention to the fund terms with LPs, as fund terms have influenced decisions for 85% of investors. 

Fund terms can be a source of conflict within the LP/GP relationship, and setting competitive terms can be a tricky task for GPs in private markets. The opaque and confidential nature of private capital investment means that fees are rarely disclosed outside of a fund and, as such, it is difficult to benchmark against other GPs and the wider industry. 

This chart shows the main areas in which investors believe the alignment of interests between LPs and GPs could be improved. Perhaps unsurprisingly, fees – and particularly management fees – are one of the most contentious areas across all private capital asset classes. Greater transparency is also high on the list of demands from LPs.

The Key Fund Terms

GP Commitments
It is standard practice for the GP managing a private capital fund to make a financial commitment to the vehicle on the same basis as LPs in the fund, also known as having ‘skin in the game.' This is seen as an important driver in the alignment of interests between GPs and LPs as it helps to demonstrate a GP’s financial commitment to the fund. Historically, the benchmark for GP commitments has been 1% of the total fund size; however, a significant proportion of GPs are making larger commitments (relative to the size of the fund).
Key-Man Clause
A key-man clause is a contractual clause that states if there are not enough ‘key people’ to dedicate the necessary amount of time to a specific investment, the firm cannot proceed. Key people usually possess skills, knowledge, leadership abilities, and experience that are considered crucial to decision-making. Implementation of a key-man clause is now commonplace across most private capital fund types.

The majority of key-man clauses specify the number of partners at the firm, often naming specific individuals that would need to devote their time for an investment to advance. Some LPs even request specific quantitative terms, for example that “75% of their business time” is dedicated to the fund or related entities.
Fund Organizational Expenses
Most partnership agreements make provision for the costs associated with the formation of the fund (up to a certain limit) to be borne by the fund itself, rather than the GP. The allowable limit to organizational expenses generally scales with the size of the fund.
Time Limits
Time Limit on Final Close agreements typically restrict how long after first close the fund can remain open to new investors and continue to fundraise. This is an important consideration for LPs, as they would prefer fund managers focus their attention on identifying investment opportunities and putting capital to work, instead of spending time on a prolonged fundraising period. Time limits can be extended with the consent of the LPs investing in the fund.

LPs maintain liability for their own individual investments, while GPs carry complete liability for all investments. It is crucial for LPs that there are limits to how many investors are able to commit to a fund, as the more investors there are, the more parties take a split of rewards, lowering profits for each individual LP.
No-Fault Divorce Clause
A no-fault divorce clause permits investors, at a time after the final closing date, to remove the GP of a fund and either terminate the partnership or appoint a new GP. A no-fault divorce clause is activated when a supermajority of LPs (typically 75%) lose faith in a GP’s abilities.

Activation of a no-fault divorce clause will prevent the manager from making further investments. Importantly, however, LPs are not given veto rights over individual investments through a fund’s lifetime.
Investors are typically liable to pay two types of fees to fund managers: management fees and performance fees.

Management fees are designed to cover administrative, operational, and management items, such as salaries and deal fees. Often, this is 2% of the capital committed by the LP. For example, if an LP commits $1mn to the fund, the fee would be $20,000. The management fee is due regardless of positive or negative fund performance.

In contrast, performance fees are dependent on a fund generating positive returns for its investors. GPs often charge a performance fee as high as 20% of profits. The performance fee serves to improve the alignment of interests between LPs and GPs, ensuring there is mutual financial benefit for both parties in achieving high rates of return. Performance fees are referred to as carried interest, or sometimes simply ‘carry’, in private markets.
Hurdle Rate (Preferred Return)
Hurdle rates refer to the minimum rate of return a GP has to meet before receiving their performance fee – often around 7-8%. If the fund achieves a return below the hurdle rate, profits will be returned to the LPs only. However, once this hurdle rate has been reached, the GPs are entitled to a 20% share of anything generated both above and below the hurdle.
Distribution of Fund Proceeds
Distribution of fund proceeds can be structured in two principal ways: on a whole-fund basis or on a deal-by-deal basis. Charging carried interest on the whole fund is the more common method for most private capital fund types. Over 80% of buyout, growth, infrastructure, real estate, and venture capital funds use this structure, as well as a smaller proportion of natural resources funds. The deal-by-deal method is most widely used by direct lending, distressed debt, and mezzanine debt funds.
The time period for exiting a fund is usually set upon committing capital. However, it can be lengthened if market conditions mean it is necessary to delay in order to perform positively.
Investment Restrictions and Other LP Requirements
As mentioned above, LPs are not given a say in individual investments made by a fund, although there may be specific investment restrictions laid out within the limited partner agreement. These restrictions will take into account specific requirements from the investor. These can include restrictions on asset size, type, location, and more. There are also often limits to how much a GP can invest against the potential return targets set by the institutions. Once a GP has reached their limit, banks are often called upon to loan the remainder of capital required.

LPs are increasingly seeking greater representation on the LP Advisory Committee (LPAC), which is generally used to settle conflicts of interest between LPs and GPs on issues such as investment decisions or fund operations. On average, 39% of advisory committees appoint five or six LP representatives.

The Rise of Responsible Investing

In recent years, ESG (environmental, social, and corporate governance) has become a more important factor in investment decisions. Preqin’s recent survey showed that nearly half of investors have turned down a fund that did not comply with their ESG program.

Almost a quarter of investors currently have an ESG program in place, and increasing numbers of fund managers are already responding by incorporating ESG principles into their investments. ESG is therefore likely to become one of the most significant topics surrounding fund terms in the coming years. Explore Preqin's ESG insights here.

In this lesson, we delved into the LP/GP relationship, including one of the most important factors for investors – fund terms and their fees. We explored the key terms in depth, covering the costs and processes associated with private capital investments. Finally, we introduced you to ESG, an increasingly prevalent and important topic in today’s investment landscape.