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Fund Terms and Conditions

Industry Definitions

In this article

Learn the different fund terms and conditions commonly used across private capital and hedge funds.

Private capital terms

Deal-by-Deal Distribution of ProceedsA GP earns carry related to the specific deal for which distributions are being made, as long as LPs have received back their contributions made with respect to investments realized up to that point in time, and commonly also contributions made with respect to any write-down amounts on unrealized investments, as well as expenses attributable to both (plus any specified preferred return).
Earn-out ClauseAn agreement included within a secondary transaction that protects the interests of the seller. The pricing of the offering is directly related to the future performance of the underlying funds and can be structured, mainly, in two ways:
1. A minimum price can be agreed and paid in full, with the buyer agreeing to make further regular payments based on the performance of the funds.
2. A buyer can purchase a portion of the offering, with the remainder purchased at a later date when the price can more easily be calculated by taking into account the performance of the underlying funds.
Fee Rebates to LPsCommon practice for funds to provide corporate finance and other services to the portfolio companies/assets that they own, and to charge for these services. These fees can be significant, often amounting to 1.0-1.5% of the value of companies acquired. In addition, the firms will charge monitoring fees and directors’ fees to the companies in the portfolio. It used to be common for managers to retain these fees, but now all or a significant proportion are rebated to investors in the fund, often offsetting against the management fee.
Fund Formation Costs/Organizational ExpensesMost partnership agreements make a provision for the costs of setting up the fund to be borne by the fund itself (as opposed to being an expense for the GP), up to a stated amount. Allowable costs generally rise with fund size. Placement fees are generally explicitly excluded from the costs to be borne by the fund, as these are the responsibility of the GP.
GP CarryGPs managing most private funds earn a share of the net investment gains from the fund through the carry, which can be structured in two principal ways: on a deal-by-deal basis or on a whole fund basis.
GP Catch-up RateOnce the hurdle rate has been met, the GP catch-up rate is the proportion of subsequent gains that are allocated to the GP until the GP has caught up to its predetermined share of overall profits. For example, a GP catch-up rate of 100% would mean that after investors had received all the returns up to the hurdle rate, the GP would then receive all gains thereafter until its overall share of all gains reached the stated rate of carry.
GP CommitmentThe GP managing a fund generally makes a financial commitment to the vehicle on the same basis as the LPs in the fund, and this is seen as an important factor driving the alignment of GP and LP interests.
Hurdle Rate/Preferred ReturnThe level of return that must be achieved by the GP before they are able to claim carry.
Key-Man ProvisionKey-man provisions or key-man clauses are an important non-economic governance factor for funds. The clause gives LPs the opportunity to terminate the fund’s investment period and/or appoint a new GP to manage the fund in the event that specified provisions are not met by the GP, including the number of original principals of the managing firm or the amount of time they have spent managing the fund.
LP Advisory CommitteeThe majority of funds have LP advisory committees, and include provisions for investors to be appointed to the board by the GP, with a majority of investors being independent of the fund manager. The membership of these committees tends to increase with fund size.
Investment Period Management FeeManagement fees during the investment period are almost invariably calculated as a percentage fee applied to the commitments made by the LP to the fund. The logic behind this is that the primary determinant of the workload for the GP is the search for potential investments, and this is driven by the size of total commitments to the fund, and not the actual amount invested at this stage in the fund’s lifetime.
Post-Investment Period Management FeeAlmost all funds base their management fees during the investment period on a percentage fee rate multiplied by the LP’s commitment to the fund. The investment period is generally the costliest period for managing the fund, due to the workload of finding and acquiring investments, and the management fees reflect this. Fees for most funds are reduced after the investment period, and the reduction can be effected through a range of mechanisms including a step-change in the percentage rate charged, an annual reduction in the rate charged, and/or changing the asset base for fee charging from commitments to the cost basis of the unrealized portfolio.
Minimum LP CommitmentMost funds impose restrictions on the minimum commitment that LPs can make to the fund. As might be expected, the minimum required size tends to be larger for funds targeting larger amounts of total capital.
No-Fault Divorce ClauseFunds have always had provisions for terminating the investment period and/or appointing a new GP to manage the fund in the event that the GP is guilty of gross misconduct or breaches material provisions of the partnership agreement. However, in a development aimed at improving governance and security for LPs, an increasing proportion of funds now have so-called no-fault divorce provisions, whereby a stated supermajority of LPs can elect to make these changes without cause. These provisions appeared during the late 1990s, and have now become an industry standard, with almost all funds now having a no-fault divorce clause included.

Hedge fund terms

Gate PercentagePercentage of fund/investor’s capital which can be redeemed from the fund at any one time.
Gating ProvisionsFund Level: Provision to limit the amount of capital that can be redeemed from the fund at any one time. Gate usually imposed on 20% of the fund’s asset value.
Investor Level: Provision to limit the amount of capital that can be redeemed from the fund at any one time. Gate usually imposed on up to 25% of an investor’s money each quarter, over four quarters.
Hybrid: Provision to limit the amount of capital that can be redeemed from the fund at any one time. Gate imposed at the investor- and fund-level.
Hard Lock-upA period of time in which investors are not permitted to redeem their investment in the fund.
High-Water MarkMechanism that addresses the problem of managers being rewarded for poor performance. The high-water mark ensures that performance fees are based on the net new profits for each investor on an annual basis and that a manager does not collect a performance fee until previous losses have been recouped, at which time the high-water mark resets.
Hurdle RateMechanism that ensures that performance fees are only levied after a performance target or rate has been met. Typical hurdle rates are either a fixed or variable rate, linked to specific benchmarks.
LeverageBorrowed money that amplifies the risk/return profile of an investment and in turn amplifies any subsequent gains and losses.
Management FeeAnnual fee charged by the manager to investors to cover the costs and expenses of a hedge fund. This has typically been charged at 2% of the net asset value of a fund over a 12-month period; however, the amount varies.
Maximum Leverage Employed The maximum amount of leverage a fund manager is willing to use in order to generate the returns it seeks.
Performance FeeFee charged to the investor to reward positive returns of the fund. The manager usually takes 20% of the fund’s profits. Also known as an ‘incentive fee.’
Redemption FeesThe fee charged by the fund to investors redeeming their capital earlier than their designated redemption date.
Redemption FrequencyDetermines how often an investor can redeem capital from a hedge fund.
Redemption Notice Period Determines the amount of notice required from investors wishing to redeem their capital from the fund.
Rolling Lock-upA provision allowing investors to redeem capital on their designated redemption date but which enforces an additional lock-up period for investors in the event that they forfeit their right to redeem.
Seed CapitalThe initial capital used to start a hedge fund.
Soft Lock-upA period of time in which investors may withdraw their investment subject to a redemption fee (see Redemption Fees).
Subscription FrequencyDetermines how often a new investor can invest in a hedge fund.