Understanding the Relationship Between Limited Partners & General Partners

In a recent post, I discussed the basics of private equity terminology so I thought it would be helpful to drill further into Limited Partners (LPs), the LPs relationship with the private equity firm (GP) and how the relationship between the two works.  In order for the LP/GP relationship to be successful, they must be focused on the same goal or outcome.  In other words, for this to work well, their respective interests much be aligned.

There are two parties – the LP and the GP, and they have an agreement with each other.  The LPs have limited liability and usually have priority over the GPs upon liquidation of the partnership. However, the LP has no control over the daily management of the fund.  On the other side of the coin, the GP has a fiduciary responsibility to act for the benefit of the LP.  The GP is fully liable for its actions. Simply said, the LPs put up the money and for that they get 80% of the gains on the investment.  The GPs are doing the work, as in making the investments, and they get 20% of the gains.

Limited Partners (LPs)

There are several different types of LPs.  The first type being institutional investors which are professional entities that invest capital on behalf of individuals or companies, such as insurance companies, pension funds and university endowments.  Another type of LP is high net worth investors.  Alternatively, a LP can be a “fund of funds” (FOF), which is a fund created to invest in private equity which are typically individual investors and small institutional investors who participate in a FOF to minimize their portfolio management efforts.

An LP agrees to commit a total dollar amount to a fund over the life of the fund, known as committed capital. The committed capital is not drawn all at once.  The commitments allocated to a fund are drawn down pro rata on an as needed basis, such as to make investments or payment management fees.  This is known as invested capital. The LP usually does not have any rights for approval over investments, as the decision lies with the GP.  Occasionally, funds can employ an LP Board which is intended to screen deals prior to final investment decisions. Throughout the year, the GP provides the LP with quarterly or semi-annually reporting packages to provide updates on the performance on the fund’s investments. Funds also host annual LP meetings.

General Partners (GPs)

When a GP is raising a fund, there are several criteria required that they must surpass.  The GPs track record will be examined to include a top-down and bottom-up analysis. Other criteria include an evaluation of the management team, investment strategy, other investors, and consistency in terms and conditions. The term of a private equity fund is typically ten years, with two to three-year extensions at the approval of the LP.  The standard investment period is between five and six years.

The GP is primarily compensated through a management fee which is typically 2% of the committed capital and is paid annually.  The management fee is used to compensate for GP salaries and overhead costs.  This is also the same fee that has come under recent and continued scrutiny by the SEC.  In addition, there is the carried interest fee, which is the GP’s share of the profits that are generated by the fund’s investments.  Although it can vary across funds, 20% is the most common fee.  It is important to note that the GP does not have to commit to capital to earn its carried interest.

GPs have an additional stake in the outcome because the do invest some of their own money alongside the LPs.  The is a strong incentive to ensure the outcomes are successful.  If it does not work, then the GP does not get paid.  One of the strongest incentives for the GP is the fact that all of the capital is pooled together.  They have to succeed in the entire pool.  If the GP has taken more money than they were entitled or made bad decisions, they will have to pay that money back.  This is known as a “claw back” and it is very different from any other type of investment manager.  Again this is a strong incentive to do well on the entire pool of invested capital and not just on individual investments.

The Exit

Upon exiting a deal, the fund will distribute proceeds to the LPs following a liquidity event, which can be in the form of debt or equity recapitalization, dividends, public offering or sales the company to another fund or strategic.  These proceeds are net of the GPs carried interest if a gain is realized.  Most often, funds will distribute cash to the LPs but they may distribute securities, such as share in a publicly traded stock.

When thinking about raising the next fund, the timing does vary by firm and the conditions of the market.  The term, “dry powder”, is a slang term referring to cash reserves or marketable securities and it important in the context of raising the next fund.  Generally, a GP will begin discussing the next fund after the current fund is 50% invested and there is enough “dry powder” remaining for three to four deals.  The LPs will heavily weigh the prior fund’s exits and external market validation of fund performance.