Happy Friday, Funds Family!

Today we’re going to take a deep dive 🏊️ into investment fund economics and mechanics.

We’ll discuss 20 of the most important deal terms in investment funds and syndications.

🤝 20 key terms in investment funds and syndications

Buckle up.

1. Carried Interest

Carried interest is the share of the fund’s profits the GP gets to keep. The LPA’s distribution waterfall determines how the GP and the LPs split the money. 💵 

⚠️ Unlike the management fee (discussed below) the carried interest is not guaranteed and the GP may end up earning no carried interest.

For more, we go into serious detail in these articles:

1. Carried Interest, Part 1: Waterfalls and Distributions in Kind

2. Carried Interest, Part 2: European versus American Waterfalls

3. Carried Interest, Part 3: Preferred Returns, GP Catchups, and Clawbacks

2. Management Fees

The management fee is a contractually guaranteed, recurring fee paid to the GP or its affiliate.

A typical management fee might be 2% of capital commitments during the investment period, and 2% of invested capital thereafter.

We discuss typical management fees in this article and management fee step-downs in this article.

3. Other Affiliated Fees

The fund documents should disclose any other fees paid to the GP or its affiliates. 💵 

Examples include:

• Acquisition fees

• Guarantee fees

• Closing fees

• Disposition fees

• Property management fees

• Development fees

Real estate funds typically have one or more of the above fees. Other types of funds, such as venture capital funds, do not typically have any of the above.

4. Fund Term

The term is how long the fund lasts. A closed-end fund might last 10 years, while an open-end fund could last forever. ♾️ 

The timeline of a fund’s life is discussed in detail in this article.

5. Investment Period

The investment period is the period during which a closed-end fund can make new investments. It’s typically the first half of the fund term.

In addition, the management fee typically decreases 📉 after the investment period ends, as discussed in this article.

6. Subsequent Closings

How are investors admitted after the initial closing date? Most closed-end funds have a final closing date 📆, after which no new LPs can join. See this article for an overview.

In addition, many closed-end funds require LPs admitted after the initial closing date to pay late fees. 💸 These late fees are paid to the early LPs to compensate them for taking the risk earlier (and to recognize the time value of money).

Some funds may also require late LPs to pay the GP management fees as if the LP were in the fund since the initial closing date. The GP can typically waive these fees in its discretion.

7. Fund Expenses

Fund expenses are costs paid directly by the fund (i.e., the LPs and the GP to the extent of its own capital commitment).

➡️ Typical fund expenses include the following (with respect to the fund and its investments):

• Legal

• Accounting

• Audit

• Diligence

➡️ The following are not typically fund expenses (they’re paid by the GP):

• GP salaries

• GP offices

• GP accounting and tax returns

• GP equipment and software

Most funds have a cap on organizational expenses (fund setup costs). If the costs exceed the cap, the GP has to pay for it. A typical cap might be 1% of the fund size.

8. GP Commitment

How much money is the GP putting into the fund? The bare minimum is typically 1% of the fund size, but many GPs put in much more.

As discussed in this article, GPs can get creative in how they fund their commitment, including by using any combination of the following:

• Cash contributions

• Contributions of property

• Waivers of management fees or acquisition fees

9. GP Removal

Can the LPs remove the GP? 🛑 

Many funds give LPs the right to remove the GP if the GP commits a cause event 🚨 (something really bad, like fraud or material violation of securities laws).

A smaller number of funds let the LPs kick out the GP for any reason.

Removing the GP for cause might require a smaller voting threshold (51-66% of LPs) while removing the GP for any reason often requires a larger threshold (66-85%).

For “no cause” removal, the right to remove might only begin a year or two after the fund starts. That way, the LPs can’t kick out the GP without giving the GP a fair chance to perform.

As you can imagine, the definition of “cause” is highly negotiated, with GPs wanting a narrower version of “cause” and LPs negotiating a broader set of events that can be considered a cause event.

10. Key Person Event

Many funds require the key persons (the individuals running the fund) to dedicate a certain amount of time to the fund.

Examples of time commitments include:

• Substantially all of their time

• A majority of their time

• A substantial amount of their time

• Remaining “actively involved”

If the required threshold of key persons (such as a majority) fails to uphold their time commitment requirement, the fund often enters a suspension period and the fund can’t make any new investments unless the LPs vote to end the suspension period.

11. Investment Limitations

Some funds have contractual limitations on what the GP can invest in.

Examples:

• No more than 20% of commitments can be invested in a single investment

• No more than 20% of commitments can be invested outside the United States

• At least 75% of commitments must be invested in multifamily

• No investments in public securities

• No investments outside North America

• No investments in fossil fuels, porn, or weapons (this comes up more than you think)

The LPs can typically waive these limitations under certain circumstances.

In some cases, LPs might have their own unique investment restrictions in a side letter with the fund. If the fund were to make one of these excluded investments, the LP with the side letter would not participate in that investment.

12. Leverage

Some funds have contractual limitations on how much debt the fund can take on.

For example, a multifamily fund might limit leverage to 50% of the total value of its assets.

⚠️ Note for VC funds: As discussed in this article, VC funds should limit their total indebtedness to 15% of the fund size. In practice, many VC funds don’t take on any debt.

13. Co-Investments

In some funds, LPs are given pro-rata rights to invest in co-investments or follow-on investments.

For example, let’s say the fund invests in the Series A round of a tech company. Later, the fund has the opportunity to invest in the Series B round, but the fund is already fully deployed.

In this situation, the fund might spin up an SPV to invest in the Series B round, and give each fund LP the right to invest in the SPV.

14. Successor Funds

Most funds prohibit the GP from raising a successor fund (the next fund) until a certain time. Often, this prohibition ends once the fund’s investment period is over (typically halfway through the fund’s life).

Note: “Successor fund” typically means a fund that is substantially identical to the existing fund. For example, the principals of private equity Fund I couldn’t raise another private equity fund until the investment period ends. However, they could raise a venture fund or a real estate fund.

15. LP Withdrawal Rights

In most closed-end funds, LPs do not have a right to withdraw money before the fund term ends.

Open-end funds typically do permit LPs to withdraw. However, these rights are typically subject to lock-ups (time-based restrictions) and gates (amount-based restrictions), each of which is discussed in this article.

16. In-Kind Distributions

Can the fund distribute anything other than cash to the LPs? For example, restricted securities?

Many funds limit distributions in kind before the end of the fund’s life, as discussed in detail in this article.

(As you can imagine, distributions in kind are not common in funds like real estate funds. LPs do not typically want distributions of apartment complexes.)

17. GP Clawback

Is there a GP clawback requiring the GP to return any excess carried interest to the fund?

This is discussed in this article on carried interest and clawback.

18. Limited Partner Advisory Committee (LPAC)

Many funds have an LPAC made up of the largest (or most strategic) LPs. The LPAC can approve certain actions under the LPA and can provide guidance to the GP.

Examples of matters requiring LPAC approval might include:

• Making an investment that would otherwise be prohibited

• Approving a transaction between the GP and the Fund

• Extending the fund term or the investment period

• Ending a suspension period

The LPAC is great for the GP. 😃 In most cases, the LPs at large could approve the bulleted points above with a majority vote (based on commitments).

However, getting a full LP vote is burdensome. By creating an LPAC of 3-5 engaged LPs, the GP can get things approved much faster and easier. ✅ 

19. Reports to LPs

What sort of reports are given to LPs? What are the time limits?

Many funds provide annual financials, quarterly financials, and K-1s.

While some funds are required to provide audited annual financial statements, many funds are not required by law to have their financials audited. However, at a certain fund size (perhaps around $30-50 million), LPs will start demanding an audit.

⚠️ Note: As discussed in this article, state law may require your fund to get an audit, even at a very small fund size. Work with your lawyer!

20. Amendments

How are amendments handled? Most funds require a majority of the LPs (based on commitments) to approve LPA amendments. Often the GP can make administrative updates without LP approval. ✍️ 

In some cases, the LPA might deem a failure by an LP to respond within a certain time period (such as 15 days) to be an automatic approval of the proposed amendment.

Whew! We made it 😅 

Thanks for reading, everyone.

Have a great weekend! 🙌 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.