🛠️ The LP Punchlist

5 Things Every Limited Partner Must Know About Investment Funds and Syndications

Happy Friday, Funds Family!

As a limited partner (LP) in an investment fund or syndication, you should understand your investment. What a novel concept!

Today, we’ll discuss 5 key business terms LPs should consider when investing in funds or syndications:

But first…

/ SELF PROMOTION

If you’re a general partner (GP) raising an investment fund or syndication in private equity, private credit, real estate, or venture capital, we may be a good fit for you. We also represent limited partners (LPs) investing in funds and syndications.

Thanks for reading, now let’s jump into the article 😃 

📜 What Are Side Letters?

After the general partner (GP) completes the first draft of the fund documents, the GP sends the documents to LPs. At this point, the LPs can choose to invest or not invest. Or, if they’re feeling spicy, they can try to negotiate for better terms via a “side letter.” ✉️

🛠️ "Side Letters" in Funds and Syndications are discreet agreements between a fund or syndication and a specific LP. With a side letter, the GP can grant special rights or terms to a particular LP without changing the terms of the main fund documents (which would apply to all LPs).

Common side letter provisions include:

  • Fee reductions

  • Carried interest reductions

  • Rights to transfer fund interests to an affiliate of the LP

  • Special information rights

  • Rights to invest in future funds

  • Special tax/regulatory provisions

  • Opt-out provisions for certain investments

  • Most-favored nations (MFN) clauses

If you’re a larger investor, consider asking for an MFN clause. An MFN clause gives you the right to receive the best side letter terms offered to other LPs.

💵 How Are Profits Distributed? 

The “distribution waterfall” (a section usually called “distributions” in the fund agreement) determines how profits are distributed between LPs and the GP.  💰️ 

Example – fund with no preferred return

In a simple fund or syndication, the waterfall might look like this:

  1. Return of Capital: LPs receive distributions until their initial investment is returned.

  2. Carried Interest: Remaining profits are split between LPs and the GP.

Carried interest, also known as "carry" or "promote," is the GP's share of the fund's profits.

A common carried interest split is 80% to the LPs and 20% to the GP, though many syndicators have tried for 30% (or more!) in recent years. We’ve also seen people go for 50/50 after a return of capital, which is ~absurd.

Example – syndication with preferred return and GP catch-up

In many cases (especially in real estate, private, equity, and private credit), the waterfall can get more complex than our simple example above.

Here’s an example of how this would work.

  1. Return of Capital: LPs receive distributions until their initial investment is returned.

  2. Preferred Return: LPs receive a priority rate of return (e.g., 8% annually) on their investment.

  3. Catch-up: The GP receives distributions to "catch up" to the profit split percentage in Step 4 below.

  4. Carried Interest: Remaining profits are split between LPs and the GP (e.g., 80/20).

Waterfall structures can vary widely, with distinctions like European vs. American waterfalls and premium carry arrangements. We’ve spent enough time on the waterfall for one article, but please reach out if you have questions on more complex structures.

🧾 What Fees Are Reasonable?

Other than carried interest, GPs typically earn two types of fees:

  • Asset Management Fees: Recurring fees to cover the GP's overhead costs, usually 1.5-2% of committed or invested capital.

  • Other Fees: These may include acquisition fees, property management fees, and development fees, among others.

An asset management fee of over 2% would be considered “above market” in our experience. You should also double-check the “base” of the management fee, too. 2% of committed capital and 2% of assets under management can lead to wildly different results!

Below are some common “other fees” earned by funds and syndications.

  • Acquisition fees: 1-2% of the purchase price of an asset.

  • Property Management Fees: 3-7% of gross revenues for real estate investments.

  • Guarantee fees: 0.5-1% of the guaranteed debt amount.

  • Disposition fees: 1-2% of the sale price when assets are sold.

  • Development fees: 5% of hard costs for development projects.

The above are just common ranges. A fee outside of the above doesn’t necessarily mean the GP is out of control. Most funds and syndications pick one or two of the fees above (though some take the full menu).

Make sure to read these fees sections carefully. We recently reviewed documents on behalf of an LP client and found that there were two acquisition fees (one called an “acquisition fee” and one called an “equity fee”) for a total fee of 4% of the asset’s purchase price. Boo. 👎️ 

☎️ When do you have to send the money? An explanation of capital calls

In most multi-asset funds, LPs commit to a certain amount of capital but don't invest it all at once. Instead, the GP "calls" capital as needed for investments or expenses. 💵 

Typical capital calls in multi-asset funds

Capital calls are a standard practice in multi-asset funds. They allow GPs to manage cash efficiently by only drawing down capital when needed for investments or expenses. And LPs don’t need to send money before the fund actually needs it.

To be clear, it is not a sign that a fund is in trouble if they are issuing capital calls in respect of an LP’s original capital commitment. This is normal.

⚠️ LPs must be prepared to meet capital calls promptly when issued. Failure to do so can result in 🛠️ default penalties (default interest, dilution, or even forfeiture of their interest).  

Additional capital calls in single-asset syndications

So, why do people on the internet complain about capital calls? Some syndications allow for additional capital calls beyond the investor’s initial commitment. These are often used in real estate syndications to address unexpected expenses, new opportunities, or shifts in economic conditions.

Despite these capital calls being “optional,” non-participating LPs can face dilution, and some documents include punitive dilution clauses for those who don’t participate. Make sure to understand how dilution works before signing on the dotted line. ✍️ 

🙋 When do you get your money back? 

The timing of when you can generally expect to get your money back depends on whether you’ve invested in an 🛠️ open-end or a closed-end fund. The chart below highlights some key distinctions. ⏱️

In short:

  • Closed-end funds have a defined life, after which they wind down and liquidate. LPs cannot withdraw early. 🔒

  • Open-end funds last forever, but LPs can withdraw money (subject to limitations). 🔓

The “limitations” mentioned above for open-end funds typically include a lock-up period (a waiting period before an LP can withdraw money) and a gate (a restriction on how much an LP can withdraw in any single quarter or year).

Before investing, find the answers to the following questions:

  1. Is the fund closed-end or open-end?

  2. If closed-end, when does the fund’s life end? Can the GP extend the fund’s life?

  3. If open-end, what are the limitations on withdrawals? Is there a lock-up period? Is there a gate?

Single-asset syndications often have an undefined life and a prohibition on early withdrawals, which can make them somewhat riskier from a liquidity standpoint. In these cases, make sure you trust the sponsor and are comfortable holding on for the long-term.

And so ends our rant on LP investments.

 / WRAPPING THE CASE

  1. Consider asking for a side letter if you’re a larger investor.

  2. Carefully review the distribution waterfall.

  3. Review the fees to see if they are reasonable or outrageous.

  4. Be prepared for capital calls and understand your obligations.

  5. Understand when you get your money back and manage your liquidity accordingly.

Thanks for reading, everyone.

Have a great weekend! 🙌 

/ JURY TRIAL

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⚠️ 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.

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