Private capital fund terms

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).

A key-person 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-person clause is now commonplace across most private capital fund types.

The majority of key-person 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.

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 organisational expenses generally scales with the size of the fund.

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 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 share of anything generated in excess of the hurdle (typically 20%).

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. Preqin estimates 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 to improve performance outcomes.

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.

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.