PE 101: What is a Limited Partnership?

Understanding the Limited Partnership

Limited partnerships (LPs) play a crucial role in the world of private equity (PE) and venture capital (VC). Most people who invest in a PE or VC fund, are by default part of a limited partnership whether they realize it or not. In this post, we will delve into the concept of limited partnerships, exploring their definition, characteristics, legal structure, and governance. Understanding LPs is essential for potential limited partners looking to invest in PE and VC funds.

Definition and Role of Limited Partnerships: A limited partnership is a legal structure that enables individuals or entities to pool their capital as investors while limiting their liability to the amount they have invested. Members of a limited partnership are known as limited partners. This can get confusing sometimes as both often use the acronym "LP", but those terms can usually be used interchangeably. In the context of PE and VC, LPs are typically passive investors who provide capital to fund managers, known as general partners (GPs), for investment in various assets or businesses.

The GP ends up making the investment decisions on behalf of the LPs, although the GP will typically commit some of its own capital to the fund that the LPs are backing and may be required to get LP input on key decisions. While this may at first blush feel odd, after all, the LPs are committing the majority of the capital and paying fees to the GP but they don't get a say in investment decisions, it is an important factor in providing limited liability protection to LPs. Also, the LPs typically do not have to do any work for the fund other than providing capital, so they can invest more passively.

Types of Limited Partners: Limited partners can encompass a wide range of entities, including institutional investors such as pension funds, endowments, insurance companies, and sovereign wealth funds. Additionally, family offices, ultra-high-net-worth (UHNW) individuals, and funds-of-funds may also act as LPs. Each type of LP has its own characteristics, investment preferences, and requirements.

At OneFund, we are working to disrupt this by allowing everyday investors to participate in PE and VC investing, not just institutional investors and UHNW individuals. When someone chooses to invest using OneFund, they become an LP in one of the entities that we run. In turn, that entity then becomes an LP in a top-tier PE or VC fund, allowing OneFund's LPs to benefit from the returns generated by the underlying PE or VC fund.

Legal Structure and Governance: Limited partnerships are governed by legal agreements known as limited partnership agreements (LPAs). These agreements outline the terms and conditions of the partnership, including the rights, obligations, and responsibilities of the LPs and GPs. LPAs typically cover aspects such as capital commitments, profit sharing, decision-making authority, and dispute resolution mechanisms.

LPAs serve as the cornerstone of the LP/GP relationship. LPAs outline important provisions, including the duration of the partnership, investment objectives, restrictions on transferring ownership, and procedures for admitting or removing partners. It is crucial for LPs to understand the terms of the LPA to ensure the alignment of interests and protect their investment.

Contributions and Distributions: LPs commit a specific amount of capital to the partnership, which is referred to as a capital commitment. These commitments are often not provided upfront in their entirety but, drawn down by the GP over the fund's investment period as needed. LPs contribute capital in accordance with the capital call process specified in the LPA.

As mentioned earlier, one of the key advantages of being an LP is the limited liability it offers. LPs' liability is generally restricted to the amount they have committed to the partnership. In terms of distributions, LPs typically receive their share of profits, known as distributions or dividends, based on the distribution waterfall outlined in the LPA.

Reporting and Transparency: To maintain transparency and accountability, GPs are generally required to provide regular reports to LPs. These reports are typically made quarterly, although sometimes only annually with smaller funds, and will include information on the fund's performance, investment activity, financial statements, and compliance with regulatory requirements. LPs should review these reports to assess the progress and performance of their investments and keep an open dialogue with the GP.

You can see our previous article on the J-Curve to understand how performance for a typical fund should be expected to evolve over time.

Limited Partner Fees and Expenses: LPs typically pay fees and expenses associated with investing in PE and VC funds. These may include management fees, administrative fees, and expenses related to due diligence, legal and regulatory compliance, and fund administration. LPs should carefully evaluate the fee structure and if they have the leverage, even negotiate terms to ensure they are fair and aligned with the fund's performance.

In general, PE and VC funds charge what is called a "2 and 20" structure, meaning they charge a 2% management fee annually on committed capital and 20% "carried interest". Carried interest is a share of the profits in the fund - this helps to ensure that incentives are aligned between the LPs (who pay the fees) and the GP (who receive the fees). There are a lot of nuances to fees in PE and VC funds, you can check out our previous post here on how they typically work.

 

Conclusion: Limited partnerships serve as a vital structure for investors seeking exposure to private equity and venture capital opportunities. Understanding the definition, characteristics, legal structure, and governance of LPs is essential for potential limited partners. By better understanding the intricacies of limited partnerships, investors can navigate the PE/VC landscape with greater confidence and make informed investment decisions.

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