11.1 Legal structures of VC and PE funds
2 min read•august 9, 2024
Venture capital and private equity funds rely on specific legal structures to operate effectively. Limited partnerships are the most common, with general partners managing investments and limited partners providing capital. These structures offer tax advantages and liability protection.
Funds also use various structuring approaches to accommodate different investor types and regulatory requirements. Offshore and master-feeder structures cater to international investors, while parallel and structures provide flexibility and diversification options.
Legal Entity Structures
Limited Partnerships and General Partners
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- (LP) serves as primary structure for most VC and PE funds
- LPs provide capital and have limited liability up to their investment amount
- (GP) manages fund operations and investment decisions
- GP assumes unlimited liability for fund's debts and obligations
- GP typically contributes 1-5% of total fund capital
- LP investors include pension funds, endowments, and high-net-worth individuals
- LP structure offers tax advantages ()
- GPs receive (1.5-2.5% of committed capital) and (20% of profits)
Limited Liability Companies in Fund Structures
- (LLC) provides alternative legal structure for some funds
- LLCs combine elements of partnerships and corporations
- Members of LLCs enjoy limited liability protection
- LLCs offer flexibility in management structure (member-managed or manager-managed)
- Pass-through taxation applies to LLCs, similar to LPs
- LLCs used for management companies of VC/PE firms
- Some smaller funds or single-investment vehicles structured as LLCs
Fund Structuring Approaches
Offshore and Master-Feeder Structures
- established in tax-neutral jurisdictions (Cayman Islands, British Virgin Islands)
- Offshore Funds cater to non-US investors and tax-exempt US investors
- Benefits include tax efficiency and regulatory flexibility
- combines onshore and offshore funds
- (typically offshore) holds and manages all investments
- (onshore and offshore) channel investments into Master Fund
- Structure allows different investor types to invest in same portfolio
- Simplifies administration and reduces operational costs
Parallel and Fund of Funds Structures
- involves multiple funds investing side-by-side
- Funds maintain separate legal entities but invest in same deals
- Allows for customized terms for different investor groups
- Useful for accommodating regulatory or tax requirements of various jurisdictions
- Fund of Funds (FoF) invests in multiple underlying VC or PE funds
- FoFs provide diversification and access to top-tier funds for smaller investors
- FoF managers conduct due diligence and negotiate terms with underlying funds
- Additional layer of fees in FoF structure (management fee and carried interest)
- FoFs can focus on specific strategies, geographies, or stages of investment
Key Terms to Review (25)
Advisory agreements: Advisory agreements are formal contracts between a venture capital or private equity fund and external advisors, which outline the roles, responsibilities, and compensation for services provided by the advisors. These agreements are essential for clarifying the expectations and contributions of advisors, who can offer valuable insights, industry connections, and strategic guidance to the funds. This structure not only helps in managing relationships with advisors but also plays a key role in ensuring compliance and alignment with the fund’s investment strategies.
Capital commitment: Capital commitment refers to the legally binding agreement made by investors to contribute a specified amount of capital to a fund over a defined period. This commitment is crucial for funds as it determines their fundraising capability and overall investment strategy, impacting how they manage investor relations and allocate resources.
Carried Interest: Carried interest refers to the share of profits that general partners (GPs) of private equity and venture capital funds receive as compensation, which is typically a percentage of the fund's profits after returning capital to limited partners (LPs). This mechanism aligns the interests of GPs and LPs by incentivizing GPs to maximize the fund's performance, creating a potential for substantial earnings that reflect their success in managing the investments.
Feeder Funds: Feeder funds are investment vehicles that pool capital from multiple investors and direct that capital into a master fund, which is typically a larger investment fund, like a venture capital or private equity fund. This structure allows smaller investors to participate in investments that they may not be able to access directly, enhancing diversification and providing professional management. Feeder funds are commonly used to aggregate capital from various sources to achieve a critical mass of investment for the master fund.
Form D: Form D is a regulatory filing used by companies to notify the Securities and Exchange Commission (SEC) of an exempt offering of securities. This form is particularly significant for private companies seeking to raise capital through private placements, as it helps them comply with federal securities laws while minimizing the regulatory burden. Filing Form D not only provides important information about the offering but also establishes a formal record of compliance with exemptions under Regulation D, connecting it to the legal structures and frameworks governing venture capital and private equity funds.
Fund documentation: Fund documentation refers to the legal agreements, contracts, and other formal records that govern the operation and management of venture capital (VC) and private equity (PE) funds. This documentation lays out the rights and obligations of the fund's stakeholders, including investors, fund managers, and portfolio companies, ensuring compliance with regulatory requirements and providing clarity on investment strategies and terms.
Fund of Funds: A fund of funds is an investment strategy that involves pooling capital to invest in a diversified portfolio of other investment funds rather than directly in securities. This approach allows investors to gain exposure to a range of asset classes and investment strategies, enhancing diversification and potentially reducing risk.
General Partner: A general partner is an individual or entity in a partnership who has unlimited liability and is responsible for the management of the partnership's operations and decisions. This role is crucial in venture capital and private equity as they lead fund management, make investment decisions, and engage with limited partners to secure funding and provide updates on fund performance.
General Partnership: A general partnership is a business structure where two or more individuals share ownership and management responsibilities, as well as the profits and liabilities of the business. In this setup, all partners have equal authority in decision-making, and they also share personal liability for the debts and obligations of the partnership. This structure is often favored for its simplicity and ease of formation, making it a popular choice among venture capital and private equity firms when pooling resources and expertise.
Investment Advisers Act: The Investment Advisers Act is a federal law enacted in 1940 that regulates investment advisers, requiring them to register with the SEC and adhere to fiduciary standards when managing client assets. This act establishes the legal framework that ensures advisers act in the best interest of their clients, which is crucial for maintaining trust and accountability in financial services, particularly within private equity and venture capital firms.
Investment Company Act: The Investment Company Act of 1940 is a federal law that regulates investment companies, including mutual funds and closed-end funds, to protect investors by ensuring transparency, fair practices, and sound financial management. This act plays a crucial role in establishing the framework for how these companies operate, influencing key players in private equity and venture capital, affecting capital allocation decisions, and serving as a benchmark for performance evaluations.
Limited liability company: A limited liability company (LLC) is a flexible business structure that combines the benefits of a corporation's limited liability with the tax efficiencies and operational flexibility of a partnership. This structure protects its owners, known as members, from personal liability for the company's debts and obligations, which is especially important in the high-risk environments often associated with venture capital and private equity investments.
Limited Partner: A limited partner is an investor in a private equity or venture capital fund who contributes capital but has limited liability and does not participate in the fund's management. They are crucial for providing the financial resources that fuel investment opportunities across various stages of a company's growth, from early startups to later-stage ventures, while maintaining a hands-off approach in decision-making.
Limited Partnership: A limited partnership is a business structure consisting of at least one general partner, who manages the business and has unlimited liability, and one or more limited partners, who contribute capital and have limited liability based on their investment. This structure is crucial in venture capital and private equity as it enables the pooling of funds while protecting limited partners from personal liability beyond their initial investment.
Limited Partnership Agreement: A limited partnership agreement is a legal document that outlines the terms and conditions under which a limited partnership operates, defining the roles and responsibilities of general partners and limited partners. This agreement is crucial for establishing the relationship between the partners, detailing capital contributions, profit distribution, governance structure, and the management of the partnership's assets. It is essential in shaping the legal structures of venture capital and private equity funds, as well as influencing the evolving dynamics between limited partners (LPs) and general partners (GPs).
Management Fees: Management fees are the charges that venture capital and private equity funds impose on their investors to cover operational expenses and compensate the fund managers for their services. These fees are typically calculated as a percentage of the committed capital and are a critical aspect of fund economics, influencing both fund performance and investor returns.
Master fund: A master fund is a pooled investment vehicle that aggregates capital from multiple investors to make investments in a variety of assets or funds, often serving as the primary investment structure for managing assets in venture capital and private equity. This structure allows for efficient management of assets and provides investors with diversified exposure, while also enabling the use of feeder funds that channel investments into the master fund.
Master-feeder structure: A master-feeder structure is a common investment arrangement used by hedge funds and private equity firms where multiple feeder funds pool capital from investors and direct it into a single master fund. This setup allows the master fund to execute investment strategies while streamlining operations and management for the feeder funds, which can be tailored to different types of investors, such as domestic or offshore clients. The master fund then allocates investments based on its overall strategy, creating efficiencies and simplifying investor communications.
Offshore funds: Offshore funds are investment funds that are established in jurisdictions outside the investor's home country, typically for the purpose of tax efficiency, regulatory advantages, and privacy. These funds often attract investors seeking to diversify their portfolios while potentially minimizing tax liabilities and gaining access to a wider range of investment opportunities.
Parallel fund structure: A parallel fund structure is a legal arrangement in which multiple investment funds are established to operate simultaneously, typically with similar investment strategies but tailored to different investor requirements or regulatory environments. This structure allows fund managers to attract capital from various types of investors while maintaining flexibility and efficiency in investment operations.
Pass-through taxation: Pass-through taxation is a tax structure where the income generated by a business entity is not taxed at the corporate level but instead 'passes through' to the individual owners or partners, who report the income on their personal tax returns. This system helps avoid double taxation, which is common in traditional corporate structures, making it particularly advantageous for venture capital and private equity funds that are often structured as partnerships or limited liability companies (LLCs). The benefits of pass-through taxation can enhance returns for investors and align interests more closely between fund managers and their backers.
Periodic Reporting: Periodic reporting refers to the systematic communication of a fund's performance and financial status at regular intervals, typically quarterly or annually. This practice ensures that stakeholders, including investors and regulators, are kept informed about the fund's activities, investment performance, and any changes in strategy or market conditions. Regular updates help maintain transparency and accountability, which are critical in the context of investment management.
Securities regulations: Securities regulations are laws and rules that govern the issuance, trading, and enforcement of securities, which include stocks, bonds, and other financial instruments. These regulations are designed to protect investors from fraud, ensure transparency in financial markets, and maintain fair and efficient capital markets. Understanding securities regulations is crucial for exit planning, fundraising efforts, and the legal structures of venture capital and private equity funds.
Subscription agreement: A subscription agreement is a legal document that outlines the terms under which an investor agrees to purchase shares or interests in a venture capital or private equity fund. This agreement is crucial as it establishes the commitments of both the investor and the fund manager, including the amount of investment, the rights and obligations of each party, and the conditions under which funds will be deployed. It serves as a foundation for the legal relationship between limited partners and general partners.
Unrelated business taxable income: Unrelated business taxable income (UBTI) refers to the income generated by a tax-exempt organization from a trade or business that is not substantially related to its exempt purpose. UBTI is important because it is subject to federal income tax, unlike most income earned by tax-exempt entities. Understanding UBTI is crucial for venture capital and private equity funds, especially when they partner with tax-exempt investors such as pension funds or charitable organizations.