Limited Partnership Structure
Contents
Trevor L Taylor, a Miami private investor and the founder of Fortius Capital, works in private markets where the limited partnership remains a standard way to pool money. The structure splits a venture into two kinds of owners: a general partner who runs it and limited partners who fund it. PitchBook calls it the most common legal structure for private equity funds1, explaining that the capital providers carry limited liability for investment decisions while the general partner is responsible for allocating the money.
Two kinds of partner
Every limited partnership needs at least one general partner, usually a management company created for the purpose. The general partner chooses investments, negotiates terms, oversees the holdings and decides when to sell. It also carries broad liability for the partnership’s obligations, which is why it is often set up as a separate entity rather than as the individual managers themselves.
Limited partners contribute capital and little else. Their exposure is capped at the amount they committed, and in exchange they accept that they will not direct the daily work. In a private equity fund the limited partners are typically pension plans, endowments, foundations, insurers and wealthy families, including many of the offices described in the entry on the family office. A single fund may have dozens or hundreds of them, each holding a share of the partnership in proportion to its commitment.
The agreement that binds the partners is long and detailed. It sets how long the partnership lasts, how capital is called, how profits are split, what the manager may and may not do, and what happens if the manager leaves. Much of the negotiation in private markets is negotiation over that document. Capital is rarely handed over all at once. Limited partners commit a total amount at the start and then send money in installments as the general partner finds deals, a process known as a capital call. Distributions flow back as investments are sold, so a partner’s cash goes out early and returns later, often over ten years or more. Planning for those uneven flows is one of the main tasks of any investor that holds many partnership interests.
A contract older than the corporation
The arrangement is centuries old. Historians trace it to the commenda of medieval Mediterranean trade, in which a stay at home investor financed a voyage and a traveling merchant carried it out. Max Weber’s history of medieval commercial partnerships, now available in English translation, describes how a contract for a sea venture set out the distribution of profits and the route of travel2 for the traveling partner.
Florence turned the idea into a formal institution. A seminar by the historian Francesca Trivellato traces how a decree of 1408 created the accomandita, and shows a contract from 1484 in which one partner contributed labor while several others supplied capital as limited partners3, among them a member of the Medici family. The stated goal was to draw in investors who feared the unlimited exposure of an ordinary partnership. The same slides map how the form spread to France, the Netherlands, New York State and the United Kingdom over the following centuries.
Why the form suits pooled capital
Part of the appeal is liability, and part is tax. In the United States a partnership files an annual information return but does not pay income tax itself4. Profits and losses pass through to the partners, who each report their share on their own returns from a statement the partnership supplies. Pooled vehicles avoid a second layer of tax that a corporation would face, which matters a great deal when gains are large and arrive all at once.
The form is also flexible. Partners can agree to almost any division of profits, any order of payment and any set of protections, so long as it is written into the agreement. That flexibility lets the same legal shell serve a buyout fund, a venture fund, a real estate fund or a single property deal, and it is why related vehicles such as the special purpose vehicle often borrow the same mechanics.
Fees and carried interest
The general partner is paid in two ways. A management fee, traditionally around two percent of committed capital a year, covers salaries and running costs. Carried interest, usually a fifth of profits, rewards performance. Institutional Investor reported that by 2018 the two percent figure was no longer fixed, as firms offered alternative carry structures, lower fees and early bird discounts5 to win commitments.
The timing of carry matters as much as its size. Some funds pay it deal by deal; others pay only after limited partners get their capital back plus a hurdle rate. Research reported by Institutional Investor found that venture managers paid on a deal by deal basis outperformed those subject to hurdle rates6, a counterintuitive result for investors who assumed stricter terms would always help them.
The balance of power between partners
Who sets the terms depends on the market. When money is plentiful, established managers can dictate them; Pensions and Investments described powerful general partners setting the terms again7 in a report from late 2014. When money is scarce, limited partners gain leverage.
Limited partners have also organized. The Institutional Limited Partners Association publishes principles meant to foster proper alignment of interests between limited and general partners8, covering governance, transparency and fee reporting. The relationship keeps evolving. PitchBook has reported that, in a year when private equity fundraising fell to a seven year low, some limited partners were reconsidering GP stakes, minority investments in the managers themselves9, which give a share of the manager’s fee income and carry.
The core bargain has barely changed since the Florentine accomandita. One party brings skill and labor, others bring money, and a written agreement decides how the rewards and the risks are shared. Readers who want to see how limited partners take a more active role can continue to the entry on coinvestment, and the entry on investment due diligence covers how partners evaluate a manager before they commit.
