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What’s up, everyone? Today, I want to dive deep into one of the most critical aspects of running a successful fund: fund structure. In the world of funds, getting your structure right is not just important—it’s everything. If you get it wrong, you’re setting yourself up for failure. So let’s break down how I structure my funds and use that structure to pitch to investors effectively.
Understanding the Basic LP/GP Structure
The Limited Partner (LP) and General Partner (GP) structure is the most common framework in the fund industry. It’s versatile and provides the flexibility you need to determine how to compensate your investors—and eventually yourself.
What is the LP/GP Structure?
- LP (Limited Partners): These are your investors. They contribute capital to the fund but have limited liability and typically do not participate in the fund’s day-to-day operations.
- GP (General Partner): This is you, the fund manager. As the GP, you oversee the fund’s operations, make investment decisions, and manage the fund’s assets.
Why is This Structure Important?
The LP/GP structure allows you to design a compensation model that aligns your interests with those of your investors. It’s crucial to get this right because the structure you choose can significantly impact your ability to attract and retain investors.
Should You Charge a Management Fee?
Some fund managers charge an upfront management fee. This fee, usually between 2-5% of the total assets under management (AUM), compensates the GP for managing the fund's daily operations, regardless of the fund’s performance.
The Pitfall of Management Fees for New Fund Managers
If you’re just starting out, I strongly recommend against charging a management fee. Investors are wary of paying a management fee to someone without a proven track record. It’s difficult to justify this fee if you haven’t already demonstrated your ability to deliver returns.
The Solution: Performance-Based Compensation
Instead of a management fee, consider using a performance fee. This approach aligns your compensation with the fund’s success and shows investors that you’re confident in your ability to generate returns. Performance-based compensation is a much more attractive option, especially for new fund managers.
Structuring Your Fund with a Pref, Catch-Up, and Carried Interest
Let’s break down how you can structure your fund to attract investors and set yourself up for success. The structure I’m about to outline is not only effective but also proven to be mutually beneficial for both the GP and LPs.
1. Pref (Preferred Return)
The pref is the first component of the structuring process. It’s a predetermined return that your investors will receive before you, as the GP, earn any profits.
- Example: Suppose your fund generates a 30% return on an investment. The first portion of this return, say 8%, is allocated directly to the LPs. This ensures that your investors get a solid return before you start taking your share.
Setting a pref around 8% is a common practice. It assures investors that they will receive a return on their investment before any profits are distributed to the GP.
2. Catch-Up
The catch-up is a smaller percentage of the returns that goes directly back to the GP. It’s designed to cover the fund’s operational expenses.
- Example: You might allocate 2% of the returns to the GP as a catch-up. This ensures that the fund’s operations are funded without dipping into the LPs’ returns.
Although the catch-up is not where you’ll make significant money, it’s essential for maintaining the fund’s operations.
3. Carried Interest
Carried interest is where you, as the GP, stand to make the most money. It’s a share of the profits that the GP receives after the pref and catch-up have been allocated.
- Example: After allocating the first 10% (8% pref to LPs and 2% catch-up to the GP), you have 20% of the returns left. With an 80/20 split, 80% of this remaining return (16%) goes to the LPs, and 20% (4%) goes to you, the GP.
Carried interest is typically structured with splits like 80/20 or 70/30 but can vary depending on the deal. Some funds also have benchmarks, where once a certain return (e.g., 30% IRR) is achieved, the split becomes more favorable to the GP, such as a 50/50 split.
Why This Structure Works
This structure is appealing to investors because it shows that you, the GP, only get paid if the fund performs well. It aligns your interests with those of your investors and demonstrates your confidence in the fund’s potential.
Experimenting with Percentages
Feel free to experiment with the percentages. For instance, you might offer a higher pref to attract more conservative investors or adjust the carried interest split to better reflect your confidence in the fund’s performance.
Conclusion: Structuring Your Fund for Success
Getting your fund structure right is crucial to winning over investors and setting your fund up for long-term success. The LP/GP structure, combined with a well-thought-out pref, catch-up, and carried interest model, can be incredibly powerful.
As you move forward, consider what makes sense for you and your investors. Play around with the numbers, test different structures, and find the best fit for your fund.
If you want to dive deeper into fund structures and learn more about launching a successful fund, check out Fund Launch for additional resources and guidance.
Take care,
Want access to free trainings? Visit Fund Launch for more fund resources!
DISCLAIMER: This content is for educational and informational purposes only. It is not to be taken as tax, financial, or legal advice. You should always consult a legal professional before taking action. Furthermore, this is not a recommendation to buy or sell any security. The content is solely just the opinion of the authors.
