Investment Funds – Structure and Mechanics Part II

[video_lightbox type=”url” style=”3″ auto_play=”Y” auto_buffer=”Y” url1=”” url2=”” width=”720″ height=”405″ placeholder=”” placeholder_width=”640″ placeholder_height=”360″ align=”center”]aHR0cDovL2V2cC00ZGFkZWU5ZDJjNmQyLTIwNzI1MDEyYzM4YjY5Yjg4NTJkZGQxOTA4NTAyZGJjLnMzLmFtYXpvbmF3cy5jb20vaW52ZXN0bWVudF9mdW5kX3N0cnVjdHVyZV8yLm1wNA==[/video_lightbox]
In the last video we ended with a slide that showed the tremendous leverage that is available on the General Partner’s capital.

Before we dig into the economic mechanics of an investment partnership, we need to understand a few concepts:

  • Carried Interest
  • Preferred Return
  • Waterfall

Carried Interest is defined as a share of any profits as long as i) all capital is returned to the investors; and ii) the investors receive their Preferred Return.

Preferred Return is the return on invested capital before the General Partner receives its carried interest.

The Waterfall defines the priority of the distribution of invested capital of an investment fund in general, and from the exit of each discrete investment in particular. The Waterfall is not just for an investment fund, or blind pool; its also applicable if you are raising money for a single asset transaction – such as a single real estate investment.

So, what does a waterfall look like, in other words, what does the priority of distribution look like?

Below is the “Executive Summary” version of a waterfall from one of our offering memorandum templates:

i.     return of 100% of invested capital;
ii.    the Preferred Return;
iii.  100% to the G.P. as a catch-up until the G.P. has received 20% of distributed profits; and
iv.  thereafter, 80% to the partners and 20% to the G.P.

Traditionally, the carried interest on investment funds is 20%

Also, note that the Partners do not receive their Preferred Return AND an 80% allocation of the profits; they receive 80% of the profits. The Preferred Return is the hurdle rate for the G.P.

For example, if the G.P. has been receiving its Carried Interest in the early years of the partnership, but the the partnership sustains some losses so that the Partners’ return is less than the Preferred Return, then the Partners can “Claw Back” some of the Carried Interest received by the G.P. until the Preferred Return is met.

Towards the end of the video in this post I walk through an example of a fund and show how the dollars flow. I also present the IRR for the fund, the Limited Partners, and the General Partners.

Investment Funds – Structure and Mechanics Part I

[video_lightbox type=”url” style=”3″ auto_play=”Y” auto_buffer=”Y” url1=”” url2=”” width=”720″ height=”405″ placeholder=”” placeholder_width=”640″ placeholder_height=”360″ align=”center”]aHR0cDovL2V2cC00ZGFkZWU5ZDJjNmQyLTIwNzI1MDEyYzM4YjY5Yjg4NTJkZGQxOTA4NTAyZGJjLnMzLmFtYXpvbmF3cy5jb20vaW52ZXN0bWVudF9mdW5kX3N0cnVjdHVyZV8xLm1wNA==[/video_lightbox]

You want to establish an investment fund when you are seeking capital to pool capital for investments that have yet to be identified.

Your investors will be committing capital to you based on your experience, track record and the investment profile, or investment theme that your Investment Fund will be pursuing. Since the investors are committing capital  to yet-to-be-identified investments, an Investment Fund is also known as a “blind pool.”

Investment Funds are established as Limited Partnerships, with investors coming in as Limited Partners (“LP”). You, as the Sponsor of the fund, are the General Partner (“GP”).

The GP manages all fot he activities and affairs of the Investment Fund/partnership.

Sometimes the General Partner is the Investment Manager, and sometimes the Investment Manager is a separate entity.

I’ve seen three ways that the relationship between the General Partner, Investment Manager, and Fund are set up (and I’m sure there are more).

The simplest, and the structure I’ve seen the most, is one where the GP and the Investment Manager are one and same, with the GP formed as an LLC.

The second structure is one that I’ve only seen a few times, and it’s one where the GP is formed as a Limited Partnership. An Investment Manager is formed as a separate entity, usually an LLC, and is the General Partner of the GP of the Fund.

There is a dotted line from the Investment Manager to the Fund, which represents the contractual relationship between the two, with the Investment Manager providing services to the Fund such as deal sourcing, negotiating, due diligence, closing and post-closing portfolio management.

The third structure is one where the GP is formed as either a Limited Partnership or an LLC. The Investment Manager is typically fomed as an LLC, and again having a dotted line to the Fund for investment management services.

Some people are not clear about the mechanics of an Investment Fund. When you close on your fund, you don’t collect the investments from your investors at Closing and then deploy the proceeds into investments over time. When you Close on your fund, you’re closing on “Commitments” from the investors. At Closing there will be some amount that gets drawn down to fund the first quarter of management fees, pay Fund Closing costs, which are mostly legal expenses, and finally, fund any pending investments. As you source opportunities, you will draw down, or “call” on the Limited Partner’s commitments.

Finally, as a preview of the next video, there is tremendous leverage to the General Partner’s capital with an Investment Fund. Typically the General Partner will invest 1% of the total commitments of the Fund, with the Limited Partners committing the remaining 99%. The profits, on the other hand, are allocated 80% / 20%, with 80% going to the Limited Partners and 20% to the General Partner.