Discover how ScaleX Invest can help LPs and GPs
In finance, the partnership structure is steeped in tradition but remains a cornerstone of modern finance. Within business venture, two predominant archetypes govern the distribution of power, responsibility and financial return: the Limited Partner (LP) and the General Partner (GP). Understanding the difference between these roles is essential for finance professionals, fund managers and investors when engaging in collaborative ventures. Each has distinct responsibilities and obligations. This article aims to explore the technical details and nuances surrounding these functions in private equity, in order to highlight their interdependent but distinct roles. Here's a bit of vocabulary clarification.
The essence of partnership
Partnerships are defined by their cooperative nature. They bring together stakeholders, each holding a stake in the venture, to pool resources and expertise towards a common goal. With such collaboration comes shared profits, shared risks, and, in most cases, legal responsibilities that each partner must adhere to.
Limited partner: passive investment takes centre stage
A Limited Partner (LP) is an entity that contributes capital to a fund with the expectation of receiving a return on their investment, while not being involved in the fund’s daily operations. In Private Equity, this means contributing funds to a VC firm or private equity (PE) fund, where management and investment decisions are left to the general partners. Unlike their GP counterparts, LPs generally have a more distant role in the management and operations of the company. They are often similar to silent investors, with their involvement limited to financial contributions, valuations and advice. LPs actively participate in fund governance, exercising oversight and monitoring functions to ensure alignment with their investment objectives.
Key characteristics of a Limited Partner
·Financial contribution: LPs are distinguished by their participation in the partnership via financial investments.
·Passive role: LPs have limited involvement in the day-to-day operations.
·Limited liability: one of the most attractive features of an LP role is the capped financial responsibility. Generally, the liability of an LP extends no further than their initial investment.This means that the most a Limited Partner can lose is the total amount of their investment in the fund.
·Defined return: LPs usually have clear expectations and structures for return on their investment, often through distributions from the partnership's profits.
They are often financial institutions, sovereign wealth funds, pension funds, family offices, endowments, or funds-of-funds.
General Partner: The orchestra conductor
The general partners are the active managers, the decision-makers and often the creators of the partnership entity. In addition to strategic direction, they are responsible for the direct management of the business, assuming both a leadership role and an increased level of responsibility. GPs draw on their expertise, industry networks and operational acumen to identify lucrative investment opportunities and unlock value within their portfolio companies. GPs are fiduciaries charged with safeguarding the interests of LPs while generating attractive risk-adjusted returns. This fiduciary duty entails responsibilities, including transparency, accountability and ethical conduct throughout the investment lifecycle.
Key characteristics of a General Partner
·Control: GPs wield authority over the partnership's operations, making decisions that can significantly impact the partnership and its stakeholders.
·Active participation: unlike LPs, GPs are involved in the day-to-day running of the company, leveraging their expertise to meet operational and strategic objectives.
·Unlimited liability: The GP has full legal decision-making authority for the fund. This body carries all associated legal liability.
·Variable compensation: the return for GPs is often contingent on the profitability and success of the partnership. This can include a share of the profits alongside a management fee.
A duet dance: LPs and GPs in action
In practice, LPs and GPs represent a time-proven and robust division of tasks. LPs provide the funding and, in return, share in the financial rewards of a successful partnership. Conversely, GPs leverage their skills, time and expertise to drive the partnership to success, but at the cost of potentially greater risk exposure and higher performance requirements.
LP-GP dynamics in private equity
Private equity is a prime area for LP-GP dynamics. In this case, the GP offers a collective investment system in which many investors collectively invest in private equities. LPs and GPs are associated through a Limited Partnership Agreement which defines the rights, responsibilities, profite-sharing arrangements and obligations of each party. This agreement is crucial in defining the roles and obligations of each partner and in establishing the governance structure of the partnership. The GP is generally the fund manager and receives a management fee for its services, plus a percentage of the fund's profits, often called "carried interest".
Carried interest: a unique incentive for GPs
One of the most debated forms of remuneration for GPs, carried interest aligns the interests of the GP with those of the LPs by generally representing a percentage of the fund's profits after certain predefined conditions have been met. This important element of private equity can define the attractiveness of the investment terms. This means that when the fund's investments are profitable, the GPs receive a share of the profits above a certain threshold (called the hurdle rate). Example: If the fund makes a profit of $100 million, the GPs can receive a share of this profit based on their carried interest percentage.
Let's take a hypothetical example: our Growth Equity Fund
The Growth Equity Fund is focusing on investing in high-growth companies. The fund raises capital from institutional investors (LPs) such as pension funds, endowments, and family offices. The total fund size is $500 million, with LPs contributing $450 million (90% of the total) and GPs contributing $50 million (10% of the total).
The LPs contribute the majority of the fund's capital. They entrust management of the fund to the GPs. The LPs benefit from diversification, exposure to private markets and the potential for high returns. LPs receive distributions from profitable investments made by the fund. These distributions come from realised gains (for example, on the sale of a portfolio company).
GPs actively manage the fund, making investment decisions and overseeing portfolio companies. Their role includes sourcing deals, conducting due diligence, negotiating terms and providing strategic advice. The GPs invest their own capital in the fund, aligning their interests with those of the LPs. GPs charge an annual management fee (e.g. 1-2% of committed capital) to cover operational costs. The GPs receive a share of the profits (usually 20%) above a certain threshold (e.g. 8%).
In short, LPs provide capital, GPs actively manage investments, and both share in the fund's success. The alignment of interests ensures that GPs work diligently to maximise returns for all stakeholders.
LP and GP dynamics in the digital age
As we surge deeper into the digital age, even the most established financial structures evolve to meet the demands of a dynamic market. The LP-GP model is no exception, with digital platforms simplifying and broadening access to alternative investment opportunities that were once the domain of institutional giants.
Digital platforms offering LP interests in broader partnership funds are now more accessible, allowing a wider range of investors to partake in private equity and other alternative investments. This evolution bears opportunities for GPs to expand their investor pool and for LPs to diversify their portfolios with non-traditional asset classes.
At ScaleX Invest, we support your decision-making by enabling you to monitor the performance of your portfolio of investments and by evaluating the growth potential and risk associated with each company you target.
The partnership lexicon is more than just corporate jargon; it demonstrates how the alignment of interests and division of roles can unleash synergies that propel ventures to new heights. The roles of Limited Partners (LPs) and General Partners (GPs) within the private equity landscape embody a delicate interplay of responsibilities, obligations, and incentives.
Words to remember
LP: the limited partner is an investor who is not actively involved in the management of the fund and does not make strategic decisions about the fund's investments.
GP: The person or company that manages a venture capital or private equity fund. The GP is responsible for managing the fund's assets, making strategic decisions and seeking out new investment opportunities. The GP may also be involved in the management of the company in which the fund has invested.
Carried interest: performance or incentive fee paid to the GP calculated on the basis of the income and capital gains of a private equity fund. The incentive, set by the fund rules, is paid to the fund managers and amounts to around 20% of capital gains, provided that investors (LPs) have been able to benefit from a minimum internal rate of return, also known as the hurdle rate. Carried interest may only be paid if investors have recovered their investments and the associated return (hurdle).
Hurdle rate (also called preferred return): a minimum return that LPs must receive before the GP can share in the profits. If the expected rate of return on an investment is higher than the hurdle rate, it is considered acceptable or worthwhile to pursue. The hurdle rate serves as a threshold that investments must surpass in order to be considered attractive or worthwhile from a financial perspective.
Due diligence: all the measures taken to seek out and control information enabling an equity investor to base his judgement on the business, financial situation, results, development prospects and organisation of the company.
