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By reading this article, you will have a much clearer understanding of the GP's critical role in managing the fund and its responsibilities to the Limited Partners (LP).
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Defining the GP (General Partner)
In a hedge fund context, General Partners (GP) can be either an individual or an entity that steers the fund by shouldering crucial decisions and supervising daily activities. Below are some of the responsibilities covering various fund management areas, from building out investment strategies to ensuring compliance with regulations.
Management of Portfolio Performance
GPs have autonomy when it comes to making investment decisions. They are responsible for monitoring the performance of the investment model and adding or removing assets based on current market direction. Staying on top of market trends to identify complementary strategies that add value to the portfolio, and continuously assessing market risk and, when necessary, implementing strategies to protect the interests of the Limited Partners.
Management of Day-to-day Activities
Overseeing office staff and delegating responsibilities. Making strategic decisions to improve operational efficiency. Maintaining the capitalization table to reflect the current status of owners and shares. Working closely with the accounting service to keep records audit-ready.
Investor Communications
Keeping the LPs updated via bulletins, emails, or newsletters on how the fund is performing and its financial health and addressing any Limited Partner issues or concerns.
Adhering to Laws and Regulations
The GP oversees compliance with all regulatory obligations that govern the fund's operation. Employs a standard operating procedure (SOP) that fosters transparency and honesty in accounting for all inbound or outbound funds.
General Partner Liability
The General Partner(s) (GPs) in a hedge fund can face unlimited personal liability for the debts and obligations of the partnership.
Joint Liability
Each GP is personally liable jointly and severally for the entire amount of any partnership obligation incurred during their tenure as a partner. Each GP is responsible regardless of their involvement in the decision that led to the liability.
Personal Assets at Risk
GPs are liable for debts and other liabilities, including those resulting from contracts signed by any partner within the scope of the partnership's business. Each GP acts as an agent of the partnership, and their actions can bind the partnership and all its partners to contractual obligations. The unlimited liability of GPs extends to their assets, such as homes, savings, and other properties, which can be seized to satisfy the fund's obligations.
Fiduciary Duty and Legal Compliance
GPs have a fiduciary duty to act in the best interests of the partnership and its Limited Partners. Breaches of this duty can lead to personal liability for damages or penalties.
Hypothetical Scenario
To illustrate, if an individual GP makes a decision that results in a lawsuit against the partnership (e.g., copyright infringement), all GPs are personally liable for the entire judgment, even if they were not directly involved in the decision.
How can General Partners mitigate the risks of unlimited liability? General Partners (GPs) can reduce the risks of unlimited liability through several strategies.
Liability Insurance
A GP may consider purchasing comprehensive general partners liability policy (GPL) insurance to protect personal assets from business-related liabilities. A general partners' liability policy (GPL) covers the named risks and excludes bodily injury, property damage, or fraud.
Indemnity Clauses
It is possible to include indemnity clauses in the partnership agreement so that the latter acts as a protective measure. Such clauses can also help shield a partner from certain liabilities or losses that may occur during the partnership business that the partner could not have prevented.
Structuring of the Partnership Agreement
It is possible to include indemnity clauses in the partnership agreement so that the latter acts as a protective measure. Such clauses can also help shield a partner from certain liabilities or losses that may occur during the partnership business that the partner could not have prevented.
A well-thought-out partnership agreement details the various roles and responsibilities of the partners. This agreement should also contain dispute resolution procedures and partner exit plans.
Legal and Financial Planning
It is essential to undertake legal and financial planning properly. Legal experts can help prepare partnership agreements to address liability issues and ensure that the business is adequately capitalized and has contingency plans to avoid or mitigate risks.
Maintaining Formal Separation of Personal and Business Assets
GPs can in no way combine their personal and business assets. Doing so would bring the full wrath of the regulatory bodies to bear. As a function of creating your hedge fund, keep personal and fund assets separate with the supporting documentation proving this. By implementing strategies such as these, GPs can minimize the risks of personal financial liability.
NOTE: Before making any decisions, always seek appropriate legal counsel
Defining the LP (Limited Partner)
A Limited Partner (LP) is an individual or entity that provides capital to the fund without involvement in its management and decision-making processes.
Fund Relationship
The LP contributes investment capital in exchange for ownership shares in the fund. The LP's number of shares determines the profits (or losses) distributed pro rata. Under current tax law (2024), the IRS considers fund distributions as passive income, which is not subject to self-employment taxes.
Operational Oversight
Limited partners are not involved in fund management. They only provide investment capital. The GP(s) handle the active day-to-day management.
Voting Rights
The limited partners have no right to vote on major decisions for the fund, ensuring that the liability of limited partners is restricted solely to their investment amount.
No Authorization to Bind
An LP cannot authorize any business dealings or agreements on behalf of other LP(s) or the GP(s).
Limited Liability
The limited liability of an LP is further supported since they are not involved in fund business decisions and cannot vote on fund decisions. Therefore, their financial liability is "limited" to the amount invested. Limited Partners are often called "silent partners" due to their passive role in the fund's operations. There is a certain level of trust between LPs and GPs, reinforced through active communication and dialogue.
GPs receive two primary forms of compensation
Management Fees
A fixed percentage of the fund's assets under management (AUM) (usually 2% annually) covers operational costs and base salaries.
Carried Interest
A performance-based fee, typically 20% of the fund's profits, incentivizes the GP to generate strong returns for the investors.
Hurdle Rate
Before the GP can claim carried interest, the fund must achieve a minimum return, known as the "hurdle rate." This set rate ensures that the LPs receive a specified return on their investment (ROI) before the GP starts earning carried interest. For example, if the hurdle rate is 8%, the GP only earns carried interest on profits above this threshold.
Here is a hypothetical example
- Total LP Investment: $100 million
- Year-end value with profits: $140 million
- Hurdle Rate: 8%
- Year-end Profit $40 million.
- Carried Interest Fee 20%: $40 million x 20% = $8 million.
- In this scenario, the GP would receive $8 million in carried interest, and the LPs would receive the remaining $32 million in profits.
GP vs. LP: Key Differences
GPs are personally liable, without limits, for the debts and responsibilities of the partnership. If the fund can not meet its obligations, creditors can demand that the GPs assets be attached to settle the partnership's debts.
Prioritize the well-being of the Limited Partners
GPs are obligated to prioritize the well-being of the Limited Partners. Failure to fulfill this obligation could lead to GPs being held accountable for any resulting losses. They could face consequences, for neglecting their responsibilities or failing to uphold their duties with care and integrity.
Complying with all laws and regulations
GPs ensure that the fund abides by all laws and regulations. Failing to comply may result in fines or legal consequences.
Tax Obligation
Typically, general partners (GPs) handle the tax responsibilities of the partnership and could be held responsible for any taxes the partnership owes.
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This is why many hedge funds are structured as limited partnerships, with an entity, like an LLC or corporation, acting as the General Partner to protect the fund manager(s) from liability while maintaining the partnership format investors are comfortable with.
The LLC Structure
An LLC is a legal entity combining some of a corporation's and a partnership's best features. An LLC operating agreement spells out the operational and financial duties of the member-owner(s) and how the profits will be distributed.
One of the standout benefits of LLCs is their legal limitation of liability for the member-owner(s). This protection shields their assets from the business's debts and liabilities, except in cases of fraud or improper mixing of personal and business assets (more on the dangers of commingling in a moment).
LLCs generally avoid double taxation on income
LLCs are generally pass-through entities for federal income tax purposes. The benefit is that the LLC does not pay any corporate income taxes. Instead, the business income passes through to the member-owner(s), who report this income on their tax returns.
For multi-member LLCs, the IRS treats the business as a partnership. The LLC files a partnership information return (Form 1065) to report the business's profits, losses, credits, and deductions. Each member receives a Schedule K-1, which they use to report their share of the LLC's income, credits, and deductions on their tax returns (Form 1040). This structure also avoids double taxation.
Articles of Organization
Articles of Organization are mandatory for forming an LLC, providing the legal framework and protection for the business and its members.
Articles of Organization are filed with the state government, typically with the Secretary of State's office, to register an LLC as a legal entity.
Filing Articles of Organization provides the LLC with limited liability protection, separating the personal assets of the member-owner(s) from the business's liabilities.
Once filed and approved, the LLC is officially recognized as a separate legal entity, allowing it to conduct business and enjoy the benefits of pass-through taxation and limited liability protection
Operating Agreement
An Operating Agreement for an LLC is an essential document that sets forth the purpose and scope, rules regarding the management structure, defined roles, and financial arrangements within the LLC.
Roles and Responsibilities
Describes each member-owner(s) precise roles and responsibilities, as well as their powers and restrictions.
Decision-Making
The agreement outlines how decisions will be made and by whom.
Capital Contributions
The agreement recognizes the capital contributions of each member-owner and how they can contribute additional capital.
Profit and Loss Distribution
The document details how profits or losses will be allocated among the member-owners(s).
Compensation
The member-owners of the LLC may receive monetary payments for their services to the company.
Expenses and Reimbursements
Specifies procedures for reimbursement for member-owners who have incurred expenses on behalf of the LLC.
Meetings and Voting
The agreement includes the requirements for holding meetings, the frequency of meetings, the notice periods, and the voting procedures.
Record Keeping
Identifies the person(s) responsible for managing the LLC's financial statements, minutes of meetings, and other necessary documents.
Dispute Resolution
This document usually lists the procedures for settling disputes between member-owner(s), such as mediation or arbitration clauses.
Amendments
The agreement describes the procedure for modifying the operating agreement.
Clarity and Consistency
The operating agreement clearly defines roles, responsibilities, and procedures. Preventing misunderstandings and conflicts among the member-owner(s).
Predefined Processes
By having pre-established processes for the decision-making process, financial distributions, and dispute resolution, the chance of disputes caused by unclear expectations is reduced.
Subscription Agreement
A subscription agreement establishes a member-owner(s) commitment to bring in capital and participate in the LLC. The subscription agreement stipulates the terms under which the member-owner(s) will make the capital contributions to the LLC. It guarantees that each member is not only aware of it but also consents to the financial and operational duties imposed by the company.
Ownership Percentage
The member-owners percentage is based on their contribution of capital as it relates to the valuation of the LLC in its entirety.
Profit and Loss Distribution
The manner of distributing the profits among the members, based upon their ownership percentages or other agreed-upon methods.
The subscription agreement is the company's business agreement that governs the relationship of the members of the LLC. While the operating agreement covers a broader area of the LLC's management and operations, the subscription agreement is key to the member-owner(s) capital commitments and financial participation. These two documents are the core of a systematic and organized LLC.
In Conclusion
Launching a fund is much like building a house. First, you decide on the floor plan and size. Second, list all of the features you want to include. Third, have a professional draw up the plans; fourth, choose the custom builder to make your dream come to life.
Over 900 fund managers have chosen Fund Launch© to help them design, create, and launch their dream, and they now have over 1.8 billion (AUM). We have years of experience in this industry and have engineered a proven step-by-step system to help you avoid the headaches, frustration, and expenses other people suffer by going it alone.
Fund Launch© provides the tools, support, and expertise to successfully navigate the fund management world. Our Black Card program takes it even deeper with in-depth training, mentorship, and support for GPs.
We help people just like you launch and run their hedge funds. Visit us at https://www.fundlaunch.com/
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.
