Before a manager raises their first dollar of outside capital, they need to understand the legal architecture they are operating inside. The GP/LP fund structure is not just a legal convention — it is the framework that determines who owes what duties to whom, how money flows in and out, what the manager gets paid, and under what circumstances the manager loses control of their own fund. Emerging managers who treat fund documents as boilerplate to be negotiated down to cost are creating problems they will spend years cleaning up.

This post covers the basic architecture, why three entities are used instead of one, the economics of the management fee and carried interest, the mechanics of the distribution waterfall, and the governance provisions that matter most in practice.

The Three-Entity Architecture

A standard private fund uses three entities: the fund LP, the general partner entity, and the management company. Each serves a distinct function, and collapsing them is a mistake.

The fund LP is the investment vehicle. It is the entity that holds the portfolio assets, enters into subscription agreements with investors, and issues LP interests. In a domestic structure this is typically a Delaware limited partnership. In an offshore structure it is typically a Cayman Islands exempted limited partnership. The fund LP is the entity into which capital is called and out of which distributions flow.

The general partner is the managing entity of the fund LP. It has the authority to make investment decisions, execute documents on behalf of the fund, call and return capital, and manage day-to-day operations. Under partnership law, the GP has unlimited liability for the fund's obligations — which is why the GP is almost always an LLC (or a Cayman exempted company) rather than an individual. The GP also receives the fund's carried interest: its share of the profits above the preferred return. The GP is the entity that owes fiduciary duties to the limited partners.

The management company is a separate entity — again, typically an LLC — that employs the investment professionals and charges the management fee. The management company is distinct from the GP for two reasons. First, the management fee is ordinary income to the management company, while carried interest received by the GP is treated as a profits interest potentially eligible for capital gains treatment. Keeping the two income streams in separate entities preserves that distinction. Second, separating the management company from the GP insulates the management fee-generating entity from the unlimited liability that partnership law attaches to the GP role.

The manager (and typically their principals) owns both the GP and the management company. But they are not interchangeable, and they should not be merged or ignored in the fund's governing documents.

The Limited Partnership Agreement

The limited partnership agreement (LPA) is the governing document of the fund. It is not a form to be downloaded and lightly edited. It is the contract that controls how every material economic and governance question gets resolved over the fund's ten-year (or longer) life. The following provisions require particular attention.

Capital contributions and capital accounts. The LPA establishes the mechanics for capital calls — how much notice LPs receive, what happens on default, and whether the GP can impose dilution penalties on defaulting LPs. It also establishes the capital account framework: each LP's capital account tracks their contributions, allocated income and loss, and distributions. Capital accounts are the accounting mechanism through which the waterfall ultimately operates.

The distribution waterfall. The waterfall is the sequence in which fund proceeds are distributed. In a private equity fund, the standard deal-by-deal waterfall distributes proceeds from each realized investment as follows: (1) return of contributed capital to LPs; (2) return of called management fees and fund expenses; (3) the preferred return to LPs (typically 8% per annum, compounded annually, on unreturned capital); (4) the GP catch-up (the GP receives 100% of distributions until it has received 20% of total profits above the preferred return); (5) 80/20 split to LPs and GP on remaining proceeds. The whole-fund waterfall — where the GP does not receive carry until LPs have received back all capital across all investments plus their preferred return on the entire fund — is more LP-friendly and is increasingly standard for first-time funds.

Key person provisions. Key person provisions identify the specific individuals whose full-time involvement is a condition of the fund's continued operation. If a key person leaves, is incapacitated, or devotes less than a specified percentage of their professional time to the fund, a key person event is triggered. Upon a key person event, the investment period is automatically suspended — the manager cannot make new investments or call additional capital — until either LPs vote to reinstate (typically requiring a majority-in-interest vote) or a permanent suspension occurs. Key person provisions are non-negotiable for institutional investors.

Removal provisions. Most LPAs include both for-cause and no-fault removal of the GP. For-cause removal — triggered by fraud, gross negligence, material breach, or criminal conviction — typically requires a lower LP vote threshold (majority-in-interest or two-thirds) and does not require any payment to the GP. No-fault removal allows LPs to remove the GP without cause, but typically requires a higher vote (two-thirds or 75% in interest) and may require payment of a termination fee. No-fault removal is a critical LP protection, but GPs should resist structures that make it too easy — a no-fault threshold below two-thirds in interest can create a governance vulnerability.

The Management Fee

The management fee is the manager's operating revenue. It is not profit — it funds salaries, rent, technology, compliance, and the ordinary costs of running an investment firm. The typical private equity fund charges 1.5% to 2.0% of committed capital during the investment period (usually years one through five), shifting to 1.0% to 1.5% of invested capital (or cost basis of unrealized investments) during the harvest period. Hedge funds typically charge on NAV rather than committed capital, because capital is not locked up the same way.

Management fee offsets are standard in institutional LPAs: typically 50% to 100% of monitoring fees, transaction fees, and board fees received from portfolio companies are credited against the management fee. An offset of less than 50% will face resistance from sophisticated LPs. Some LPAs provide for a fee holiday — a period at the fund's inception where the management fee is waived or reduced — which is sometimes used as a concession to anchor investors or in lieu of a fee discount.

Carried Interest and the Preferred Return

Carried interest is the GP's share of fund profits — typically 20%. It is the primary economic incentive for fund managers and, structured correctly as a profits interest, receives favorable tax treatment (discussed in detail in a separate post on Section 1061). The critical mechanics are the preferred return, the catch-up, and the clawback.

The preferred return (or hurdle rate) is the minimum annualized return that LPs must receive before the GP is entitled to any carried interest. The market standard for private equity is 8% per annum, compounded annually on unreturned contributed capital. Hedge funds and venture funds often have no preferred return, or use a high-water mark mechanism instead. The preferred return is not a guaranteed return — it is simply the threshold below which the GP earns nothing on carried interest.

The catch-up provision allows the GP to receive a disproportionate share of distributions after LPs have cleared their preferred return, until the GP has received 20% of total profits above the preferred return. In a standard 100% catch-up, the GP receives 100% of distributions (after the preferred return is satisfied) until the GP's cumulative share equals 20% of total profits. After the catch-up is complete, distributions split 80/20 between LPs and GP on remaining proceeds. Some LPAs use an 80% or 50% catch-up, which slows the GP's path to 20% but is less LP-favorable at the margin.

The clawback is the obligation of the GP to return carried interest previously distributed if, at the end of the fund's life, the GP has received more carry than it would have been entitled to under a whole-fund calculation. Clawbacks arise when early investments are highly profitable (generating early carry distributions) and later investments underperform. The clawback ensures LPs are not subsidizing early wins that are later erased. Institutional LPs require clawbacks. The GP should ensure the clawback obligation is limited to the GP entity and not extended personally to the principals, and should negotiate a cap at the after-tax carry received rather than the gross amount.

The Limited Partner Advisory Committee

The Limited Partner Advisory Committee (LPAC) is a subset of LPs — typically three to seven of the largest or most sophisticated investors — that serves as a consultative and consent body on conflicts of interest and certain discretionary GP decisions. The LPAC does not govern the fund in the ordinary course; it does not approve individual investment decisions or replace the GP's authority. Its role is narrower: approving or waiving conflicts of interest (co-investments, cross-fund transactions, valuation disputes), consenting to extensions of the investment period or fund term, and serving as a sounding board on matters where the GP's interest may diverge from the LPs'.

LPAC membership is a negotiating point for large LPs. It provides visibility and influence without the fiduciary obligations that would attach to a governance role. For the manager, the LPAC provides a defensible process for conflict resolution that reduces litigation risk — an LPAC approval of a conflicted transaction is strong evidence that the GP acted in good faith.

Understanding this architecture thoroughly — before the first subscription agreement is signed — is what separates managers who build durable institutions from those who find themselves renegotiating fund terms under pressure from their largest LPs three years in.