Historically, that question was often framed primarily as a tax, securities law, domicile or investor preference question. Should the fund be Delaware or Cayman? Should there be a parallel fund? Should there be a blocker? Should certain investors come through a feeder? Will non-US investors receive US tax reporting? Will US tax-exempt investors have unrelated business taxable income (UBTI) concerns? Will there be treaty, withholding, passive foreign investment company (PFIC), controlled foreign corporation (CFC) or other tax issues?

Those questions still matter. They have not gone away.

But for global venture capital and private equity funds, especially funds investing across the US and China in technology-adjacent sectors, the question has become broader. Managers now need to think not only about where the fund is formed, but also about where the capital comes from, who controls the fund, what sectors the fund will invest in, what information investors will receive, what rights investors will have and whether the fund structure can adapt as regulatory rules change.

The practical point is simple, even if the underlying rules are complex: In today’s environment, global fund structuring is increasingly about routing capital, control, information and governance in a way that matches the regulatory profile of the fund’s strategy.

That does not mean global investing is impossible. It does not mean funds should avoid every sensitive sector. It does not mean managers should abandon US-China strategies, global technology strategies, life sciences strategies or multicountry venture strategies. It does mean that managers should be more deliberate at the time the fund is formed and launch with more agility to react in a needed way, and on a reasonable timeframe, as the years unfold.

In that way, fund documents need to anticipate the regulatory architecture the manager may need later. A manager should not be discovering, after signing a term sheet for a sensitive investment, that the fund cannot create the right parallel vehicle, exclude the right investors, make capital calls by regulatory sleeve, limit information rights, form an alternative investment vehicle (AIV) quickly, use a power of attorney to implement a pre-agreed structure or keep the wrong investors out of the wrong governance process.

In complex global strategies, capital, control, information and governance all need to tell the same story.

Start with the strategy

The first question is what the fund is trying to invest in.

A global fund investing in ordinary consumer products, furniture, apparel, restaurants, local services or basic nonsensitive manufacturing presents a very different profile from a fund investing in semiconductors, quantum computing, AI, advanced computing, cybersecurity, defense-adjacent technologies, critical infrastructure, sensitive data businesses or other sectors that governments increasingly view through a national security lens.

There is also a large middle category.

Life sciences, biotechnology, healthcare technology, AI-enabled drug discovery, clinical trial platforms, robotics, fintech, logistics, data-enabled consumer businesses and other technology-adjacent sectors may not always sit at the center of current regulatory focus. But they may still raise meaningful issues depending on the facts. A life sciences company may use AI to identify drug targets. A healthcare business may hold large amounts of personal information. A robotics company may have applications that look commercial in one context and sensitive in another. A data company may appear benign until one understands what data it holds, who its customers are and how the data could be used.

Managers should therefore think about investment strategy as a spectrum.

At one end are strategies that are highly unlikely to raise significant national security or outbound investment concerns. At the other end are strategies where regulatory structuring should be central from the beginning. In the middle are strategies that may look ordinary in some deals and sensitive in others.

The middle category is often where mistakes happen.

A manager may say, “We are not a semiconductor fund.” That may be true. But if the fund expects to invest in AI-enabled biotechnology, data-heavy healthcare platforms, robotics, cybersecurity, advanced computing infrastructure or companies with meaningful US-China technology exposure, the manager should not assume the fund is outside the relevant regimes. The answer will depend on the facts.

There is also a timing point. A closed-end private fund is not making all of its investments on the day it holds its first closing. It may invest over four, five or six years and manage its portfolio for 10, 12, 15 or more years. Regulatory focus can change during that period. Sectors that are not the focus of today’s rules may become the focus of tomorrow’s rules. A fund formed today should not be drafted only for the first deal in the pipeline.

The fund documents should be built with enough flexibility to respond to a changing regulatory environment.

Investor identity matters

The second question is who the investors are.

For global funds, this is no longer just a subscription document detail. Investor identity can affect whether particular investments are possible, whether particular investors need to be excluded, whether parallel vehicles are needed, whether information must be limited, whether side letter assurances are required and whether the fund can make certain investments without creating regulatory problems for its investors.

For US outbound investment purposes, US person investors may care deeply about whether their capital is used for certain China-related investments in sensitive sectors. Even if the fund itself is organized outside the US, a US person investing indirectly through that fund may have a legal issue if the fund makes investments that fall within the outbound investment rules and the US investor does not fit within an exception or receive an appropriate contractual assurance.

That is a critical fund formation point. The fund’s later investment activity can create a problem for the limited partner (LP).

For Committee on Foreign Investment in the United Stated (CFIUS) purposes, foreign investors can matter when a fund invests into US businesses, particularly US businesses involving sensitive technology, infrastructure or data. The analysis is not simply whether there is a foreign LP somewhere in the fund structure. Many US venture and private equity funds have foreign LPs. The practical questions are who the foreign LPs are, how much they own, whether they are related to each other, whether they are sovereign or state-linked, what rights they have, what information they receive, whether they sit on the Limited Partner Advisory Committee (LPAC), whether they can influence fund decisions and whether the fund structure keeps the fund passive for the relevant regulatory purposes.

Investor identity also matters as a matter of perception. Some rules are formally country-specific; others are not. For example, the US outbound investment regime identifies countries of concern. CFIUS is not framed in the same way for every part of its analysis, but CFIUS is an interagency US government national security process. It is not realistic to think investor identity, country sensitivity, sovereign status, strategic status or geopolitical context never affects how facts are viewed internally at the agency. In practice, those items certainly do.

The legal test may not always name a particular country. The practical risk analysis often still cares very much about which country, which investor, which sector and which rights are involved.

Control matters too

The third question is where control sits.

This is one of the most important distinctions in this area. Managers need to think separately about equity and control.

Equity asks whose money is being invested, who holds the economic interest and who is exposed to the investment.

Control asks who makes the investment decision, who controls the fund, who controls the manager, who sits on the investment committee, who has approval rights, who receives sensitive information, who can influence portfolio company decisions and who participates in governance.

Different rules care about these concepts differently.

Some rules focus heavily on capital flows and economic exposure. Others focus heavily on control, rights, information and decision-making. A fund may have foreign capital but US control. It may have US capital but non-US control. It may be organized in one jurisdiction but managed from another. It may have a non-US general partner (GP) but US investment professionals. It may have US persons participating in decisions for a non-US vehicle. It may have foreign LPs with only passive economics, or foreign LPs with significant approval or information rights.

There is another important definitional point. CFIUS and the US outbound investment rules do not use identical concepts of who is a US person. For example, US green card holders may be treated differently under the two regimes. A manager should not assume that a person who is treated as a US person for one regime is treated the same way for the other. These definitions need to be checked under the specific rules being applied.

These facts matter.

A manager should not assume that a Cayman fund is “non-US” for all relevant purposes merely because it is organized in Cayman. Nor should a manager assume that a Delaware fund is necessarily treated as US-controlled for every national security purpose if the economics and governance are effectively controlled by a foreign investor. Nor should a non-US manager assume that US person investment committee members can participate freely in sensitive China-related investment decisions merely because the vehicle is offshore.

The analysis often starts with a simple discipline: Identify the capital, control and information rights. Then see whether they match the regulatory posture the fund is trying to achieve.

CFIUS and ‘US person for CFIUS purposes’

For investments into US businesses, CFIUS is often the primary US national security regime managers need to consider.

At a high level, CFIUS reviews certain foreign investments in US businesses that may raise national security concerns. Historically, many people thought about CFIUS primarily in the context of foreign acquisitions of US defense contractors or other obviously sensitive businesses. That is no longer sufficient. CFIUS can be relevant to noncontrol investments in certain US businesses involving critical technology, critical infrastructure or sensitive personal data.

For private funds, one key question is whether the investor is a US person or a foreign person for CFIUS purposes.

The last words matter: for CFIUS purposes.

We are not asking whether the fund is “US” for tax purposes, securities law purposes, immigration purposes, branding purposes, office location purposes or ordinary commercial purposes. We are asking how the fund is treated under the CFIUS rules. This is particularly important because a green card holder is not treated the same as a US citizen for all CFIUS purposes, while the US outbound investment rules may treat green card holders as US persons. The definitions are not interchangeable.

There are several ways a fund structure may raise foreign person issues for CFIUS purposes.

• First, the fund may be foreign at the fund level. If the fund is organized outside the US and controlled by non-US persons, the starting point may be straightforward.
• Second, the fund may be foreign-controlled because the manager, GP, investment committee or other control persons are foreign persons. The fund’s domicile alone is not the whole answer. Control matters.
• Third, and often less discussed, a US-organized fund with US manager personnel may still raise foreign person issues if one or more foreign LPs effectively control the fund. This is a real issue, even if it is not always analyzed carefully.

The third point is often overlooked in articles about this topic. Consider a simple example. A Delaware fund has a US GP and US personnel, but a highly sensitive foreign strategic investor is the sole LP. It would be difficult to assume CFIUS would ignore that fact simply because the entity is a Delaware limited partnership and the nominal manager is US. A sole LP may have statutory rights, contractual rights, amendment rights, consent rights, removal rights, economic leverage or other powers under the limited partnership agreement. If the rule could be avoided merely by placing a sensitive foreign investor behind a US fund shell, the regime would be too easy to end-run.

Now consider a different case. A Delaware fund has several unrelated foreign LPs, none of whom owns a controlling position, none of whom can veto material decisions, none of whom has special information rights, and none of whom can control the GP, investment decisions or portfolio company rights. That is a very different fact pattern.

The practical lesson is not that foreign LPs are always a problem. The lesson is that foreign LP control is a problem, and it is sometimes underanalyzed.

A foreign LP is not the same thing as foreign LP control. But foreign LP control is real.

Passive economics versus covered rights

If a foreign or global fund wants to invest in a US business that may be sensitive for CFIUS purposes, the fund may sometimes have a choice. It can try to structure itself as a US-controlled vehicle, or it can invest in a more passive posture.

The passive posture can be useful, but it must be truly passive.

In ordinary venture capital practice, investors often expect a package of rights. These may include board seats, board observer rights, regular management updates, detailed information rights, technology updates, pro rata rights, consultation rights, consent rights and access to founders. Those rights may be commercially normal in many venture deals.

In a CFIUS-sensitive investment by a foreign or global fund, some of those rights may be exactly the problem.

The safer posture is generally limited to ordinary economic rights, basic tax reporting and high-level financial reporting. The investor should not receive a board seat, observer right, director nomination right, access to material nonpublic technical information, detailed technology roadmaps, engineering materials, source code, cybersecurity information, sensitive personal data, critical infrastructure information, or involvement in substantive decisions about sensitive technology, infrastructure or data.

This can be commercially awkward. Venture capital investors often want to help. They want access. They want to support the founder. They want to know what is happening. They want to be in the room.

But in a CFIUS-sensitive passive investment, being in the room may be the problem.

That does not mean the fund can receive no information. A fund needs ordinary financial information for valuation, audit, tax, reporting and administration. The distinction is between basic financial information and technical or operational information that creates sensitivity. A revenue number is not the same thing as an engineering roadmap. Audited financial statements are not the same thing as a board deck. A high-level business description is not the same thing as material nonpublic technical information.

In this context, passive should mean passive.

That may work if US sensitive investments are only a small portion of a global fund’s strategy. The fund may be willing to participate economically in those companies without the full venture capital rights package. It may not work if the fund’s core strategy is to lead US sensitive technology rounds and provide hands-on strategic support. In that case, the manager may need a different architecture, such as a genuinely US-controlled vehicle, rather than relying on passive rights.

Sometimes the answer is not a different vehicle. Sometimes the answer is a different investment posture.

OISP and US capital into China-related sensitive technologies

The US outbound investment regime raises a different kind of issue.

For purposes of this article, the details are less important than the practical fund formation point. The outbound rules focus on certain US person investments into China-related covered sectors, including areas such as semiconductors, quantum information technologies and AI. The regime distinguishes among prohibited transactions, notifiable transactions and transactions outside the covered categories.

The key point for fund managers is that US persons can have issues not only when they invest directly, but also when they invest indirectly through funds.

If a US investor commits capital to a Cayman, Singapore or other non-US fund that may invest into China-related covered sectors, the fund’s later investment activity can create a problem for that US investor. The investor may need to fit within an exception, receive a contractual assurance that its capital will not be used for certain investments or choose a vehicle that does not participate in certain categories of transactions.

Here again, definitions matter. The US outbound investment rules may treat US green card holders as US persons even though CFIUS may not treat them the same way for CFIUS purposes. Managers should not use one regime’s definition as a shortcut for the other.

That makes the Outbound Investment Security Program (OISP) a fund formation issue, a side letter issue, a parallel fund issue and an administrative issue. It is not merely a regulatory footnote for the investment team.

The US LP may say, in substance: “I can invest in your global fund, but I cannot be in a vehicle that will use my capital for prohibited transactions, and I may or may not be comfortable with notifiable transactions.”

Different investors may answer that question differently.

Some US institutional investors may be willing to participate in notifiable transactions, especially if they believe the return opportunity is significant, and the notice process is manageable. Others may want no exposure to notifiable or prohibited categories. Some non-US investors, including investors from jurisdictions closely aligned with the US, may voluntarily choose the more conservative vehicle even if the rule does not technically require them to do so. Their concern may be reputational, policy-driven, relationship-driven or simply a desire not to be close to the line.

This means a global manager cannot always solve OISP with one on/off switch. The structure may need multiple regulatory buckets.

Why excuse rights may not be enough

Historically, many legal, tax, regulatory and investor-specific issues in private funds were handled through excuse or exclusion rights. If a particular investor could not participate in a particular investment, the manager could excuse that investor from the investment. The rest of the fund would proceed.

Those rights still matter. They should still be included in fund documents. They may be very useful as rules evolve over time.

But in the current outbound investment environment, excuse rights may not always be enough.

Consider a non-US fund that intends to make China-related investments in sectors that may be prohibited for US persons. One might ask: Why not put all investors into one fund and simply excuse the US investors from those deals?

For many large US investors, that may feel too close to the sun. The rules are new, enforcement history is limited, the penalties can be significant, and the investor may not want to be in the same legal vehicle that is making the investments, even if the investor is technically excused from them. The cleaner answer may be a separate parallel fund that does not make those investments at all.

That distinction is very important.

Excuse rights are helpful, but they are not always sufficient. In the most sensitive settings, investors may want a different vehicle, not merely an excuse from a deal.

Parallel funds as regulatory routing tools

Parallel funds are not new. Fund managers have long used parallel funds for tax, regulatory, Employee Retirement Income Security Act (ERISA), treaty, domicile, currency, investor preference and administrative reasons.

What is changing is that parallel funds are increasingly being used as regulatory routing tools.

A global manager may have one parallel fund for investors that can participate in all global investments. It may have another parallel fund for investors that cannot participate in OISP-prohibited China-related investments. It may have another for investors that do not want exposure to notifiable transactions. It may have a separate RMB fund for local China investments. It may have a Delaware or US-controlled structure for certain US investments. It may use AIVs for particular investments. It may need to separate investors based on US person status, non-US status, China sensitivity, sovereign status, currency, local filing requirements or risk tolerance.

In simple fund structures, this may sound excessive. In complex global venture structures, it is increasingly where the action is.

Some global capital systems now involve four, five or six parallel vehicles or sleeves. That is not because managers enjoy complexity; it is because the capital, control and regulatory issues do not line up neatly in one vehicle.

The challenge is to make the structure flexible without making it unbounded. LPs need to know the ground rules when they commit. The manager needs enough authority to move quickly when a sensitive opportunity appears. The structure needs to be administrable by the manager, counsel, tax advisors, fund administrator and finance team.

The flexibility should be negotiated at formation. The execution often happens later.

Build the routing system before you need it

In complex global strategies, the fund documents should usually authorize the manager to create additional parallel funds, AIVs, feeder vehicles, sleeves or similar structures after closing.

Ideally, that authority is built into the limited partner agreement (LPA) and related documents at inception, often supported by powers of attorney. The goal is not to let the manager rewrite the bargain later. The goal is to agree on the ground rules in advance so the manager can implement the structure quickly when a deal requires it.

This is critical because sensitive investment opportunities often move quickly. The target company, co-investors, sellers, regulators and other parties will not necessarily wait while the manager goes back to every LP for real-time approval of complicated new documents. If the fund structure requires investor-by-investor consent each time a parallel vehicle is needed, the fund may lose the deal.

The documents should therefore consider authorizing the manager to:

• Create additional parallel funds, AIVs or similar vehicles after closing.
• Admit some or all investors to those vehicles.
• Allocate investments among vehicles.
• Transfer or allocate investments among parallel funds where appropriate.
• Make a particular investment only through selected vehicles.
• Classify investors by regulatory category or risk-tolerance bucket.
• Allow investors to make later elections where the issue is primarily an investor-specific risk tolerance question.
• Make capital calls only to the applicable vehicles or investors.
• Exclude investors or vehicles from particular investments.
• Withhold information where disclosure would create legal, regulatory, confidentiality, national security or portfolio company issues.
• Use powers of attorney to implement pre-agreed mechanics.
• Require investors to provide and update status information.

The art is in the ground rules.

LPs should understand how economics, expenses, follow-ons, recycling, defaults, capital calls, reporting and governance will work across the vehicles. The manager should not have unlimited discretion to move economics around in a way that changes the bargain; but the manager should have enough pre-agreed discretion to route capital properly when the regulatory facts require it.

A structure that is theoretically elegant but cannot be executed quickly is not a good structure.

Side letters are supporting tools, not the whole structure

Side letters remain important in this area. They may be used to obtain investor status information, provide investor-specific assurances, document OISP-related contractual assurances, limit information rights, address CFIUS concerns, create reporting exceptions, provide excuse rights or reflect an investor’s election into a particular regulatory bucket.

But side letters are not a substitute for the main fund architecture.

A side letter is bilateral. It can accommodate a particular investor. It should not be used to rewrite the entire fund’s investment program for everyone. A manager generally should not try to solve a fund-wide regulatory routing issue by promising one LP in a side letter that the entire fund will not make a category of investments, if that is inconsistent with the main fund documents, the expectations of other investors or the common bargain.

If the strategy requires one vehicle that can make a category of investments and another vehicle that cannot, that structure should usually be built into the fund architecture. The side letter can support the structure, but it should not be the structure.

This is especially important because the most sensitive issues may need to be administered across the full life of the fund. A promise that cannot be operationally tracked is dangerous. A side letter restriction that the deal team, finance team, administrator and investment committee do not understand may create more risk than it solves.

Information rights are usually curtailed

In complex global capital structures, information rights are usually more limited, not more robust.

This may surprise some investors – it should not.

If the structure is designed to keep certain investors passive, keep certain US persons out of certain non-US investment decisions, or avoid giving foreign investors rights that create CFIUS concern, the manager should not simultaneously give those investors extensive portfolio company information rights.

In practice, LPs in private funds generally do not receive material nonpublic technical information, board materials, export-controlled information, cybersecurity architecture, customer-level personal data or investment committee materials. That is especially true in sensitive global structures.

The more realistic issue is enhanced information. Strategic investors, corporate investors, funds of funds, large institutions or heavily negotiated investors may ask for portfolio company updates, operating data, technical descriptions, valuation support, co-investment materials, pipeline information or other information beyond ordinary fund reporting. In a complex regulatory structure, those rights may need to be limited.

The information package should match the regulatory posture.

A passive investor structure can be weakened if the investor receives information that makes it look less passive. A foreign LP that is supposed to be passive for CFIUS purposes should not receive detailed technical information about US sensitive portfolio companies. A US person that is not supposed to participate in a China-related sensitive investment should not receive materials that make it look like that person is involved in the decision.

The documents should preserve the manager’s ability to withhold or limit information where disclosure would create legal, regulatory, national security, sanctions, export control, data, confidentiality, material nonpublic information or portfolio company issues.

This should not be viewed as evasive; it is responsible administration.

LPACs may need to follow the capital

LPAC rights create a related issue.

Historically, managers often thought of the LPAC as a fund-level body. It received information, reviewed conflicts, approved waivers, considered valuation issues, approved affiliate transactions, reviewed fund term extensions and addressed other governance matters for the fund as a whole.

In a simple fund, that model works.

In a complex global capital structure, a single all-purpose LPAC may not work for every matter.

If one parallel fund is permitted to participate in an OISP-sensitive China-related investment and another parallel fund is specifically designed not to participate in those investments, the LPAC members associated with the nonparticipating fund may not be the right people to receive information or provide approvals for that investment. In some cases, involving them could undermine the regulatory architecture.

For example, assume a parallel fund exists specifically so US person investors do not participate in OISP-prohibited investments. If a different parallel fund is making one of those investments, and the manager needs an approval related to that deal, such as a single-investment-limit override, a conflict approval or another governance matter, it may be inappropriate for US person LPAC members from the nonparticipating vehicle to review and approve that matter.

This is why we are increasingly seeing sub-LPACs, vehicle-specific LPACs or deal-specific governance processes in complex global fund structures. That was much less common historically but is becoming more relevant because the governance structure needs to match the investment structure.

If the capital is separated, the governance may need to be separated too.

A structure that separates capital but leaves all approval rights, information rights and LPAC processes pooled together may not solve the problem it was designed to solve.

A practical global venture example

Consider a global venture manager based primarily in Singapore. The senior team includes several Singapore nationals and one PRC national. The manager has a strong reputation and access to capital from US institutional investors, Asian sovereign investors, China-related investors resident outside China with dollar capital and RMB investors inside China. The manager wants to invest globally, including in US technology companies and China-related technology companies. Some of those investments may involve AI, semiconductors, life sciences, data or other sensitive sectors.

A single fund may not be enough.

One parallel fund might participate in all global deals for investors that do not have OISP concerns. Another parallel fund might participate in all deals except OISP-prohibited China-related investments. A third might avoid both prohibited and notifiable China-related investments for investors with a more conservative risk tolerance. Some US investors may be comfortable with notifiable transactions; others may not. Some non-US investors may voluntarily elect the more conservative path because of their own institutional, policy or relationship concerns.

The same manager might also have an RMB fund inside China for local RMB investments in companies intended for local listing paths. That brings a different set of China local law, currency, regulatory, listing and historical dollar/RMB fund issues. Those issues have not disappeared merely because US inbound and outbound regimes have become more prominent.

The hardest piece may be US sensitive investments.

If the Singapore-led platform has a genuinely US-controlled affiliate or vehicle, perhaps under a brand license or carefully structured economic sharing arrangement, that may open a path for a US person fund for CFIUS purposes. But the control needs to be real. It cannot be a label. If the investment decisions are still being made by non-US persons, the structure may not accomplish what it is intended to accomplish.

If the platform does not have a genuinely US-controlled vehicle, it may still be able to invest in certain US sensitive companies, but only in a passive posture. That may mean no board seat, no observer right, no material nonpublic technical information, no special access to sensitive information and no substantive decision-making rights. The fund may receive ordinary economic rights, tax reporting and basic financial statements, but not the rights a venture investor might ordinarily seek.

That may be acceptable if US sensitive deals are a small portion of the strategy. It may be inadequate if the manager’s core investment thesis requires active involvement in US sensitive technology companies.

This example illustrates the broader point. The right structure depends on the strategy, the investors, the control persons, the target sectors and the manager’s willingness to adjust investment posture.

China and RMB capital still matter

Although this article focuses heavily on US inbound and outbound rules, managers should not forget that China-side issues still matter.

A fund investing into China-related companies may need to consider China foreign investment access rules, negative lists, security review, data rules, sector regulation, currency controls, local approvals, local listing paths, RMB funds, dollar funds, offshore holding structures and the long history of structuring issues between offshore capital and onshore China opportunities.

Similarly, PRC investors, RMB capital, China-based managers, PRC nationals and China technology moving offshore may raise their own issues. A manager with both dollar capital and RMB capital may be running parallel systems that are not merely tax or currency variants. They may have different investor bases, different investment paths, different regulatory requirements and different exit strategies.

The practical point is not that every global fund needs to become a China law treatise. The point is that US regulatory regimes are only part of the picture. A manager deploying capital globally needs to understand both sides of the capital flow.

Administration is where the structure succeeds or fails

Sophisticated fund structures can fail in administration.

It is one thing for the LPA to authorize parallel funds, AIVs, sleeves, investor exclusions, information limitations and sub-LPACs. It is another thing for the manager to operate that structure correctly for a decade.

The manager needs systems to classify investors. It needs to know which investors are US persons, which investors have OISP restrictions, which investors have elected into conservative buckets, which investors are foreign persons for relevant purposes, which investors are sovereign or state-linked, and which investors have side letter rights affecting information, reporting, excuse or participation.

The manager also needs to classify deals. Before signing a term sheet, the investment team should know whether the target may raise CFIUS issues, OISP issues, sanctions issues, export control issues, data issues, China local law issues or other regulatory concerns. The team should know which vehicle can invest, which investors can participate, which LPAC or sub-LPAC process applies, what information can be shared and whether regulatory counsel should be involved before the deal moves forward.

Capital calls need to match the structure. If one parallel fund participates and another does not, the capital call notices, equalization, expense allocations, follow-on reserves, recycling, financial statements and reporting need to reflect that.

Information flows need to match the structure. Investor relations should not send technical information to an investor that should not receive it. LPAC materials should not go to the wrong group. Side letter reporting should not override regulatory restrictions.

Governance needs to match the structure. The right LPAC or sub-LPAC should approve the right matter. US persons should not participate in decisions they should not be involved in. Foreign LPs should not receive influence or information that undercuts the fund’s position.

The administrator, finance team, deal team, investor relations team and counsel all need to understand the operating model.

In complex global structures, capital routing, control routing, information routing and governance routing are all part of the same system.

Practical drafting and administration points

Several drafting and administration points deserve careful attention:

• Identify the strategy’s sensitivity spectrum at formation. A fund investing in ordinary consumer businesses may need less regulatory architecture than a fund investing in AI, semiconductors, quantum, life sciences, cybersecurity, data or other sensitive sectors.
• Distinguish equity from control. Whose capital is exposed and who controls the decision are different questions. Both matter.
• Analyze whether the fund is a US person for CFIUS purposes, not merely whether it is organized in the US or has US personnel.
• Remember that CFIUS and OISP do not use identical US person concepts. Green card holders may be treated differently under the two regimes.
• Do not ignore foreign LP control. A foreign LP is not the same thing as foreign LP control, but foreign LP control is real.
• Recognize that OISP can create issues for US LPs investing indirectly through a non-US fund. The fund’s investment activity may create consequences for the investor.
• Do not assume excuse rights will solve every problem. In sensitive OISP structures, a separate parallel vehicle may be more appropriate than participation in the same fund with an excuse.
• Build parallel fund, AIV and sleeve authority into the documents at inception. The manager may need to move quickly when a sensitive deal appears.
• Use powers of attorney carefully but effectively. The documents should establish the ground rules at formation and allow implementation later without real-time investor consent where appropriate.
• Make side letters administrable. Side letters can support the structure, but they should not be used as a substitute for fund-wide architecture.
• Preserve the right to withhold information where disclosure would create legal, regulatory, national security, confidentiality, data, export control, sanctions or portfolio company concerns.
• Be careful with LPAC rights. In complex structures, sub-LPACs or vehicle-specific LPACs may be needed.
• If relying on a passive posture for a CFIUS-sensitive US investment, make the posture truly passive. Ordinary economics and basic financial reporting are one thing. Board seats, observer rights, technical information and substantive decision-making rights are very different.
• Coordinate portfolio company documents with the fund structure. Rights can appear in investor rights agreements, voting agreements, side letters, management rights letters and observer letters, not only in the purchase agreement.
• Require investors to provide and update information needed to classify them for regulatory purposes.
• Involve regulatory counsel before signing term sheets for sensitive investments, not after the commercial deal is already set.

Conclusion

Global private funds can still raise global capital and deploy capital globally. But in complex regulatory times, managers need more deliberate architecture.

For many global venture capital and private equity managers, the key question is no longer simply whether the fund is Delaware or Cayman, whether investors receive a K-1 or whether the fund has authority to form an AIV. The question is how capital, control, information and governance move through the structure.

A fund with US investors investing into China-related sensitive sectors may need one answer. A fund with foreign investors investing into US sensitive businesses may need another. A global platform investing across the US, China, Singapore and other markets may need several answers at once.

The best structures are not necessarily the simplest structures. They are the structures that let the manager keep investing without giving the wrong investor the wrong exposure, the wrong person the wrong control right, the wrong LPAC the wrong approval role, or the wrong recipient the wrong information.

This is not a reason to avoid global investing. It is a reason to structure it carefully.

In complex global fund formation, the documents should not merely describe the fund. They should create the routing system the manager will need to operate the fund responsibly over time.

Those are important questions. But they are not the only questions.

A private equity (PE) or venture capital (VC) fund structure usually has an “upper tier.” Above the fund sit the entities through which the sponsor owns its carried interest, receives management fees, employs personnel, pays expenses, signs contracts, owns intellectual property (IP), governs internal decision-making, and deals with departures. For a new manager, those entities can seem like legal plumbing. They are not. They are the architecture of the management business.

This article is about that upper tier.

At a high level, two entities matter most: the GP and the management company. The GP is usually tied to a specific fund vintage. If a sponsor forms Fund II, it might also form Fund II GP, LLC. That GP will generally exist alongside Fund II for the life of that fund. It usually receives the carried interest from Fund II. It may make or coordinate the GP’s capital commitment to Fund II. It exercises the GP’s rights under the limited partnership agreement (LPA). When Fund II finally liquidates after 10, 12, 15 (or more) years, the related GP entity will also eventually wind down.

The management company is different. The management company is what we often think of as the hundred-year entity. It is the durable operating business. It does not disappear when Fund I winds down or Fund II liquidates. It is where the firm usually places the long-term platform such as:

• Employment relationships
• Benefits arrangements
• Office leases
• IP
• Technology systems
• Insurance policies
• Vendor contracts
• Investor relations function
• Compliance infrastructure
• The institutional memory of the manager

This distinction is fundamental. The fund agreement governs the bargain between the fund manager and the limited partners (LPs). The GP and management company agreements govern the bargain among the people building the manager.

Managers who focus only on the fund documents can miss this point. A beautifully drafted fund partnership agreement will not answer all of the internal questions that matter to the sponsor. Who owns the carried interest? Who funds the GP commitment? Who receives excess management fees? Who controls the GP? What happens if a founder leaves? What happens if a junior investment professional is promoted? Who owns the firm name, website, track record materials, investment memos, customer relationship management (CRM) tools, data room, domain names and other IP? Who signs the employment agreements and the office lease? Who bears clawback risk internally if a team member doesn’t pay?

Those questions are answered above the fund.

The fund entity versus the sponsor entities

The fund is where investors commit capital. It is usually the entity that makes portfolio investments, holds assets, receives exit proceeds, calls capital, makes distributions and provides reporting to investors.

The GP is the entity that controls the fund. In a typical limited partnership structure, the GP has authority to manage the fund, enter into transactions on behalf of the fund, call capital, make investments and exercise the rights of the fund. The GP usually does not have employees itself, and uses the team employed by the management company for day-to-day responsibilities (dispatching capital call notices, etc.), but the GP remains central to the fund’s legal architecture.

The management company is the operating company. It is usually the entity that receives management fees, employs the team, pays salaries and bonuses, enters into leases and vendor arrangements, maintains technology and systems, coordinates fundraising, supervises investor relations, and provides services to one or more funds.

In simple first-time structures, the same people may own all of these entities in the same percentages. In more developed structures, the economics may differ. A founder may have a larger share of management company profits than carried interest in a particular fund. A junior partner may have carry in Fund III but no ownership in the management company or Fund I and II. A chief financial officer (CFO) may receive carried interest or an employee profit-sharing bonus but not voting control. A retired partner may retain vested carry in an older fund’s GP but no longer participate in the management company.

The entities need to be coordinated, but they are not the same.

The GP as the fund-vintage entity

The GP is almost universally formed to act solely for a particular fund vintage. A manager raising Fund I forms Fund I GP. When it later raises Fund II, it will form Fund II GP. Each GP holds the right to carried interest for its corresponding fund and usually makes or coordinates the sponsor’s capital commitment to that fund.

This vintage-specific structure has practical advantages. Fund-level economics are easier to track. Carried interest from a particular fund is shared through the GP or carry vehicle associated with that fund. Capital obligations for that fund can be allocated among the people responsible for funding that vintage’s GP commitment. Clawback obligations and restoration rights can be tied to the recipients of that fund’s carry. When the fund finally winds down, the related GP can also wind down, subject of course to continuing tax, clawback, indemnity, recordkeeping or other tail obligations.

Importantly, using distinct entities for each vintage “ring fences” liability on the most valuable income stream: carried interest. If there is a liability event (lawsuit, judgment, etc.) impacting Fund I GP, if properly structured and operated, the assets of Fund II GP should be protected from collection for Fund I GP’s liabilities.

The GP agreement usually addresses several core topics:

• How carried interest is shared
• How the GP commitment is funded
• Who shares in the GP’s capital interest?
• What happens to carried interest when someone leaves?
• Whether carried interest vests over time
• What happens to forfeited carry?
• Whether the GP has a complete buyout right for difficult departures
• Who controls the GP?
• What voting thresholds apply to ordinary and extraordinary matters?
• How clawback obligations are shared internally

These are not merely legal mechanics. They are the sponsor’s internal economic and governance bargain.

The management company as the hundred-year entity

The management company is different because it is not usually tied to a single fund.

A fund has a finite life. Even a long-duration venture or PE fund usually has an initial term, extension periods and a liquidation period. It may remain alive for longer than expected, but it is not designed to exist forever.

The management company is the continuing business. It is where the sponsor builds the platform that can manage Fund I, Fund II, Fund III, co-investment vehicles, special vehicles (SPVs), continuation funds, opportunity funds, growth funds, parallel funds and other products over time.

The management company usually receives the management fees from the funds it handles. It then pays the costs of running the business. Those costs can include salaries, bonuses, payroll taxes, benefits, rent, insurance, travel, technology, compliance, fund administration support, finance personnel, investor relations, marketing, legal bills, accounting support, cybersecurity, software, data subscriptions, website expenses, recruiting, and other ordinary operating costs.

The management company usually owns or controls the long-term assets of the firm. That may include the firm name, logo, domain names, website, marketing materials, investment memos, CRM tools, databases, track record materials, diligence files, policies, templates, presentation decks, and related IP. These particular assets should generally not live in a fund-vintage GP that may eventually wind down.

This is why we sometimes refer to the management company as the hundred-year entity. It is the vehicle through which the firm becomes an institution rather than a single fund.

Why management fees usually flow to the management company

Management fees are typically the operating budget for the manager. For that reason, they are usually paid to the management company. This may be provided directly in the fund agreements, or (in many cases) the management company becomes the designee payee of the GP by contract. That contract is often called a “management services agreement” or similar. At its core is a simple bargain : the management company – being the only entity with actual employees – will provide fund administrative services (e.g., portfolio sourcing, preparation of annual reports, etc.) in exchange for the fee. Most often the bargain stops there, inasmuch as there is not a delegation of legal authority in favor of the management company as so legally, the GP continues to make decisions for itself and the fund – the most important being investment and divestment determinations.

The above fits the economics. The GP receives carried interest, which is intended to reward investment performance. The management company receives management fees, which are intended to pay for the people, systems and infrastructure needed to manage the fund. If the management fees exceed the management company’s expenses, the residual profit is often referred to as excess management fees.

Excess management fees are not the same thing as carried interest.

Carried interest is performance economics. It is tied to fund profits. It may not be realized for many years, if ever. Excess management fees are operating profits of the management company. They may exist if management fee revenue exceeds the cost of running the platform. Some firms distribute excess management fees to management company owners as income distributions tied to equity. Some use them to make year-end payroll bonuses. There is not a material distinction between those methods – they both get income to owners. Some managers reinvest profits in the platform. Some retain profits as working capital. Some do a combination of some or all of the preceding.

The sharing of excess management fees may or may not match the sharing of carried interest. In some firms, the same founders own the management company and the carried interest in the same percentages. In others, the management company ownership is narrower, more founder-weighted or otherwise different from fund-vintage carry sharing. This can be entirely appropriate if the parties understand the distinction.

The important drafting point is that the flow of money should match the intended business model. If management fees are intended to support the long-term platform, the management company should be structured to receive them, spend them, account for them and allocate any excess consistently with the sponsor’s internal agreement.

The three main economic streams above the fund

A sponsor should usually separate three economic streams: carried interest, capital interest and management company economics.

They are related, but they are not identical.

Carried interest

Carried interest is the sponsor’s disproportionate (usually 20%) share of fund profits. In many PE and VC funds, it is the most important long-term upside for founders and senior investment professionals. It is usually shared through the GP or a carry vehicle associated with the GP.

Carried interest is typically allocated among founders and senior investment professionals, but it may also be shared with CFOs, operating partners, venture partners, platform professionals, junior investment professionals or others. Some firms also use direct carried interest grants. Others use employee profit-sharing pools or bonus arrangements for more junior personnel. How far “down” the ranks carried interest is shared varies by platform and is a critical distinguishing factor for the firm in terms of culture, attraction and retention of talent, and so forth.

The key takeaway is that carried interest represents fund-vintage economics. A person may have a certain percentage of carry in Fund I, a different percentage in Fund II, and no carry in a later fund if that person leaves before the later fund is formed.

Capital interest

Capital interest is different. It refers to the GP’s own cash investment in the fund.

LPs generally expect the sponsor to have meaningful capital at risk. Many funds provide for a GP commitment, typically in the range of 1% to 2% of fund commitments, although the amount can be lower or higher depending on the manager, strategy, investor base and fund size.

Someone must fund that commitment. The members of the GP, or related persons, usually make capital commitments to the GP so that the GP can in turn make its commitment to the fund. Those who fund the commitment generally share in the investment return on that capital.

Capital interest sharing percentages may be the same as carried interest percentages (often referred to as a “lockstep” model), but they do not have to be. One person might have 20% of the carry but fund only 10% of the GP commitment. Another person might have 10% of the carry but fund 30% of the GP commitment.

Firms differ in how they think about this. Some view the GP commitment as a burden that should be shared in proportion to carry. Others recognize that more senior partners may have more personal wealth and may be better able to fund a larger share. Still others view the right to invest through the GP as a valuable opportunity or perk, and may allocate more of that opportunity to senior members.

The right answer depends on the firm.

Management company economics

The third stream is management company economics. This includes excess management fees and any other revenue or residual profit of the management company.

In many structures, this is the most important economics for the day-to-day business. Carried interest may be more valuable over the long term, but management company economics pay the bills now. They support hiring, retention, infrastructure and growth.

Management company economics may be shared among founders or owners of the management company. They may be used to fund bonuses or profit-sharing programs. They may be reinvested. They may be distributed. The sharing may be lockstep with carry, or it may be different.

For example, a founder-heavy management company may reflect that the founders built the platform, signed leases, funded operating losses, guaranteed obligations or created the firm’s brand. They took risk. A broader carry-sharing arrangement may reflect the contributions of the investment team to a particular fund vintage.

Again, the point is not that one model is right. The point is that the model should be intentional.

Sharing carried interest internally

The simplest and most common approach is to assign carried interest among the team at inception in fixed percentages.

For example, the founders and senior investment professionals may agree that 100% of the carried interest will be shared among them in specified percentages. If someone leaves, that person keeps the vested portion of carry and forfeits the unvested portion. The forfeited portion is then reallocated under the rules of the GP agreement.

This model is common because it is simple. It also reflects a practical view: if a person performs better or worse than expected, the firm can adjust that person’s carry in the next fund vintage. In a more serious case, the firm can remove the person, which usually causes forfeiture of unvested carry. The current fund’s carry schedule does not have to become a year-by-year performance compensation system.

Some firms, however, want more flexibility inside the current vintage. They may want to reward deal sourcing, portfolio work, fundraising contributions, leadership, mentoring, operational projects or other contributions in a more real-time way. Those firms may consider more complex models.

Deal-by-deal sharing

Deal-by-deal carry sharing sounds attractive. If one partner sources and manages a successful investment, why not allocate more carry from that investment to that partner?

The difficulty is that most PE and VC funds do not pay carried interest at the fund level on a pure deal-by-deal basis. Most funds – by custom and demand of LPs – calculate carry on a whole-fund basis and are subject to clawback. Even in a fund with a deal-by-deal or American-style waterfall, the carry is usually still subject to fund-level limits, clawback and valuation issues.

This creates a problem for internal deal-by-deal sharing. A particular investment may be highly successful, but if the fund as a whole breaks even or loses money, there may be no carried interest to share. Or a person may receive carry attributed internally to a successful deal and later be required to return it because the fund has an overall clawback. If the fund calculates carry net of expenses, two similarly successful deals can also produce different internal carry outcomes depending on timing and expense allocation.

For these reasons, deal-by-deal sharing inside a GP can be complicated. Where used, firms often allocate only a portion of total carry, perhaps 10% to 25% of the overall carry pool, to a deal-by-deal component. The firm may schedule the deal team’s percentages when the investment is made, or it may wait until exit and then allocate the deal-related pool based on contribution.

The latter approach is often more flexible, but requires judgment and can create its own disputes. The former approach is more predictable, but it may not reflect how work actually unfolds over the life of an investment.

Managers considering deal-by-deal internal sharing should understand the complexity before adopting it. It is often less simple than it sounds.

Annual investment professional profit-sharing pools

Some firms use an annual investment professional profit-sharing pool instead of true deal-by-deal carry.

Under this approach, a percentage of total carried interest is held back for annual allocation among investment professionals. The amount might again be 10% to 25% of the overall carry pool, though the number varies. Each year, after the fund’s net carry-related activity for that year is known, the managers allocate that year’s pool among the investment team based on contribution. Tax laws allow for this to be done in the following year through the March 15 partnership tax filing deadline, as long as profits are shared among the then-current partners or members of the carried interest sharing entity.

This is not technically deal-by-deal. It is annual and net. If the year includes two profitable exits, one loss, expenses and other fund-level items, the pool reflects the net carry economics for the year. The managers can then decide who contributed most meaningfully to that year’s results.

The benefit is that this model aligns more closely with the fund’s accounting and tax architecture than pure deal-by-deal sharing. It also allows the firm to reward a broader range of contributions (and more) in real-time. A person may have helped source a deal, save a struggling portfolio company, lead a financing, build a sector thesis, support fundraising, mentor junior professionals, or handle an important internal project. The annual pool can recognize those contributions without pretending that the fund’s economics are pure deal-by-deal economics.

This model is more complicated than fixed percentages, but it can be useful for firms that want a more dynamic compensation system.

Employee profit-sharing pools

Some firms also reserve a small portion of carry economics for lower-level personnel or broader employees. The key distinguishing factor compared to annual profit sharing pools is that employee pools are taxed as ordinary income, not capital gains. But payments can be made to a broader group without consideration of accredited investor status, equity ownership of the payor entity and so forth.

This is usually a modest pool, often in the range of 1% to 5% of total carry, though structures vary. Some firms use the pool for investment associates, finance personnel, platform team members or other employees who do not hold direct carried interest. Others use it more selectively.

There are practical reasons not to give every employee a direct interest in the GP. Securities law, tax, administration, confidentiality, member rights and the small dollar size of individual awards may all weigh against direct ownership. In many cases, the pool is held by a placeholder entity, often the management company, and amounts are paid as cash employment bonuses if and when distributable carried interest becomes available.

This also means the plan may operate more like a bonus plan than a vested carried interest grant. A person may need to be employed at the time of distribution to receive payment. There may be no long-term vesting. The payments will be subject to payroll withholding and ordinary employment tax treatment.

More formal phantom carry plans exist, but they are less common and require more careful drafting.

Carry reserves

New managers often ask whether they can “reserve” carried interest for future hires.

The commercial reason is obvious. A first-time manager may not know the final team at closing. It may expect to hire additional investment professionals if the fund reaches a certain size. It may want to show that a portion of carry is available for future team members.

The technical answer is more complicated. For tax and accounting purposes, income and loss associated with the carry must be allocated to someone. Federal tax laws mandate that in the situation. A reserve cannot simply sit in the air. Someone must be treated as holding the interest until it is awarded.

The usual workaround is to show a reserved amount on the carry schedule, but provide that until the reserved amount is awarded, it is treated for tax purposes as held by the existing carry recipients (often proportionately). When the reserve is later awarded, the existing recipients are diluted.

Economically, this is similar to giving everyone their full share at closing subject to later dilution. But it may be more transparent and psychologically easier because the reserved percentage is visible from the start. Existing team members know that a portion is intended for future hires.

GP capital commitments

The GP commitment is a separate topic from carry sharing.

In almost all institutional PE and VC funds, the GP or sponsor group makes an investment in the fund. Investors expect the manager to have capital at risk alongside them. The amount varies, but 1% to 2% of fund commitments is a common reference point, with many variations depending on manager size, strategy, fund size and investor expectations.

The GP agreement must decide who funds that obligation.

Sometimes the answer is lockstep with carry. If a person has 20% of the carry, that person funds 20% of the GP commitment and receives 20% of the returns on the GP’s capital interest. This is simple and has an intuitive fairness.

But lockstep is not required. A senior founder may fund a larger portion because the founder has greater personal resources. A junior partner may receive meaningful carry but fund a smaller share of the capital commitment. A noninvestment professional may receive carry but not be expected to fund the GP commitment. A founder may view the right to invest more as a benefit of seniority.

The important point is to separate the two questions:

• Who receives carry?
• Who funds the GP commitment and receives the return on that capital?

They are related questions, but not the same question.

Departures, vesting and forfeiture

Upper-tier documents matter most when people leave.

At the beginning of a new firm, everyone may expect harmony. The founders are excited. The investment team is aligned. The fundraise is underway. No one wants to discuss departures, termination, vesting disputes or difficult separations.

But funds last a long time. A ten-year fund may easily remain alive for 14 or 15 years, including extensions and liquidation. People leave. Founders disagree. Investment professionals spin out. Partners retire. Employees join competitors. Someone may be terminated. Someone may become disabled or die. Someone may become adverse to the firm.

The documents need to work when that happens.

The most common carried interest departure model is that a departing person keeps the vested portion of carried interest and forfeits the unvested portion. The change usually only applies prospectively. In other words, carry allocated before departure remains allocated as it was. The departing person’s future share is reduced to the vested percentage of the original entitlement.

For example, let’s assume that a person has 10% of total carry and leaves when 50% vested. This person’s carry entitlement is reduced to 5% going forward. Carry allocated before departure at the 10% rate is generally not reallocated retroactively. The person forfeits the unvested 5% prospectively. In some models, though, the 5% may be applied retroactively. This is almost never done by requiring the return of prior carried interest. That is viewed as being rather draconian. In these minority retroactive models, a common approach is to provide 0% allocation after departure until such time, if any, as the payee is brought to 5% in the aggregate on a from-inception basis.

Vesting schedules vary, but there has been a movement in recent years toward longer vesting. Some years ago, it was more common for carry to vest fully by the end of the investment period – say by the end of year five. That is less common today and often not advisable. If a fund may last 14 or 15 years, full vesting by year five does not reflect the full work required to manage, support and harvest the portfolio.

A common approach is monthly vesting that reaches 60% or 70% by the end of the investment period and 100% by the end of the fund’s scheduled term. Another approach is straight-line monthly vesting to 100% by the scheduled end of the fund term. Monthly vesting is generally preferable to large annual cliffs because it reduces artificial departure incentives.

Some firms add special features. They may give initial vesting credit for fundraising work. They may include a 12- to 24-month cliff so that short-term departures receive no vested carry. They may provide additional vesting credit for death or disability. They may distinguish between good leavers and bad leavers, with bad leavers suffering a reduction to vested carry. In many locations, such bad leaver provisions may be difficult to enforce. Counsel should be consulted.

Those features should be used carefully. They can solve real problems, but they also add complexity and can create difficult judgment calls.

What happens to forfeited carry?

If a person forfeits unvested carry, the agreement should say what happens to it.

There are several common approaches. The managers may decide at the time of departure. The forfeited carry may automatically reallocate pro rata to all remaining carry holders. It may reallocate only to senior managers. It may reallocate under a default rule unless the managers decide otherwise.

The best approach depends on the firm’s culture and governance. A fixed rule provides predictability. Manager discretion provides flexibility. A hybrid can do both.

What the agreement should not do is leave forfeited economics floating. If carry is forfeited, someone must know who receives it, when and under what authority.

Departures and GP capital commitments

Departures also raise capital commitment issues.

The GP’s commitment to the fund is fixed at the fund level. If the GP has committed $10 million to the fund, the fund does not care that one member of the GP has left. The commitment still must be funded.

The internal question is whether the departed person remains responsible for that person’s share of the unfunded GP commitment.

Firms are divided on this issue.

One view is that the capital commitment is a binding obligation. If a person agreed to fund a share of the GP commitment, that person should remain responsible even after departure. This avoids forcing the remaining partners to fund more than they expected.

The other view is that the right to invest through the GP is a benefit of continued participation in the firm. If a person leaves, especially if the person is no longer helping manage the fund, that person may be relieved of the unfunded portion. The remaining partners then assume that unfunded amount and receive the corresponding capital interest.

For example, let’s assume that a person has a $1 million internal capital commitment and has funded $500,000 at the time of departure. Under one model, this person remains obligated to fund the remaining $500,000. Under another model, this particular person’s commitment is reduced to the $500,000 already funded, and the remaining $500,000 is assumed by other members.

Neither answer is universally right. It depends on whether the firm views the GP investment as a burden, a perk or both.

Company interest on departure

Management company or company economics are usually treated differently from carried interest.

In many sponsor arrangements, a departing person’s right to future company profits or excess management fees is reduced to zero upon departure. This makes sense because management company economics are tied to the ongoing operating business. If a person is no longer part of the operating business, the firm may not want that person to continue sharing in future management company profits. There may be monetization payments in limited cases, more often situationally (e.g., on disability) and more often in PE compared to VC.

This is one reason it is important to separate carried interest from management company economics. A departed person may retain vested carry in a particular fund because that person helped create value in that vintage. But that does not necessarily mean the person should continue sharing in future excess management fees from the ongoing platform.

Complete buyout rights

Some firms want the ability to go further than ordinary vesting and forfeiture. They want a right to force a complete separation from a departed person.

We sometimes refer to this as a complete buyout right.

The issue arises because a departed person who retains a residual interest in the GP may remain intertwined with the firm for many years. That person may have tax reporting rights, information rights, books and records rights, inspection rights and other baseline rights as a member. That may be manageable if the departure is amicable. It may be very uncomfortable if the person has joined a competitor, spun out to start a competitive fund, threatened litigation or become adverse to the firm.

Managers who have lived through a difficult departure often understand the issue immediately. A person can be gone operationally but still be present legally and economically. The firm may be required to provide tax information, respond to information requests, maintain records and remain connected to someone who is no longer aligned with the organization.

A complete buyout right gives the GP or related entity an option, not an obligation, to repurchase all or part of the departed person’s residual interest. It usually applies after vesting has been calculated. The repurchase price is often company-favorable and may not give credit for unrealized built-in gain that might later generate carried interest.

This is a strong provision. It is not used by every firm. It is more company-favorable and less departee-favorable than ordinary vesting. It should be considered thoughtfully.

In our experience, new groups sometimes resist these provisions because they cannot imagine a future dispute. Everyone is aligned at formation. The fundraise is exciting. The idea of a hostile departure feels remote. Later, after a firm has experienced a difficult departure, the same managers may ask why they did not include a clean separation mechanism at the beginning.

That does not mean every firm needs a complete buyout right. Some firms operate for decades with harmonious relationships and never need one. But managers should at least understand the issue before deciding.

Voting and control

The GP controls the fund. As a result, voting and control at the GP level are not merely internal housekeeping.

The right voting structure depends heavily on the number of decision-makers.

If there is one voting person, the structure is simple. That person controls the GP. If additional voting persons are admitted later, the agreement can be amended or reconsidered.

If there are two voting persons, the structure is harder. Many two-person firms choose unanimous approval as the general rule. That may feel fair, but it creates deadlock risk. If both people must approve every material action and they disagree, the firm can become stuck. For that reason, two-person firms should consider deadlock-breaking mechanisms carefully. As an example, sometimes the limited partner advisory committee (LPAC) of the most recently raised flagship fund may be permitted to break a two-person team’s management deadlock after some passage of time.

If there are three or more voting persons, the general rule is often majority in number, such as two of three or three of five. Some firms use ownership percentages. Some use founder consent. Some use investment committee approval for investments and a different standard for other matters.

There are often special voting rules for extraordinary matters. These may include:

• Admitting new economic members
• Admitting new voting managers
• Removing a manager or member
• Approving investments or exits
• Approving budgets
• Changing compensation
• Issuing additional carry
• Entering into related-party transactions
• Amending governing documents
• Selling or merging the management company
• Approving a successor fund
• Settling disputes
• Exercising a complete buyout right

The practical point is simple: design the voting structure for the day people disagree, not only for the day they sign the agreement. A governance structure that works only in perfect harmony is not much of a governance structure.

Coordinating the GP and management company agreements

The GP agreement and management company agreement should be coordinated.

Carry may live in the GP. Employment relationships may live in the management company. Management fees may flow to the management company. The GP commitment may be funded through the GP. IP may be owned by the management company. Restrictive covenants may be in employment agreements, management company agreements, GP agreements or separate documents. Clawback restoration obligations may need to apply to people who receive carry even after they leave employment.

If these documents are not coordinated, gaps can appear.

A person might leave employment but retain vested carry. Does that person still owe confidentiality obligations? Does that person still have clawback restoration obligations? Does that person have access to books and records? Can that person use the firm’s name or track record? Can that person solicit employees or investors? Can the firm buy out the residual interest? Who decides?

Similarly, a person might own part of the management company but not have carry in a future fund. Or a person might have carry in a fund but no management company ownership. Or a founder might retain management company ownership after stepping back from day-to-day investing. These arrangements can be appropriate, but they should be clear.

The management company should generally own the long-term business assets. The fund-vintage GP should generally not be the owner of the firm’s brand, website, IP, employment relationships or office lease unless there is a specific reason. Those assets belong in the entity intended to survive across fund vintages.

Emerging managers versus established managers

Emerging managers and established managers often approach upper-tier structuring differently.

Emerging managers are often focused on getting the first fund raised. They may under-document internal arrangements. They may assume that the founding team will remain aligned. They may not know who will be hired later. They may have limited liquidity for the GP commitment. They may want a carry reserve. They may avoid discussing departures because the conversation feels uncomfortable.

That is understandable, but it can be a mistake. The first fund’s upper-tier documents can have consequences for a decade or more. A small ambiguity at formation can become a large dispute after value has been created.

Established managers often have more refined structures. They may have separate GP entities for multiple vintages, a durable management company, established vesting schedules, internal carry plans, profit-sharing programs, buyout rights, clawback restoration agreements, succession plans and more detailed voting provisions. Many of those features exist because the firm has learned from experience.

This is a recurring pattern. Fund I managers often believe everything will remain harmonious. Fund II, III and IV managers have often seen enough departures, promotions, performance differences, fundraising pressures, succession issues and interpersonal strain to appreciate the value of more complete documents.

The right structure should match the stage of the firm. A first-time fund should not necessarily adopt every feature of a mature global PE platform. But it should not ignore the issues either.

Practical drafting considerations

Several practical points are worth emphasizing:

• Decide which entity receives management fees and which entity receives carried interest. In many structures, management fees flow to the management company and carried interest flows through the GP.
• Treat the management company as the long-term operating business. Employment, leases, benefits, IP, systems, insurance and platform contracts usually belong there.
• Treat fund-vintage GPs as tied to particular funds unless there is a reason to do otherwise. This helps separate carry, clawback and capital commitment economics by fund.
• Separate carried interest, capital interest and management company economics. They may be shared in the same percentages, but they do not have to be.
• Make GP capital funding obligations clear. The GP commitment requires real money. Managers should decide who funds it, whether funding is lockstep with carry and what happens when someone leaves.
• Use vesting schedules that reflect actual fund duration. A fund may last far longer than its investment period.
• State what happens to forfeited carry. Do not leave forfeited economics unallocated.
• Consider whether a complete buyout right is appropriate. It is not for every firm, but managers should understand why it exists.
• Coordinate departure provisions across GP, management company, employment, restrictive covenant and carry grant documents.
• Address clawback restoration obligations internally. If someone receives carry, the obligation to restore amounts needed for fund-level clawbacks should follow the economics.
• Design voting rules for disagreement. Deadlock and removal provisions are uncomfortable to discuss, but they matter.
• Avoid placing long-term firm assets in a fund-vintage GP. The firm’s name, brand, website, records, systems and IP usually belong in the management company.
• Revisit the structure as the platform matures. A structure that works for a first-time fund may need to evolve by Fund II, III or IV.

Conclusion

The fund agreement governs the bargain with investors. The GP and management company agreements govern the bargain among the people building the manager.

Both matter.

A manager can have a well-drafted fund agreement and still have serious internal problems if the upper-tier documents are unclear, incomplete or unrealistic. The fund documents may say exactly how carry is calculated, when capital can be called, what governance rights investors have and how expenses are allocated. But they may not answer who inside the sponsor receives the carry, who funds the GP commitment, who controls the GP, who owns excess management fees, what happens when someone leaves or who owns the long-term assets of the firm.

The best upper-tier structures are clear about economics, practical about control, candid about departures and designed for the full life of the platform. A fund may last 10 or 15 years. A management company may last much longer. The documents should be built with that horizon in mind.

For new managers, the lesson is straightforward: do not only form the fund. Build the firm.

With that in mind, at a high level, there are several things to consider when structuring carried interest:

• What is the baseline percentage rate of gains that will apply as investment gains are allocated to the capital accounts of the general partners (GPs) and limited partners (LPs)? Is it 20% or a different percentage rate?
• How will the amount of investment gains be calculated when applying that percentage rate?
• Does the fund have a preferred return, and if so, how does the GP catch up (if at all) after that preferred return is satisfied?
• Does the fund have a performance hurdle that can increase the carried interest percentage from the baseline rate to a premium rate, and similarly, is there a catch-up?
• Sharing of gains into capital accounts aside, at what point will the fund manager be permitted to take distributions of cash or securities distributions constituting carried interest?
• If distributions are made to the GP or carried interest recipients in excess of the agreed amount, will there be a return obligation, commonly called a “clawback”?
• How should the fund agreement address the tax allocation rules applicable to carried interest (such as the general three-year holding period requirement for long term capital gain treatment and phantom taxable income)?

These questions are related, but they are not the same. A fund can have 20% carry with a European waterfall, no preferred return and a back-end clawback. Another fund can have 20% carry, an 8% preferred return, a 100% GP catch-up, deal-by-deal distributions, interim clawbacks and an escrow. Another fund can have premium carried interest that increases from 20% to 25% or 30% if the fund achieves specified return thresholds. Each structure allocates economics, timing, risk and tax consequences differently.

A note on terminology

Before turning to the market terms, it is worth pausing on terminology. In casual conversation, terms like “preferred return,” “hurdle,” “catch-up” and “premium carry” are sometimes used loosely or even interchangeably. That can create confusion, because they refer to different concepts. In this post, we will use the terms in the following way.

A preferred return is a minimum baseline return that the fund must generate for investors before any carried interest is payable to the GP. In many private equity funds, the preferred return is expressed as an annual percentage return, often historically around 8%, calculated on contributed capital or a similar base. The concept is that investors receive a threshold return before the GP participates in profits through carried interest.

Preferred returns are much more common in private equity than in venture capital. The reason is not merely historical convention. Private equity funds often invest in more mature businesses with revenue, profitability, cash flow, leverage capacity and more modelable exit assumptions. In that model, LPs often expect some return over a baseline or risk-free capital rate before the GP earns carry. Put differently, if a manager is investing in mature, revenue-generating companies and cannot underwrite to a minimum return, investors may reasonably ask why carry should be paid.

Venture capital, especially early-stage venture capital, is different. Early-stage venture-backed companies may not have profitability. They may not have revenue. In many cases, they may still be proving product-market fit, building a management team, developing a market or trying to create a category. The same kind of cash-flow modeling that may be relevant in a buyout or growth equity investment is often not available. For that reason, early-stage venture funds have generally not had preferred returns. Instead, they more commonly provide that investors receive a return of contributed capital before the GP takes carried interest distributions.

A hurdle, as we use the term in this post, is different. A hurdle is a superior investment return threshold that must be satisfied before carried interest increases above the baseline rate. For example, a fund may provide for 20% carried interest generally, but 25% carried interest if the fund returns more than 2.5x contributed capital, and 30% carried interest if the fund returns more than 3x contributed capital. That 2.5x or 3x threshold is not a preferred return in the sense described above; it is a performance hurdle for premium carry.

A catch-up is the mechanism used to move the economics to the agreed sharing ratio after a preferred return or hurdle has been satisfied. Catch-ups can be full and immediate, meaning the GP receives 100% of the next profits until the negotiated sharing ratio is reached, or they can be tapered, meaning the GP receives a higher-than-normal but less-than-100% share of the next profits until the same economic result is achieved. Catch-ups can apply after a preferred return, after a premium carry hurdle or both.

These distinctions matter. Two funds can each be described as having “20% carry,” but the economic result may be very different depending on whether there is a preferred return, whether premium carry is available above a hurdle, whether there is a catch-up and whether the catch-up is immediate or tapered.

The carry percentage

As to the percentage rate of gains that will apply, it remains widely accepted that the starting point is 20%. That is true across much of the private equity and venture capital market.

It is rare for a mainstream private equity or venture capital fund to assess a carried interest rate lower than 20%, though in some cases the rate may be higher. The surrounding economics may differ, because many private equity funds include a preferred return before carried interest is paid, while many early-stage venture capital funds do not. But the baseline carried interest percentage itself generally starts from the same market reference point: 20%.

Some exceptionally well-performing funds with superior investment track records or similar pedigree attributes assess flat headline rates of 25%, 30% or, in a few outlier cases in the industry, something higher. We call this “flat premium carry.” Flat premium carry exists in both private equity and venture capital, but in our experience, it is more commonly discussed in the venture capital market, particularly for highly sought-after managers with exceptional prior fund performance, very strong access to competitive investment opportunities or a differentiated strategy that investors believe is capacity constrained.

Flat premium carry is not, however, the main direction of travel for new fund negotiations. Many managers that have flat premium carry have had that term for a long time and are largely replicating an existing economic bargain with their investor base. From time to time, a new manager or a manager raising an early fund may obtain flat premium carry, but that is quite uncommon in today’s market. By contrast, the incidence of earned premium carry has been expanding.

Where there is potential for carried interest above 20%, the more common market approach is often “earned premium carry,” meaning that the higher carry percentage applies only if investment gains warrant it. This can be a useful compromise. It allows a manager to receive enhanced economics if the fund substantially outperforms, while giving investors comfort that the enhanced economics are paid only after investors receive the benefit of that outperformance.

LPs may not merely accept this structure; in some cases, they may affirmatively appreciate it. Earned premium carry can create alignment. The manager is rewarded for exceptional performance, but only if investors first receive exceptional results. Flat premium carry does not work the same way. A flat 25% or 30% carry rate gives the manager enhanced economics from the first dollar of profit, whether the fund modestly outperforms, dramatically outperforms or merely clears the basic return-of-capital threshold. Earned premium carry, by contrast, asks the manager to earn the enhanced economics through actual fund performance.

In Cooley’s 2026 survey of private fund terms, 34% of funds reviewed had some form of premium carry. That does not mean premium carry is the default. It is not. But it does mean that premium carry is a meaningful and recurring part of current fund terms, particularly for managers with strong performance, strong investor demand or a strategy where investors are willing to share more of the upside if the fund substantially outperforms.

In an earned premium carry model, investment gains are often measured by reference to cash-on-cash return thresholds, such as 2x, 2.5x or 3x contributed capital. In a minority of cases, the calculation may use thresholds based on internal rate of return (IRR) or a combination of IRR and multiple-of-capital thresholds. Cash-on-cash tests are often simpler and more intuitive in venture capital, where fund returns can be highly nonlinear and driven by a small number of large winners. IRR-based tests are more common in some private equity contexts, where investment timing, leverage, distributions and current yield may be more central to the investor’s underwriting. That said, some private equity funds with premium carry hurdles use cash-on-cash multiple thresholds as well, particularly where the parties want a simpler test that is less sensitive to interim timing and calculation conventions.

The higher carried interest rate may apply only prospectively after the relevant condition is satisfied. For example, the manager may receive 20% carry until the fund reaches a specified return threshold and then 25% carry on gains above that threshold. More commonly, however, the higher rate applies on a retroactive basis through a catch-up to the fund manager. In that model, once the condition is satisfied, the manager may receive 100% of the next gains until it has received the higher percentage of gains on a from-inception basis. Sometimes the catch-up is softened by providing that, instead of receiving 100% of the next gains, the manager receives a lesser but still elevated percentage, such as 50% of the next gains, until the intended sharing ratio is achieved.

Sometimes there may be multiple tiers. For example, a fund might provide that the manager receives 20% of gains until investors have received a 2x cash-on-cash return, 25% of gains once the fund has achieved a 2x return, and 30% of gains once the fund has achieved a 3x return, with catch-ups applying at each tier. In these models, the precise drafting matters a great deal. The agreement needs to specify whether the test is based on contributed capital, aggregate commitments, realized proceeds, unrealized value, net or gross proceeds, expenses, recycling, or reserves, and the timing of measurement.

Cash-on-cash measurements are often based on contributed capital rather than committed capital. This means that as more capital is drawn, a manager that previously satisfied a 2x condition may no longer be in that position. Where this is the case, the manager will usually have to defer the collection of incremental carried interest until the applicable condition is again satisfied.

Preferred returns

The preferred return is one of the more important areas where private equity and venture capital often diverge.

In many private equity funds, particularly buyout, growth equity and other strategies involving more mature portfolio companies, investors expect a preferred return before the GP receives carried interest. The classic formulation is an annual preferred return, often around 8%, followed by a GP catch-up and then the agreed sharing ratio, often 80/20. The exact number and calculation vary by strategy, manager leverage, investor base and market conditions, but the concept is familiar: Investors receive a minimum return on contributed capital before the GP begins to participate meaningfully in profits.

In early-stage venture capital, preferred returns are much less common. There are historical and practical reasons for this. Venture capital funds often have long J-curves, little or no current yield, unpredictable exit timing and returns that may be driven by a small number of very large outcomes. A preferred return can become more of an accounting hurdle than meaningful investor protection in that setting, and it can create pressure against the long-duration nature of venture investing. For that reason, mainstream early-stage venture capital funds often use a return-of-contributed-capital-before-carry model rather than an annual preferred return.

That said, the line is not absolute. Later-stage venture, growth equity and hybrid venture-growth funds may include preferred return concepts more frequently than seed or early-stage venture funds. Similarly, some private equity funds, especially funds with very strong demand or specialized strategies, may deviate from the classic preferred return formulation. The appropriate answer depends on strategy, investor expectations and the overall economic bargain.

Where a preferred return exists, the catch-up mechanics are important. A 100% GP catch-up means that after investors receive their preferred return, the GP receives all or nearly all of the next distributions until the GP has caught up to the agreed carried interest percentage. This is common and often understood by investors. But it can be surprising if not explained clearly, because there may be a period in which distributions go disproportionately to the GP even though the headline carry rate is 20%. That is not a deviation from the 20% carry rate; it is the mechanism by which the waterfall gets to the negotiated sharing ratio after the preferred return has been paid.

What gains are subject to carry?

The second general issue in structuring carried interest is determining the amount of investment gains used when applying the agreed carry percentage.

There are two general approaches. In some funds, the carried interest percentage is applied against total investment gains in the portfolio net of total investment losses, without taking into account fund expenses. In other funds, fund expenses, in addition to investment losses, are debited against total investment gains in determining the relevant amount against which carried interest is assessed.

Consider a simple example, ignoring the GP commitment. Assume a $100 million fund invests $80 million and spends $20 million on management fees and other expenses. Assume the $80 million of investment doubles and becomes $160 million. The fund has $80 million of gross investment gain. In a gross carry model, the GP receives 20% of the $80 million of gross investment gain, or $16 million. In a net carry model, the $20 million of fees and expenses is subtracted from the $80 million of gross investment gain, resulting in $60 million of net gain. The GP then receives 20% of $60 million, or $12 million.

Each model is associated with numerous funds in the marketplace. Neither model is exclusive. The first model is more favorable to the manager because carry is calculated on investment performance without reducing the base for fund expenses. The second model is more favorable to investors because expenses reduce the pool of profits on which carry is paid. The commercial answer may depend on the overall fee level, fund size, expense load, organizational expense cap, expected investment strategy and whether expenses are expected to be unusually high.

This issue can be more significant in smaller funds, funds with meaningful broken-deal expenses, funds investing internationally, funds with significant regulatory or tax structuring costs, or funds that expect to use parallel vehicles, alternative investment vehicles or blockers. In a very large fund with ordinary expenses, the difference may be less central to the economic deal. In a smaller or more complex fund, it can matter materially.

Timing of carry distributions: European and American waterfalls

The next issue is when the fund manager can take cash or securities distributions representing carried interest. This is commonly described by reference to the fund’s “waterfall,” meaning the sequence in which distributions are made among LPs and the GP.

Two terms are commonly used in this context. A European waterfall, also called a whole-fund waterfall, generally means that the fund must first return contributed capital before the GP may start to receive carried interest distributions. An American waterfall, also called a deal-by-deal waterfall, generally means that the GP may receive carried interest after a realized investment if certain conditions are satisfied (occasionally measured by examining the carrying value of the remaining portfolio against its cost basis, though there are other methods), even if the fund has not yet returned all contributed capital across the whole portfolio.

The difference is mostly about timing and overdistribution risk. A European waterfall delays carry distributions until the fund has more clearly produced whole-fund profits. An American waterfall may allow earlier carry distributions, but creates a greater possibility that the GP receives carry on early winners before later investments underperform or fail.

It is important to distinguish the accrual of carried interest to the GP’s carried interest capital account from the right to receive distributions. The allocation of profits to the GP on an accounting basis begins at inception of the fund’s life (which is necessary, because if deferred there is a risk there will not be sufficient allocable gain to fill up the GP’s capital account to agreed levels later). But the right to take cash or securities out of the fund on a distributions basis is effectively always delayed until some condition is satisfied.

Consider a $100 million fund that draws $5 million for its first investment and sells that investment relatively quickly for $25 million. If the fund has a 20% carried interest rate, there is $4 million of carry on the $20 million gain. But the early winner does not mean the fund will ultimately return all contributed capital or generate whole-fund profits. If the fund later draws the remaining $95 million and the later investments perform poorly, the manager may have received more than it was entitled to retain on a whole-fund basis.

That is the core overdistribution risk. Since carried interest is usually assessed on a whole-fund basis, investors – and many managers, especially those who have lived through the pain of asking a team to return carry distributions they may have already spent – may want to defer carry distributions until there is greater confidence that the carry will not become an overdistribution.

The most prevalent method of delay is a European waterfall. In the same example, assume that by the time the $25 million in exit proceeds are received, the fund has called $30 million of capital for other investments and expenses. In a European waterfall model, no carried interest distribution is permitted yet, because the $25 million is not sufficient to return the $30 million contributed.

This approach is very common in the market. In Cooley’s 2026 survey of private fund terms, approximately 90% of funds reviewed used a European waterfall. The remaining funds used some form of deal-by-deal or American-style waterfall. The prevalence of European waterfalls is especially notable in venture capital, but whole-fund distribution protections are also common in many private equity funds.

If the fund instead uses an American waterfall, the manager may be permitted to receive carried interest on the realized investment if the applicable deal-level test is satisfied. Deal-by-deal waterfalls are more common in parts of the private equity market than in early-stage venture capital, although they are not unknown in venture and are often modified by safeguards, which may include net asset value (NAV) tests, escrow arrangements, interim clawbacks, reserves or other mechanisms. For example, a fund might permit carried interest distributions on a realized deal only if, after giving effect to the proposed distribution, the remaining portfolio has a value of at least 125% of cost, or if the fund would not be in a hypothetical clawback position based on the then-current value of remaining assets.

The important point is that venture capital funds, because they often make many investments over a long period and may experience a small number of highly material winners, commonly use whole-fund distribution protections. Private equity funds, particularly buyout and growth equity funds, may be more likely to negotiate deal-by-deal distribution models, but with more robust clawback and security architecture. Neither model is inherently right or wrong. The question is whether the timing of carry distributions matches the strategy, investor expectations and overdistribution risk.

Tax distributions and phantom income

In the US and some other tax regimes, the carried interest recipients may be taxed not on cash distributions, but on allocations of taxable income or gain. This is sometimes referred to as “phantom income” and creates a practical problem. A manager may be allocated taxable income before the manager is permitted to take regular carried interest distributions under the waterfall.

Most fund agreements address this issue through tax distributions. A tax distribution provision permits distributions to the GP or carried interest recipients in an amount intended to help pay taxes on taxable income or gain allocated to them, even if regular carried interest distributions are otherwise delayed.

Tax distributions are usually advances against future amounts that the manager would otherwise be entitled to receive. They are not intended to give the manager more economics, but rather, are used to avoid a cash flow mismatch between tax liability and distribution timing.

The details matter. Fund agreements need to determine the assumed tax rate, whether state and local taxes are included, whether the rate is based on the highest marginal rate applicable to an individual in a specified jurisdiction, whether prior losses or deductions are taken into account, whether tax distributions are grossed up and how tax distributions are treated for clawback purposes. The rate may be expressed as a flat rate agreed on at inception (35 – 45% is common), or language may be used to describe it with reference to the highest marginal rates, as they may change over time.

Tax distributions can become especially important in a period of early realizations, securities distributions, recycling, taxable stock-for-stock transactions or carried interest waiver planning under Section 1061. They should not be treated as boilerplate.

The three-year carried interest rule under Section 1061

The most important tax development since the original carried interest primer is the now-familiar three-year holding period rule under Section 1061.

Before the Tax Cuts and Jobs Act (TCJA), both carried interest holders and capital interest holders generally could receive long-term capital gain treatment on gains from the sale of capital assets held for more than one year. The TCJA added Section 1061, effective for taxable years beginning after December 31, 2017. Section 1061 generally recharacterizes certain net long-term capital gains allocated with respect to an applicable partnership interest as short-term capital gains, unless the relevant capital asset has been held for more than three years. The IRS describes the rule as requiring that a capital asset be held for more than three years for gain allocated with respect to certain carried interests to avoid recharacterization as short-term capital gain.

Short-term capital gain is generally taxed to individuals at ordinary income rates. As a result, for US individual carry recipients, the difference can be significant. Long-term capital gain may be taxed at preferential rates, while short-term capital gain may be taxed at ordinary rates, potentially as high as 37% federally, plus the 3.8% net investment income tax where applicable.

The Treasury Department and IRS issued final regulations under Section 1061 in January 2021. The final regulations provide detailed rules on applicable partnership interests, applicable trades or businesses, holding periods, capital interest exceptions, transfers and reporting. The current rule was not changed by the 2025 tax legislation commonly referred to as the One Big Beautiful Bill Act; Cooley’s 2025 tax alert notes that the final legislation did not change the tax treatment of carried interest, although Congress had considered proposals to further limit long-term capital gains treatment.

For many private equity and venture capital funds, the three-year rule will not affect most carried interest gains. A substantial portion of private fund investments are held longer than three years. In venture capital, especially early-stage venture capital, the typical successful portfolio company is often held well beyond three years. In private equity, many buyout and growth equity investments are also held for periods exceeding three years.

But the issue is real.

It may sound somewhat counterintuitive, particularly to managers accustomed to long fund lives and multiyear holding periods, but in the current fast-paced deal environment we are seeing a not insignificant number of successful exits inside three years. In some cases, those exits are excellent business outcomes. The problem is not commercial. The problem is tax. A highly successful realization can produce an unexpectedly bad carried interest tax result if the relevant holding period is three years or less.

In venture capital, a short holding period can arise in late-stage investments, top-up funds, opportunity funds, SPVs, pre-initial public offering (IPO) investments, secondary purchases, bridge rounds before a sale, or simply a company that exits unusually quickly. In private equity, the issue can arise in fast buy-and-build strategies, continuation transactions, recapitalizations, add-on acquisitions, partial exits, minority growth investments, secondaries, structured transactions and investments sold more quickly than expected.

The issue can also arise because of transaction structure. For example, a fund may hold stock in a private company for more than three years, but then exchange that stock in a taxable or partially taxable transaction for stock of a public acquirer, or for securities whose holding period is measured from the time of the transaction. If the fund later sells those new securities before the relevant holding period is satisfied, the manager may have a less favorable Section 1061 result than expected. These rules are technical, and managers should involve tax counsel before assuming that the original investment holding period carries through all transaction structures.

Carried interest waiver provisions

In response to Section 1061, many private equity and venture capital fund agreements now include a voluntary carried interest waiver mechanism.

The basic idea is that, at the time of a realization event that would generate gain on an investment held for more than one year but not more than three years, the GP may elect to waive its right to receive the carried interest allocation or corresponding distribution attributable to that gain. In exchange, the GP receives a right to a dollar-for-dollar catch-up from future eligible gains, typically gains from investments held for more than three years.

The one-year point is important. If an investment is sold after one year but before three years, the LPs generally may have long-term capital gain, while the carried interest recipients may have short-term capital gain by reason of Section 1061. In that circumstance, a properly drafted waiver provision can be helpful to the GP without disadvantaging LPs. If the GP waives the carried interest allocation or distribution, LPs may receive more of the current realization proceeds earlier than they otherwise would have received them. That can be favorable to LPs from a timing and IRR perspective. A carried interest waiver also reduces the risk of the GP finding itself in a clawback situation.

By contrast, gains from investments held for one year or less are different. Everyone has short-term capital gain on a sub-one-year sale. A waiver of that gain by the GP should not be used to shift unfavorable tax character to LPs. For that reason, the Section 1061 waiver provisions we typically see are generally focused on the two-to-three-year fact pattern: long-term capital gain for LPs, but short-term capital gain for the carried interest recipients because of Section 1061.

In ideal circumstances, the waiver can put the manager in a similar economic position while avoiding the unfavorable tax result of having carried interest from a three-year-or-fewer gain taxed at ordinary income rates. If the waiver works as intended, the manager gives up the problematic gain and later receives an equivalent amount of carry from better-character gain.

The real-time nature of the election is important.

A fund manager does not make the decision in the abstract at the time the fund is formed. The manager makes the decision prior to an actual exit, with actual facts. That allows the manager to assess the remaining portfolio, the stage of the fund, the likelihood of future gains, the amount of the waived carry, the remaining term, the expected exit pipeline and the risk that the catch-up will never be achieved.

For example, assume investment #1 in a 10-year venture fund exits after two years at a large gain. The fund still has 20 other portfolio companies, a long remaining fund life and significant apparent unrealized upside. In that case, the manager may feel reasonably comfortable waiving the carry attributable to the early exit, because there is a credible possibility that future eligible gains will allow the manager to catch up.

The opposite case is different. If a late-life cycle fund sells one of its last remaining investments before the three-year holding period is satisfied, and there are few remaining assets with meaningful appreciation potential, a waiver may be economically unattractive. The tax benefit may be outweighed by the risk that the manager will never recover the waived carry.

This is why the provision is usually drafted as an option, not a requirement. It gives the GP flexibility to make the decision based on facts existing at the time of the exit.

These waiver provisions should be drafted carefully. The catch-up generally needs to be funded from future appreciation, not from amounts that would otherwise belong to investors without corresponding economic risk to the manager. In addition, carried interest waivers cannot be made after an exit and, in fact, the earlier the waiver is made before a disposition, the more likely the carried interest waiver will survive IRS scrutiny. The provision also typically should be designed so investors are not disadvantaged. From a commercial fairness perspective, managers generally should not be able to waive ordinary income, interest income or gain from investments held for one year or less in a way that shifts unfavorable tax character to taxable investors. The structure also involves tax risk. These waiver structures have not been blessed by Treasury or the IRS and may be subject to challenge or future legislative change.

In practice, however, this architecture has become common enough that many institutional investors are familiar with it. Investors often accept the concept with relatively little pushback if the waiver is voluntary, the manager bears real economic risk of nonrecovery, the catch-up is limited to appropriate future gains, and the provision is not expected to disadvantage LPs. For many LPs, the provision is understandable: The manager is trying to avoid a tax penalty that uniquely affects carried interest, while the LPs are not being asked to give up economics and may receive current proceeds more quickly.

Securities distributions and public stock

Carried interest is not always distributed in cash. Private equity and venture capital funds may distribute public securities or other marketable securities. This is especially common in venture capital after an IPO or public company acquisition, but it also can arise in private equity exits and continuation fund transactions.

Securities distributions create several issues.

First, the fund agreement needs to specify how securities are valued for waterfall purposes. Is value determined by a trailing average, a closing price, a volume-weighted average price (VWAP), the price used for in-kind distribution accounting or another method? What happens if the security is thinly traded, subject to lock-up, subject to volume limitations or not freely transferable?

Second, securities distributions can affect clawback risk. A manager may receive securities at a stated value, but the securities may later decline before they are sold. If the fund later has a clawback, the manager may owe cash, even though the distributed securities have declined in value.

Third, Section 1061 can continue to matter. The final carried interest regulations include rules addressing distributed property and holding periods, and tax counsel should analyze whether the carried interest recipient must continue to hold distributed property to satisfy the three-year requirement.

For these reasons, securities distributions should be coordinated among the waterfall, tax distribution provisions, valuation provisions, clawback provisions, securities law restrictions, insider trading policy and tax advice.

Clawbacks

The final core issue is whether a return obligation, called a clawback, will exist if the GP or carried interest recipients receive more than they are ultimately entitled to retain.

Most private equity and venture capital funds have some form of clawback. The clawback is the backstop that protects investors if carry distributions made earlier in the fund’s life prove, with hindsight, to have been too large.

The basic pattern that creates a clawback is usually the same: early winners, later losers.

Consider again a $100 million fund that ultimately will invest $80 million and spend $20 million on management fees and other expenses. Assume the fund first calls $50 million, uses $10 million for expenses and makes four $10 million investments. The first investment is sold for $90 million. That is an $80 million gain on that investment. Depending on the waterfall, that may be enough to return all $50 million of contributed capital and pay carried interest to the GP. But assume the fund later calls the remaining $50 million, uses $10 million for expenses, invests the remaining $40 million and every other investment goes to zero. The fund has called $100 million in total and distributed only $90 million in total. The fund has not, on a whole-fund basis, returned all contributed capital. If the GP previously received carry on the early winner, it received more than it was ultimately entitled to retain. That is the clawback fact pattern.

In venture capital funds using a European waterfall, the clawback is often assessed once, at liquidation. Interim clawbacks are less common, because the whole-fund waterfall itself substantially reduces overdistribution risk. There is still a statistical possibility of a clawback at liquidation, particularly where the fund has early winners and later losers, but the risk is generally lower than in a deal-by-deal distribution model.

In private equity funds using deal-by-deal carry, clawback mechanics are often more central to the economic bargain. Because the manager may receive carried interest before the entire fund has played out, investors may require more detailed protections. These can include interim clawbacks, escrow of a portion of carry distributions, net worth covenants, guarantees from carry recipients, after-tax clawback limitations, restoration obligations and periodic testing.

One important issue is whether the clawback is before or after tax. Managers generally resist an obligation to return amounts that have already been paid to tax authorities. Investors, for their part, want meaningful protection against overdistribution. Many agreements solve this by providing an after-tax clawback, sometimes with assumptions about tax rates and tax benefits. The drafting can become technical, especially when carry recipients are located in different jurisdictions or subject to different tax rates.

Another issue is credit support. If the clawback arises at liquidation, the fund and GP may have little or no remaining assets. The actual economic source of repayment may be the individual carry recipients. Historically, some agreements used escrows to secure future clawback obligations. Today, escrows are less common in many venture capital funds, though they may appear in certain private equity arrangements. More commonly, the issue is addressed through undertakings or guarantees by the carried interest recipients, sometimes in the fund agreement and sometimes in a separate clawback guaranty.

Managers should pay close attention to how carry is shared internally. A fund agreement may impose a clawback on the GP, but the economic recipients of carry may include partners, employees, former employees, retired partners, estate planning vehicles and other participants. If those recipients have received carry distributions but are not obligated to return their share of any clawback, the GP or remaining principals can be left bearing disproportionate risk. This is an internal governance issue as much as a fund agreement issue.

Practical market observations

For most mainstream private equity and venture capital funds, 20% carry remains the central market reference point. Departures from that baseline are possible, but they should be understood as part of the overall economic package.

In venture capital, premium carry is more common than in many private equity strategies, particularly for managers with very strong realized track records, highly competitive access or brand-driven fundraising leverage. Earned premium carry is more common in current negotiations than flat premium carry for new funds, and it is often easier for LPs to accept because the enhanced economics are tied to enhanced investor returns. Early-stage venture funds often do not include preferred returns and use European waterfalls. Section 1061 waiver provisions are common and particularly relevant for late-stage, opportunity, top-up and SPV investments that may exit inside three years.

In private equity, the headline carry rate also is often 20%, but preferred returns, GP catch-ups, deal-by-deal waterfalls, interim clawbacks, escrows and more detailed clawback security may be more common depending on strategy. Premium carry exists, but investors often evaluate it against the presence or absence of a preferred return, the amount of GP commitment, the manager’s track record, the breadth of the platform and the expected risk-adjusted return profile.

Across both markets, the same basic principle applies. Carried interest is not just a percentage. A 20% carry rate can be economically different depending on whether there is a preferred return, whether expenses reduce the carry base, whether the waterfall is European or American, whether tax distributions are broad or narrow, whether carry can be distributed in securities, whether Section 1061 waiver language is included, and whether the clawback is meaningful.

Conclusion

Carried interest is both an economic term and a behavioral term. It determines how profits are shared, but it also shapes incentives, retention, tax planning, investor alignment and long-term firm culture.

Managers should not treat these provisions as boilerplate. A venture fund with many early investments and long-duration upside may require different carry mechanics than a buyout fund with fewer control investments, leverage and more predictable exit timing. A first-time fund may require different investor protections than a heavily oversubscribed successor fund. A fund that expects late-stage investments, quick exits or continuation transactions should pay particular attention to Section 1061 waiver mechanics.

As is the case with management fees, carried interest is a core compensatory matter in the private equity and venture capital industry. In many cases, it is the most important one. Fund managers will do well to pay attention to market norms – not because every fund needs to look the same, but because investors and managers both benefit from a structure that is understandable, aligned, tax-aware and durable over the life of the fund. Sophisticated investors generally want managers to be strongly motivated to build and harvest value. Managers, for their part, should want carry terms that reward performance without creating avoidable investor friction, tax inefficiency or future disputes.

The answer is, in many cases, Delaware or the Cayman Islands. For managers seeking reputable institutional capital across the United States, Europe, Asia, Latin America, the Middle East and elsewhere, those two jurisdictions continue to be the most familiar and commonly accepted fund domiciles for many private equity and venture capital strategies.

But the analysis has become more nuanced in recent times.

Cayman funds are now subject to a more developed private funds regulatory regime than was the case historically. US national security regulation has become more important for funds investing in sensitive technologies, critical infrastructure, data-rich businesses or China-related opportunities. The US Corporate Transparency Act, which for a period was expected to create broad beneficial ownership reporting obligations for US entities, was narrowed substantially by the Financial Crimes Enforcement Network (FinCEN) March 2025 interim final rule, so that US-formed entities are currently exempt, and only certain foreign entities registered to do business in a US jurisdiction remain within the federal beneficial ownership information (BOI) reporting regime. The US outbound investment regime is now a live consideration for some cross-border technology strategies. European fundraising sometimes points managers toward Luxembourg or Ireland. Singapore, Mauritius and other jurisdictions may be relevant where a fund has a particular geographic strategy or tax treaty rationale. And yet, for many managers raising institutional private equity or venture capital funds with a meaningful US nexus, the practical question often remains the same: Should the main fund be Delaware, Cayman or some combination of the two?

This article is intended as a primer. It is not a substitute for a structuring discussion with legal and tax counsel, and it necessarily simplifies a number of issues that can become highly technical. But it should help identify the principal commercial, cost, regulatory and tax considerations that usually drive the domicile decision.

The short list is still usually Delaware versus Cayman

A fund’s domicile should follow its actual facts. A manager raising primarily from US taxable and US tax-exempt investors and investing mainly in US portfolio companies will often find Delaware to be the simplest and most efficient answer. A manager raising substantial non-US capital, investing globally or seeking to accommodate non-US investors that prefer not to receive US tax reporting may have stronger reasons to consider Cayman.

There are, however, situations where a more localized jurisdictional analysis is appropriate. A manager raising primarily from family offices in Southeast Asia may reasonably consider a Singapore structure. A manager investing substantially in India may need to consider Mauritius, Singapore or other treaty-oriented structures, recognizing that India treaty planning has become more complex and fact-dependent in recent years. For example, India-focused private equity and venture capital funds have historically considered Mauritius and Singapore structures for capital gains and other tax treaty reasons, although recent Indian tax developments, including the Supreme Court of India’s 2026 Tiger Global decision, underscore that treaty access cannot be assumed merely because a holding vehicle is organized in a treaty jurisdiction. A manager with a strategy involving European institutional capital may consider Luxembourg or Ireland, particularly where access to the EU marketing passport or an EU onshore fund product is commercially important. A manager investing in particular categories of income-producing assets, credit, infrastructure, real estate, royalty streams or natural resources may find that the analysis differs from the typical early-stage venture analysis.

Those situations should not be ignored. They are often the point of the structuring exercise. A domicile that is unnecessary or overly complicated for a generalist US venture fund may be essential for a fund investing into a particular country or asset class. If there is a specific tax treaty, regulatory, marketing, currency-control, local licensing or investor eligibility issue, that specific issue may override the usual Delaware versus Cayman analysis.

For many private equity and venture capital funds, however, Delaware and Cayman remain the most common starting points. The main decision is often Delaware versus Cayman, sometimes with parallel funds, feeders, blockers or alternative investment vehicles used to solve specific investor or investment issues.

A note for managers outside the United States

Although much of this article focuses on funds with a US nexus, the analysis is not limited to US-based managers.

We regularly see managers located outside the United States – including managers in Asia, Latin America, Europe and the Middle East – consider Delaware and Cayman structures. The right answer for those managers depends on a more global set of facts: where the manager and investment team are located, where the investors are located, where the portfolio companies are located, whether US taxable or US tax-exempt investors are expected, whether the strategy involves US portfolio investments, whether local licensing or marketing rules apply, and whether tax treaty access is relevant.

For a manager based in Singapore, Abu Dhabi, London, São Paulo, Mexico City, Hong Kong, Tokyo, Beijing, Mumbai or elsewhere, Delaware and Cayman may still be highly relevant. Cayman may be attractive as a neutral international fund domicile familiar to global investors. Delaware may be appropriate where the fund expects significant US investors, US portfolio investments or US tax reporting in any event.

The important point is that a non-US manager should not assume that “offshore” automatically means Cayman, nor should a US-based manager assume Delaware and move forward. The fund’s structure should be designed around the manager’s actual fundraising market, investment mandate and operating footprint.

Commercial issues

Commercially, reputable institutional investors globally are generally familiar with both Delaware and Cayman funds. A sophisticated investor is unlikely to be surprised by either choice. As a general matter, investors that regularly invest in private equity and venture capital funds will have seen Delaware limited partnerships, Cayman exempted limited partnerships, Cayman feeder funds, Cayman parallel funds and hybrid structures.

That does not mean the choice is commercially irrelevant.

Some non-US investors view Delaware as putting them too close to the US tax and reporting system. This may be true even where, as a technical matter, the investor’s US tax filing obligations would be driven by the character of the fund’s income rather than by the mere receipt of a Schedule K-1. Investor perception matters. Some investors simply do not want to invest directly into a US partnership unless there is a strong reason to do so.

Conversely, some investors continue to have a perception concern with Cayman. In some markets, particularly some European markets, Cayman is still viewed by certain investment committees, public institutions, corporate investors or family offices as carrying reputational baggage because it is an offshore jurisdiction. That concern is often more about optics, internal policy or political sensitivity than about the actual legal or regulatory quality of the jurisdiction. The Cayman Islands’ regulatory infrastructure for private funds, anti-money laundering/know your customer (AML/KYC), Foreign Account Tax Compliance Act (FATCA) and Common Reporting Standard (CRS) reporting is far more developed than the casual “tax haven” label suggests – and frankly more so than Delaware. The Cayman Islands also is not currently on the EU list of noncooperative jurisdictions for tax purposes; the Council of the European Union’s February 2026 list includes 10 jurisdictions, and Cayman is not among them. Still, some institutions, government-related investors, development finance institutions, pension plans, corporate strategic investors or regulated financial institutions may have internal policies or reputational sensitivities that make a Cayman fund more difficult.

This is the first practical point: The domicile decision should not be made in the abstract. Managers should map the likely investor base. If the fund is expected to be raised mostly from US individuals, US family offices, US funds of funds, US endowments, US foundations and other US institutions, Delaware may be the default. If the fund is expected to include substantial non-US investors, particularly investors that are sensitive to US tax forms or US partnership reporting, Cayman may deserve stronger consideration. If the fund expects material capital from Europe, Asia, Latin America or the Middle East, the manager should ask not merely whether those investors can invest in Delaware or Cayman, but whether a different structure would materially reduce friction with anchor investors or local regulatory expectations. If a small number of important investors have strong preferences, the fund structure may need to accommodate them through a feeder, parallel fund, blocker or alternative investment vehicle.

The second practical point is that true commercial “deal breakers” are less common than managers sometimes fear. A strong manager with meaningful demand can usually raise capital through either Delaware or Cayman. The choice more often affects friction, disclosure, investor comfort, tax administration and future flexibility than whether the fund can be raised at all.

Administrative, cost and adviser regulatory issues

Cayman is usually more expensive and administratively more involved than Delaware at the fund-vehicle level. That remains true, more so today than it was before the Cayman Private Funds Act regime became part of the standard operating environment in recent years.

A Delaware limited partnership is familiar, relatively quick to form, inexpensive to maintain, and deeply embedded in US private equity and venture capital practice. The legal documentation, tax reporting, subscription process, banking process and fund administration ecosystem are all well developed. For a smaller or first-time manager with a largely US investor base, simplicity and cost can matter a great deal.

That does not mean, however, that choosing a Delaware fund means being unregulated. For many managers, the more important US regulatory question is not the domicile of the fund vehicle, but the status of the investment adviser. A manager with a US office, US personnel, US investors or US-directed investment activity may need to analyze whether the manager must register as an investment adviser, may rely on an exemption from registration or must file as an exempt reporting adviser.

This adviser-status analysis is separate from, and often more important than, the Delaware versus Cayman fund domicile question. A US-based manager may need to register with the Securities and Exchange Commission (SEC) or state authorities, or file as an exempt reporting adviser, whether the fund is a Delaware limited partnership or a Cayman exempted limited partnership. A non-US manager may also need to consider US adviser rules if it has US clients or investors, US private fund assets, a US place of business or meaningful US fundraising activity. For example, the SEC’s private fund adviser exemption has different conditions for US and non-US advisers, including a less-than-$150 million private fund assets under management test in the relevant circumstances.

While a Cayman exempted limited partnership benefits from a very sophisticated legal and service provider ecosystem, a Cayman fund will generally require more procedural work at the fund-vehicle level. A Cayman private fund typically must register with the Cayman Islands Monetary Authority, with some exemptions available, and where applicable the Private Funds Act requires an application within 21 days after acceptance of capital commitments and prohibits accepting capital contributions for investment purposes until registration is complete. Cayman private funds also are subject to operating requirements relating to audit, valuation, safekeeping of fund assets, title verification and cash monitoring. The 2025 revision of the Cayman Private Funds Act requires at least annual valuation, sets out who may perform valuation functions and includes safekeeping/title verification and cash monitoring requirements.

These requirements are manageable. Most institutional-quality Cayman private equity and venture capital funds handle them without great difficulty. But they are real requirements, and they add cost, time and a compliance process. By contrast, a Delaware fund will generally be simpler at the fund-vehicle level. That said, as noted above, the manager will still need to consider adviser registration, exempt reporting adviser filings, Form ADV updates and state notice filings. Other requirements, such as those relating to the custody rule, pay-to-play rule, marketing rule, and books and records rule, may also be applicable if the manager is registered or otherwise within the US regulatory perimeter.

As a rough practical matter, Cayman should not be chosen merely because it sounds more “international,” and Delaware should not be chosen merely because it sounds less regulated. If the investor base, investment strategy and tax analysis do not support Cayman, the additional fund-level process may not be worth it. On the other hand, where Cayman solves real investor, tax or cross-border structuring issues, the incremental cost is usually not determinative for an institutional fund. In either case, the manager should analyze both layers: the regulation of the fund vehicle and the regulation of the adviser.

Other regulatory issues

Regulatory considerations rarely start as the primary driver of the domicile decision for a plain-vanilla private equity or venture capital fund. Tax and investor considerations usually do more work. But regulatory considerations have become more important, especially for managers investing in sensitive technologies, regulated industries, critical infrastructure, data-rich businesses, financial services, digital assets, defense-related companies or China-related opportunities.

CFIUS and US national security review

For funds investing in US businesses, particularly businesses involving critical technology, sensitive personal data, infrastructure, defense, AI, semiconductors, quantum technologies, telecommunications, aerospace, biotechnology or other sensitive sectors, Committee on Foreign Investment in the United States (CFIUS) analysis should be part of the structuring discussion.

The domicile of the fund is not the only relevant fact. CFIUS analysis can turn on control, governance rights, information rights, board or observer rights, foreign person status, limited partner rights, the nature of the portfolio company’s business and other facts. A Cayman fund with significant US management may present a different analysis than a Cayman fund managed and controlled outside the United States. A Delaware fund with substantial non-US investors may still raise CFIUS questions depending on the rights granted and the facts of a particular investment.

The “principal place of business” concept is relevant in this area. The CFIUS regulations define principal place of business, for an investment fund, by reference to where the fund’s activities are primarily directed, controlled or coordinated by or on behalf of the general partner, managing member or equivalent. The list of CFIUS-excepted foreign states currently includes Australia, Canada, New Zealand and the United Kingdom, but for this purpose the United Kingdom does not include British Overseas Territories or Crown Dependencies. This matters because Cayman is a British Overseas Territory, not the United Kingdom, for purposes of that exception.

The practical point is not that every sensitive technology fund must be Delaware. That would be too simplistic. The point is that a manager expecting to invest in sensitive US businesses should not treat domicile as a tax-only question. The fund’s structure, governance rights, investor base, side letter rights and investment strategy should be reviewed together.

US outbound investment rules

There is now also a US outbound investment regime. The Treasury Department’s final outbound investment rule became effective on January 2, 2025, and applies to certain US person investments involving covered persons of a country of concern in specified technology areas: semiconductors and microelectronics, quantum information technologies and AI. The country of concern identified in the program is the People’s Republic of China, including Hong Kong and Macau.

For private equity and venture capital managers, this can matter in at least two ways.

First, a US manager investing directly or indirectly in China-related companies in covered technology sectors may have prohibited transaction or notification issues. Second, US investors investing as limited partners in non-US pooled investment funds may have their own issues if the non-US fund is likely to invest in covered China-related technology companies. The final rule includes an exception for certain limited partner investments of not more than $2 million, aggregated across related investment and co-investment vehicles, or where the US limited partner obtains a binding contractual assurance that its capital will not be used for transactions that would be prohibited or notifiable if engaged in by a US person.

This is not primarily a Delaware versus Cayman rule. It is a US person and covered transaction rule. But it can affect fund structuring, side letter requests, excuse rights, investor diligence, parallel fund arrangements and the design of China or China-adjacent investment programs. A US manager should not assume that forming a Cayman fund moves the issue outside the US regulatory perimeter.

AML, KYC and beneficial ownership

Cayman funds have long required a meaningful AML/KYC process. Cayman funds also typically have FATCA and CRS classification, diligence and reporting obligations.

The US side has also evolved. When the Corporate Transparency Act was first implemented, many US-formed private funds, general partner entities, management companies and related vehicles had to analyze whether they were reporting companies or qualified for exemptions. That analysis changed significantly in March 2025, when FinCEN issued an interim final rule narrowing the BOI reporting regime so that US-formed entities are currently exempt, and only certain foreign entities registered to do business in a US jurisdiction remain subject to BOI reporting.

Separately, FinCEN adopted an investment adviser AML rule, but later postponed the effective date from January 1, 2026, to January 1, 2028, while indicating that it intends to revisit the substance of the rule. Managers should be careful here because the investment adviser AML landscape remains dynamic. Even where a manager is not yet subject to a comprehensive US AML program requirement, institutional investor expectations, bank onboarding, sanctions screening, Cayman requirements and best practices may effectively require a robust AML/KYC process.

The practical lesson is that Cayman is not the “lighter” compliance choice from an AML/KYC perspective. In many cases, it is the more formalized one. Delaware may be simpler at the fund-vehicle level, but managers should expect investor diligence, sanctions screening and bank compliance requirements regardless of domicile.

Tax issues

Tax remains the heart of most domicile decisions.

The following issues are not an exhaustive list, and the analysis can change materially based on the investor base, the manager’s location, the investment strategy, the expected investment geography, the possibility of US effectively connected income, the likelihood of non-US portfolio company investments, treaty planning, blocker structures, co-investment structures, and future continuation or secondary transactions. But the following issues are the ones most often discussed at the beginning of a Delaware versus Cayman analysis.

Issues of highest importance

Requirement for the fund to file a US tax return

A Delaware limited partnership generally files a US partnership tax return on IRS Form 1065 and issues Schedule K-1s to its partners. IRS guidance describes Form 1065 as the form used to report the income of every domestic partnership and every foreign partnership doing business in the United States or receiving income from US sources.

A Cayman exempted limited partnership is a foreign partnership for US tax purposes. Whether it must file a US partnership return depends on the presence of US source income, effectively connected income or other filing triggers. In practice, some Cayman private equity and venture capital funds file US partnership returns and issue US tax reporting to US investors, while others may not file where the tax analysis supports that position.

This can matter greatly to non-US investors. Some non-US investors do not want to receive a US Schedule K-1. They may view it as creating administrative friction or as evidence of unwanted proximity to the US tax system. That perception may persist even where the technical US tax filing analysis is more nuanced. Cayman can be helpful for those investors because, in some structures, US tax reporting may be limited to US taxpayer partners rather than sent to all partners.

This is one of the most common reasons managers consider Cayman.

Withholding documentation the fund must provide to third parties

A Delaware limited partnership is a US entity for US withholding documentation purposes and generally provides a Form W-9 to banks, brokers, portfolio companies, paying agents and other counterparties.

A Cayman partnership is a foreign flow-through entity for US withholding documentation purposes and generally provides a Form W-8IMY. The IRS describes Form W-8IMY as the certificate used by a foreign intermediary, foreign flow-through entity or certain US branches for US withholding and reporting. In many cases, the Form W-8IMY process requires attaching or maintaining underlying withholding documentation for partners and providing a withholding statement.

This difference should not be minimized. It can create awkward disclosure issues when a fund invests into another fund, receives certain US-source payments or interacts with counterparties that insist on complete withholding documentation. A Delaware fund may provide a Form W-9. A Cayman fund may be asked to provide a Form W-8IMY package that reveals more about its investor base than the manager would prefer.

Some Cayman funds resist providing detailed second-layer information. That may be understandable as a business matter, but it should be done only after understanding the withholding and documentation risk. In some cases, the administrative privacy gained by using Cayman at the investor reporting level can be offset by additional disclosure requests in the withholding chain.

Treaty benefits and local tax treatment

Domicile can affect the availability of treaty benefits or the local tax treatment of investments in certain countries. Some countries historically have applied less favorable tax treatment to investors from jurisdictions they view as tax havens or low-tax jurisdictions. Cayman may appear on particular country lists even where it is not on the EU noncooperative jurisdictions list. Delaware, Luxembourg, Ireland, Singapore, Mauritius or another jurisdiction may be better for a particular investment strategy depending on the target country and the treaty network.

For a classic US-focused private equity or venture capital fund, this may not matter much. For a fund investing meaningfully in India, Brazil, China, Southeast Asia, Europe, Africa or other non-US markets, it can matter a great deal. In those cases, the answer may not be simply “Delaware or Cayman.” The answer may involve a main fund, treaty-eligible holding vehicles, alternative investment vehicles, blockers or parallel funds.

India is a useful example. Many India-focused funds have historically considered Mauritius or Singapore structures because of treaty access and investor familiarity. That does not mean Mauritius or Singapore is always the right answer, and recent Indian tax developments have made the analysis more fact specific. The point is broader: A particular country strategy may create a particular tax or regulatory reason to use a jurisdiction that would not otherwise be the default choice.

Managers should be cautious about over-engineering this issue. A treaty structure that solves a theoretical future investment problem can be expensive, slow and unnecessary if the fund ultimately makes only a small number of relevant investments. But managers with a clear geographic investment mandate should address treaty and local tax issues early because retrofitting structure after signing a term sheet can be difficult or impossible.

Issues of lesser but still real importance

Requirement for the fund to act as a withholding agent

A Delaware partnership generally acts as a withholding agent with respect to certain US-source withholdable payments. A Cayman partnership may have different withholding documentation and withholding agent considerations depending on the income and structure.

For many early-stage venture funds, this issue is not usually determinative because venture funds typically do not earn large amounts of US-source interest, dividends or other income subject to withholding. The analysis may be more important for private equity, growth equity, credit, real estate, infrastructure, revenue-interest, royalty or structured equity strategies. A fund that expects current income, dividend recapitalizations, debt instruments, royalties, token income or other nonstandard income streams should consider withholding issues more carefully.

Impact on US taxation of non-US limited partners

The choice between Delaware and Cayman does not, by itself, determine whether a non-US limited partner has a US tax filing obligation. The more important question is whether the fund earns income effectively connected with a US trade or business, or other income that triggers US tax filing or withholding obligations.

Most private equity and venture capital fund agreements with non-US investors contain covenants or operating provisions designed to avoid generating effectively connected income for non-US investors absent consent, excuse mechanics or an appropriate blocker. Those provisions matter in both Delaware and Cayman funds.

In other words, Cayman may reduce certain reporting friction, but it is not a magic shield against US tax consequences. Delaware may create more visible US tax reporting, but it does not necessarily create substantive US tax filing obligations and/or income tax liabilities for non-US investors unless the fund’s income or activities do so.

PFIC issues

Many non-US early-stage companies can be passive foreign investment companies (PFICs) for US tax purposes. US taxpayers investing in PFICs may need information to make a qualified electing fund (QEF) election and satisfy related reporting obligations.

A Delaware fund, as a US partnership, is generally positioned differently from a Cayman fund for these purposes. In broad terms, a Delaware fund may make or facilitate QEF elections at the fund level, while US partners in a Cayman fund may need to make elections at the partner level. Under proposed rules that are not yet in effect, US partners in a US partnership would need to make a QEF election at the partner level, which would make the PFIC reporting rules between Delaware and Cayman funds similar. In either case, the manager will often need to identify potential PFICs and obtain sufficient information from portfolio companies to support US investor reporting.

As a practical matter, the domicile choice affects who bears the tax reporting mechanics (under current law). It does not eliminate the need for PFIC diligence if the fund invests in non-US companies and has US taxable investors.

CFC Issues

Controlled foreign corporation (CFC) issues have historically been a key reason some managers preferred Cayman for non-US investments or formed Cayman alternative investment vehicles alongside Delaware main funds.

The basic issue is that a Delaware fund is a US person for CFC determination purposes, while a Cayman fund is not. A Delaware fund’s ownership in a non-US portfolio company may therefore contribute to CFC status in ways that a Cayman fund’s ownership may not, though the ultimate tax consequences require a more detailed analysis of fund ownership, investor ownership, attribution rules, portfolio company ownership and the type of income earned by the portfolio company.

The 2017 Tax Cuts and Jobs Act and subsequent Treasury regulations changed the practical significance of some CFC planning. The old shorthand that Cayman “solves” CFC issues is no longer reliable. A Cayman fund is still less likely to cause a non-US portfolio company to be treated as a CFC, but managers should assume that a CFC analysis has become a technical issue requiring current tax advice rather than a simple domicile-based answer.

For venture funds investing only occasionally outside the United States, CFC considerations may be handled through alternative investment vehicles or investment-by-investment planning. For buyout, growth equity or other funds with a broad non-US investment mandate, CFC planning should be part of the initial structure discussion.

FATCA and CRS

A Delaware fund is not a foreign financial institution for FATCA purposes. It may have withholding and documentation obligations in certain contexts, but it does not register as a Cayman financial institution.

A Cayman fund, by contrast, will generally need to consider FATCA and CRS classification, registration, diligence and reporting. The IRS describes FATCA as generally requiring foreign financial institutions and certain other foreign entities to report on foreign assets held by US account holders or face withholding on withholdable payments. Cayman’s Department for International Tax Cooperation describes FATCA and CRS as part of the Cayman reporting framework for financial accounts and automatic exchange of information.

This is another reason Cayman can be more administratively involved than Delaware. Again, the requirement is manageable. Fund administrators and Cayman counsel are accustomed to it. But it is not costless.

What about Luxembourg, Ireland, Singapore, Mauritius and other jurisdictions?

Delaware and Cayman remain the usual short list for many private equity and venture capital funds with a US nexus, but other jurisdictions are increasingly part of the conversation.

Luxembourg is commonly considered where European institutional fundraising is central to the strategy. Luxembourg can be helpful for EU marketing, particularly where the manager wants an EU onshore product, but it brings a very different cost, regulatory and service provider profile than Delaware or Cayman.

Ireland has also become more relevant for private funds, including through the investment limited partnership. Ireland may be attractive for certain managers seeking an English-language, common law, EU onshore structure, but it is not usually the default for a US-connected private equity or venture capital manager unless EU capital or strategy considerations justify it.

Singapore is a serious fund domicile for managers with a meaningful Singapore or Southeast Asia nexus. Singapore may be especially relevant where the management team, investor base, investment strategy or tax planning has a meaningful Asia connection.

Mauritius remains relevant for certain Africa- and India-focused strategies, although India-related treaty planning has become more complex and should be analyzed carefully. Mauritius is often discussed as a fund domicile for managers deploying capital into Africa, India and other emerging markets, but the answer depends heavily on treaty access, substance, investor profile and the current tax position in the relevant investment jurisdiction.

Managers may also consider the Dubai International Financial Centre (DIFC), Abu Dhabi Global Market (ADGM), Jersey, Guernsey or other jurisdictions depending on investor base, manager location, regulatory permissions, tax analysis and market expectations. For some Middle East managers or managers raising heavily from Gulf investors, an ADGM or DIFC element may be commercially or regulatory relevant. For some European or UK-adjacent strategies, Channel Islands structures may be familiar to investors. For some Latin America strategies, the answer may turn on local tax, exchange-control or investor eligibility issues rather than on global fund market convention.

The practical point is that these jurisdictions are not “better” or “worse” in the abstract. They are tools. They solve particular problems. They also introduce cost, regulatory substance, service provider and timing issues. A manager should choose them because the fund’s facts support them, not because they appear more sophisticated.

Parallel funds, feeders and alternative investment vehicles

The domicile decision is not always binary.

A manager may form a Delaware main fund with a Cayman feeder for certain non-US or tax-sensitive investors. A manager may form parallel Delaware and Cayman funds that invest side by side. A manager may form a Cayman main fund with a Delaware alternative investment vehicle for particular US investments. A manager may use blockers for effectively connected income (ECI), unrelated business taxable income  (UBTI) or other tax-sensitive investments. A manager may use special-purpose vehicles or co-investment vehicles for particular investors or deals. A manager with a country-specific strategy may use one fund domicile for the main fund and a different jurisdiction for holding companies or investment vehicles where treaty or local tax considerations support that approach.

These structures can be highly effective. They can also add complexity.

Parallel funds require allocation mechanics, governance coordination, borrowing and collateral coordination, subscription facility analysis, tax allocations, expense sharing provisions, Employee Retirement Income Security Act (ERISA) and Venture Capital Operating Company (VCOC) analysis, regulatory analysis and careful disclosure. Feeders require attention to tax reporting, withholding documentation, investor rights and cash movement. Alternative investment vehicles (AIVs) require clear lasting power of attorney (LPA) authority and disciplined implementation.

A manager should not reflexively build a multi-vehicle structure to solve hypothetical issues. But where a small number of real issues would otherwise distort the entire domicile choice, a targeted feeder, parallel fund, blocker or AIV may be the right answer.

Practical decision framework

For many private equity and venture capital managers, the following questions will drive the analysis:

1. Where are the investors? A mostly US investor base points toward Delaware. A meaningfully non-US investor base may point toward Cayman or a feeder/parallel structure. A concentrated investor base in Europe, Asia, Latin America or the Middle East may point toward additional local or regional structuring considerations.
2. Where is the manager located? A US-based manager, Singapore-based manager, London-based manager and Abu Dhabi-based manager may all be able to use Delaware or Cayman, but the regulatory, tax and commercial analysis may differ materially.
3. What will the fund invest in? A US-focused software venture fund is different from a global deep-tech fund, China-related technology fund India fund, Latin America growth fund, crypto fund, credit fund, real estate fund, infrastructure fund or buyout fund investing in regulated industries.
4. Will the fund invest materially outside the United States? Non-US portfolio investments can raise treaty, PFIC, CFC, local tax, withholding, currency-control and reporting issues.
5. Is there a specific country or asset-class tax issue? If yes, that issue may override the usual Delaware versus Cayman analysis. India, Brazil, China, Southeast Asia, Europe, Africa and Latin America can each present structuring questions that should be considered before launch.
6. Will sensitive technology or national security issues be common? If yes, CFIUS, outbound investment rules, sanctions and export control-adjacent issues should be considered early.
7. Are there anchor investors with strong domicile preferences? One or two large investors can change the practical answer, particularly if they have internal restrictions on US partnerships, Cayman vehicles or offshore vehicles more generally.
8. How much complexity can the manager operationally absorb? First-time managers should be especially careful about creating structures that are technically elegant but operationally burdensome.
9. Is the incremental cost worth the benefit? Cayman, Luxembourg, Ireland, Singapore, Mauritius and other jurisdictions can all be excellent choices in the right situation. They are rarely the cheapest or simplest choices.

Conclusion

The answer to “Where should I form my fund?” is still usually found by working through commercial, cost, regulatory and tax considerations in that order, with tax often doing the most work.

Delaware remains the simplest and most familiar domicile for many US-connected private equity and venture capital funds, especially those raising primarily from US investors and investing primarily in US companies. Cayman remains a highly accepted and often very useful domicile for funds raising substantial non-US capital, investing globally or seeking to reduce certain US tax reporting friction for non-US investors. Luxembourg, Ireland, Singapore, Mauritius and other jurisdictions may be appropriate where the investor base, marketing strategy, management footprint, investment geography or treaty analysis points in that direction.

The most important advice is not to choose based on labels. Delaware is not always too US-centric. Cayman is not always too offshore. Cayman also should not be treated as suspect merely because it is an offshore jurisdiction; in many cases, investor concerns about Cayman are more about perception, internal policy or optics than about the actual legal or regulatory framework. Luxembourg, Ireland, Singapore and Mauritius are not automatically more sophisticated. Each jurisdiction solves some problems and creates others.

The right approach is to map the expected investor base, manager location, investment strategy, regulatory profile and tax posture before launch. Once those facts are clear, the domicile decision usually becomes much less mysterious.

The principal reason for the low incidence of serious defaults is that typical venture capital fund agreements impose very onerous default remedies against the defaulting investor, including up to full forfeiture of the capital account value associated with the interest, inclusive of paid-in capital and any gains.  Once material capital has been contributed to the fund, there is considerable impetus to make further contributions timely.  If I’ve paid in $1 million of my $5 million commitment, am I really willing to walk away from that $1 million and any attendant gains?  Even if I’m seriously distressed financially, there’s a high incentive not to simply abandon my capital account value.  In short, paying in contributions timely is something that investors are well advised to try to remain on the right side of, and most often, they do. 

With that said, occasionally cases of serious default arise, and fund managers are put in the position of acting on the default remedies found in their fund agreements.  This article explores typical options available to venture capital fund managers when defaults reach a serious level demanding action.

Do I Have to Act?  When?

The preliminary question we usually get is: do I have to act and when?  We are often contacted at a point when a contribution is several months past due, the manager may have had some initial conversations with the investor, and the investor isn’t taking, or seeming likely to take, timely remedial action. 

From a manager’s perspective, defaults are not ideal.  They disrupt budgets for future investments and follow-on activity and potentially cause shortages of cash for quite immediate investment activity, which can then require unplanned additional capital calls from other investors.  If you raised a $500 million fund, you want to end up with $500 million to invest, not $450 million.  Furthermore, defaults will eventually work their way into audited financials if there are not direct contractual notification provisions in the fund agreement or side letters in the first place.  Other investors will eventually learn of the situation, which may raise questions.  Managers typically prefer to avoid this for reputational reasons.

With the above in mind, our first advice is to try to work with the investor to rectify the situation.  Perhaps the investor is not aware of the possible onerous consequences and/or is trying to manage many different capital demands.  A stern letter reminding them of their obligation and the potential outcome can often lead to a reprioritizing of payment to the fund.  Take the case of a distressed corporate investor that has money to pay some but not all obligations.  On reminder, it is often a result that the payment to the fund is moved to the front of the payment queue after awareness is focused on the impending downside.  In our experience, stern letters of explanation may cure something like 25-40% of serious default situations.

Another potential early conversation is to encourage a secondary sale, in which the purchaser will catch-up on missed contributions and take over the interest going forward.  In the preceding example, even if the distressed investor ends up with 70-80% of FMV in a secondary (i.e., $700,000 to $800,000), the result is much more favorable than forfeiting the $1 million of value under the fund agreement’s default clauses.  Where a seller just simply does not have cash, and there is capital account value, this path almost always makes sense and a distressed investor that is rational will pursue it.  They may do that largely on their own once prompted (say by approaching typical secondary buyers), or in some cases the fund manager may wish to get more involved, for example to “steer” the interest to a friendly existing or prospective LP that is or may be a long term investor in the manager’s other funds (i.e., usually not a secondary buyer, unless they have a fulsome primary investment platform).

As to the question of whether a manager is required to do anything, and if so when, fund agreements we work with generally provide that the choice of a manager to enact or not enact default remedies, and the timing thereof, is at the manager’s discretion.  Even on this typical drafting, there may be an ultimate fiduciary duty at law to take action in good faith for the benefit of the fund and its partners as a whole.  We are not often distressed by this concept because typical contracts make it clear enough that ample time is to be permitted for rectification of the situation, and give the manager a lot of discretion on how to handle each case in particular.  Regardless, interest is frequently aligned as the manager has its own capital at stake, has the reputational concern of keeping the books and records free of evidence of serious default and more than anything, has an interest in preserving originally targeted capital to ensure budgeting for follow-ons isn’t disrupted.  In practice most managers we work with might give a long standing, credible investor suffering temporary distress some leeway to rectify, but not likely in excess of say 6 months at the outer edge.  Less known, newer investors, or those as to which there is specific doubt as to creditworthiness, would typically get less leeway, with formal default provisions enacted sooner.

That Didn’t Solve It – What Do I Do Now?

In a few cases, no matter how sensible it may be on that part of the defaulting investor to cooperate, the above methods won’t yield successful results.  So what then?

First, make sure to follow any technical “notice and cure” periods in the fund agreement, if not already done by this time.  Usually there is a requirement for a formal notice of default letter, and 10 or 20 days cure time.  There may be multiple notices and cure periods in some cases.  Given the serious nature of the situation, and notwithstanding notice procedures in the relevant fund agreement, we recommend dispatch by both trackable courier and email.  Once this box is checked, the manager is free to pursue remedies under the default provisions of the fund agreement.  Typically, the choice of which remedy or remedies to pursue is at the discretion of the fund manager, and not mutually exclusive.  Among the typical remedies we would expect to see in a typical fund agreement are the following:

1. Sue for Damages and/or Performance:  This is ordinarily provided for, including the right to collect interest on the defaulted contribution(s) at an interest rate significantly in excess of the prime rate (say 12-18%).  It is not often, however, relied upon because by the time an investor is in serious default there are likely to be collection issues on any judgment, and proceeding along this route takes time and money.  Furthermore, there is reputational risk (fund managers generally don’t want to be seen suing their investors) as well as the potential for the lodging of counterclaims, such as breach of fiduciary duty or other “complaints”.  Even where meritless, the simple potential risk of the filing of a counterclaim can deter the initiation of legal proceedings by the fund manager.  In any event, the typically found remedies listed below are stronger, faster and easier to implement. 

2.  Enact a Transfer:  Under this approach, the fund manager may designate one or more parties (which usually may be existing limited partners or third parties) to be transferees who will receive the defaulting investor’s interest (or parts of it if there are more than one transferee) in exchange for agreeing to contribute capital toward the outstanding capital calls and make good on future capital calls.  This approach usually will not involve payment of any purchase price to the defaulting investor (i.e. the “seller”), other than assumption of these liabilities.  So this approach involves a forfeiture by the defaulting investor of 100% of the existing capital account balance.  Notice that this approach results in aggregate commitments being unchanged, and therefore this is commonly a preferred method by managers.  It is also simpler to deploy (less parties to transact with) and in a sense more “private” (in terms of not “outing” the situation with each and every investor) than #3 below, and thus tends to be more frequently considered.

3.  Enact a Sales Waterfall:  Under this sort of provision, the non-defaulting investors are offered, essentially in a “ROFR” type offering, their proportionate pieces of the defaulting investor’s capital account balance in exchange for proportionate contribution of then-unfunded and future calls.  If not all investors make the election, commonly a second tranche may occur where investors initially electing can get “more”.  Ultimately if the whole interest is not spoken for, third parties may be invited to participate.  In some sense this is not vastly different from #2 above: the defaulting investor suffers a 100% forfeiture, and the fund manager (assuming a successful process) ends up with an undisturbed amount of aggregate commitments.  However, this remedy requires undertaking a significant formal process from a logistical standpoint, and furthermore involves effectively notifying all investors of the situation.  So why would a manager choose this?  Sometimes, there is a view that the most equitable result since some party stands to get a windfall is to share that windfall proportionately with the entirety of the investor base. 

4.   Run To Zero Rights:  This type of provision calls for declaring that the defaulting investor is no longer a limited partner, has no right to vote on any fund matters, and is held back from income/gain allocations into its capital account (and usually distributions as well, discussed further below); however, expenses including management fee may be debited against the capital account (and in doing so “full scheduled management fees” may be collected at the fund level) until such time as the capital account reaches zero.  If that does not occur by liquidation, the remaining balance is often forfeited and allocated proportionately to the other partners.  While this provision protects the fee base, it does not maintain the full aggregate commitments, and as such, is seen as an inferior approach to methods #2 and #3 above.  However, this type of provision is commonly present in most fund agreements in the venture space and can play a role in certain situations where macroeconomic or other events beyond the specific limited partner limit participation in amelioration efforts by other sources of capital.

5.  Pure Forfeiture Provisions:  The most punitive commonly available remedy is the provision allowing the enactment of a simple, pure forfeiture, either of the capital account balance, the right to future profit allocations, or both.  These will commonly cause the forfeited amounts to be redistributed proportionately amongst the other partners, creating a windfall for them to the extent of any capital account balance being shifted.  As is the case with #4 above, this causes aggregate commitments to decrease, and as such, is not usually a preferred method.

6.  Distribution Withholding Provisions:  Recall that the above remedies are not mutually exclusive.  Distribution withholding provisions usually exist and are used in tandem with other default remedies.  These are rights to refrain from distributing cash or securities to an investor in default, and apply proceeds to outstanding calls and expenses, including outstanding interest.  In the case of securities, a well drafted provision will allow the right to sell the securities to generate cash to satisfy such items, which for tax purposes should expressly provided to be a deemed distribution to the investor, followed by sale by them and a deemed recontribution (with a pre-agreed hold harmless in favor of the fund manager).

Anything Else To Consider?

There are a couple of closing thoughts on the issue of investor defaults to keep in mind.  First, a well drafted fund agreement will place the right to act for the defaulting investor squarely in the hands of the fund manager by reference to the power of attorney provisions.  For example if a transfer is to be enacted to rectify the situation, there should be no need to chase down the recalcitrant investor for signatures; the fund manager should be able to act on that directly using a pre-agreed power of attorney.  Ideally, the drafting is very broad, to the effect of the power of attorney being available for any needs arising under the default provisions.

Next, consideration should be given to making sure parallel funds are properly included in the default provisions.  As an example, if a sales waterfall will run to all investors, it will usually (though not always) be appropriate to include parallel fund investors for this purpose.  This should be considered and resolved appropriately in the given context.  Another item to consider is the potential for cross-default provisions, meaning a default by investor X in fund A may be deemed to be a default in additional fund B automatically and lead to the potential for enactment of remedies in both funds A and B.  This is rarely appropriate, but in some cases may be.  For example funds that are literally stapled (say a growth fund with a top up fund for home run deals that has no management fee and lower carry, and everyone is subscribed in a 2:1 ratio; in this case access to the preferred terms fund is “part and parcel” of an investment in the growth fund, and it would not be equitable for an investor to default in the growth fund and keep the preferred piece).

Another concept to keep in mind is credit security.  In venture funds with typical default provisions along the lines discussed above, credit security comes from drawing down cash in order to put value in the capital accounts.  The greatest credit risk exists right after the fund is formed, and until the time capital account balances are sufficient to provide incentive to perform contribution with respect to the remainder of the commitment.  This often deserves special consideration, especially when holding a dry closing in turbulent economic times.  Some fund managers will call a small amount of capital (~5%) in order to create this credit security at the outset of the fund. 

In the case of fund managers that utilize capital call lines or other credit instruments, there will often be borrowing covenants in their loan agreements with respect to defaults by investors in the fund that may require self-reporting or other remedial steps.  Fund managers should review their loan agreement to fully understand the implications of a default on the credit arrangement.

Yet another issues centers around questions about the extent to which a fund manager may itself participate in default remedies.  For example, could the fund manager assign itself to be the transferee of the interest where there is a material capital account balance, taking all the windfall for itself?  There are potentially significant contractual and fiduciary limitations in this area, so consult carefully with counsel before acting in this manner.

Our best closing advice is to get a health check.  Have you reviewed your default provisions with fund counsel lately?  Default provisions have come a long way in the last few market cycles, and if this area of your fund agreement has remained untouched for several vintages, the default provisions probably do not reflect the “latest and greatest” techniques being deployed.  This is an unusual area of the fund agreement inasmuch as investors are generally aligned with the fund manager to provide greater protections and remedies to the fund; unless the investor plans to be the defaulting investor, updating it serves to both help ensure the fund is fully capitalized to make investments, and create stability within the investor group.

Three Year Holding Period for Carried Interest

This blog has previously discussed how to structure a fund manager’s carried interest, meaning the contractual right of a fund manager to receive a percentage of the fund’s profits that is unrelated to any capital commitment. Prior to the enactment of the TCJA, both carried interest holders and capital interest holders were entitled to long-term capital gains rates (for individuals, generally 23.8% at the federal level) on gain from the sale of a portfolio company held longer than one year. However, the TCJA introduced a new three-year holding period requirement solely applicable to carried interest in the fund context. If an investment fund holds stock in a portfolio company for three years or less and sells it at a gain, the fund manager will now be taxed on its share of the gain allocated in respect of its carried interest at short-term capital gains rates (for individuals, as high as 40.8% at the federal level).

In order to mitigate the impact of the new three-year holding period, many fund agreements drafted after the enactment of the TCJA provide fund managers with the option to waive their right to receive carried interest from an investment that does not meet the three-year holding period. In return, fund managers have a right to receive a corresponding increased amount of future appreciation in investments that do meet the three-year holding period requirement. In ideal circumstances, this would permit a fund manager to achieve the same results economically while avoiding the higher tax imposed on short term capital gains. The waiver is typically drafted such that limited partner investors are generally not disadvantaged (e.g., the fund manager generally cannot waive interest or other ordinary income, or gain from the sale of investments held for one year or less).  It should be noted, however, that this strategy involves inherent risks. Catch-up allocations of profits must derive from appreciation in portfolio company equity after the waiver is made, making the catch-up entirely contingent on future upside.  There is no guarantee that the fund’s investments will continue to rise in value (or will rise in value in an amount equal to the waived carry), in which case the fund manager will not have new gains to completely (or partially) recover the waived carry. In addition, this structure has not been blessed by Treasury or the IRS, and may be subject to challenge by the IRS, or may be prohibited by future legislation. Nevertheless, managers we work with are somewhat regularly inserting this architecture in their existing and/or new partnership agreements and will decide whether to utilize the waiver depending on the facts at the time of an exit.

Passive Foreign Investment Companies

U.S. investors in non-U.S. corporations that are classified as passive foreign investment companies (“PFICs”) are subject to special anti-deferral rules under U.S. federal income tax law.

At a high level, a foreign corporation is a PFIC if either 50% or more of the foreign corporation’s assets are passive assets (such as cash, securities, or certain intangible assets) or 75% or more of the foreign corporation’s grossincome is passive income (such as dividends, interest, and certain rents or royalties). Technology companies, life science companies, and other IP-driven companies are often categorized as PFICs because these businesses are less likely to generate any active income during the early stages of their life cycle but can often generate passive interest income.

Typically, a U.S. investor in a PFIC is required to recognize ordinary income instead of capital gain as well as interest charges upon a distribution from the PFIC or a disposition of its stock. These are harsh consequences that can significantly decrease an investor’s profits on an eventual disposition. However, a U.S. investor can avoid these consequences by making a “QEF Election”, which will cause the investor to be currently taxable on the net income of the PFIC (whether or not distributed). Many PFICs have little or no net income, so the practical cost of this election is often minimal. In addition, an investor with leverage may be able to negotiate for distributions from the PFIC in order to pay its tax liability.

When investing in a foreign corporation, it’s important for a U.S. fund to request covenants in the deal documents that require the foreign corporation to cooperate to manage any negative tax consequences to the U.S. fund (or its investors) that could result from the corporation being a PFIC. The foreign corporation should be required to consult with U.S. tax advisors to determine if it is a PFIC on a yearly basis. This can be a complicated analysis that requires detailed information about the corporation and the corporation’s shareholders.  Accordingly, the foreign corporation is in the best position to make this determination. The deal documents should require that, if the foreign corporation determines that it is a PFIC, the foreign corporation will provide its U.S. investors with any information that they need in order to fulfill their tax reporting obligations or make a QEF Election. Taking these steps could help mitigate the negative consequences that otherwise arise from investing in a foreign corporation that is treated as a PFIC.  

Controlled Foreign Corporations (CFCs) and Global Intangible Low-Taxed Income (GILTI)

U.S. investors in foreign corporations should also consider whether those corporations are classified as controlled foreign corporations (“CFCs”). A foreign corporation is a CFC if U.S. shareholders each owning at least 10% of the corporation’s voting power or value (“Significant U.S. Shareholders”) collectively own over 50% of the total combined voting power or value of the corporation’s stock. This determination is made by applying a complex constructive ownership regime, pursuant to which shareholders can be attributed ownership by certain related parties.

If a foreign corporation is a CFC, its Significant U.S. Shareholders will be taxed on their share of certain types of income of the CFC (whether or not distributed). In the past, CFCs were only taxed on certain types of income (known as “Subpart F Income”), which includes dividends, interest, and certain income generated from related party sales and services. However, the TCJA greatly expanded the scope of current taxation to Significant U.S. Shareholders by creating a new, shareholder-level tax based on the CFC’s global intangible low-taxed income (“GILTI”). GILTI generally includes all of the income of a CFC that is not Subpart F Income (other than a deemed modest return on tangible property).

When investing in foreign corporations, investment funds should carefully consider the impact of their choice of investment entity. When determining if a foreign corporation is a CFC, a U.S. partnership is treated as a separate entity and all stock owned by the U.S. partnership is included to determine whether the partnership is a Significant U.S. Shareholder and the foreign corporation is a CFC. In contrast, a foreign partnership is disregarded as a separate entity for CFC testing purposes and each of its partners are treated as owning a proportionate amount of the stock held by the foreign partnership. As a result, an investment by a U.S. partnership is more likely to cause a foreign corporation to become a CFC than an equal investment by a foreign partnership, even if the ultimate beneficial owners of each investment are the same. 

New tax rules now treat domestic partnerships like foreign partnerships for purposes of applying the GILTI rules, meaning the U.S. partners of domestic partnerships can account directly for GILTI and if no U.S. partner is a Significant U.S. Shareholder, no GILTI tax should apply.  Proposed tax rules (which can be applied now under certain circumstances) would extend this treatment to Subpart F determinations, i.e., the proposed rules, like the final GILTI rules, would treat U.S. partnerships like foreign partnerships for purposes of determining if a U.S. partner has taxable Subpart F income under the CFC rules. However, a U.S. partnership would still be treated as a U.S. entity for purposes of testing whether a non-U.S. company has the status of a CFC.  The IRS and Treasury have not yet clarified how the new CFC rules that treat a U.S. partnership like a foreign partnership will impact PFIC reporting and PFIC taxation,

Funds with U.S. investors should require a foreign portfolio company to determine its status as a CFC each year, and to covenant to assist each U.S. investor of the fund to determine if it is a Significant U.S. Shareholder if the foreign portfolio company is a CFC. In addition, the foreign corporation should be required to provide its Significant U.S. Shareholders with the information that they need in order to comply with their tax reporting obligations and determine the amount of any current income inclusions. Funds making significant investments in a portfolio company may be able to require the portfolio company to make tax distributions to cover any tax triggered by the CFC rules, although distributions to cover GILTI tax are not common in our experience.

For any business, one’s good name is one of its most essential assets.   That is especially true in venture capital, where, according to a 2004 study[1], firms with high reputations are much more likely than others to have their startup funding offers accepted.  A VC firm’s name or logo is a symbol of its reputation, and trademark law protects the goodwill those identifiers embody.

As more and more VC firms and other financial services firms come into being, protecting the uniqueness of their names has become increasingly important.  Indeed, as of May 2020, there are over 5,000 applications or registrations with the U.S. Patent and Trademark Office covering venture capital services. 

Having a name that stands out from the crowd and protecting that name by trademark registration can help a VC firm safeguard its valuable reputation and position in the industry.  

Choosing a Unique Distinctive Name

One of the most critical steps in the formation of a new VC firm is choosing a name.  A VC firm should have a memorable name that differentiates itself from others in its field.   Bad things can happen when a firm chooses a name like someone else’s.  If the other business is hit with bad publicity, the similarly named firm’s reputation may suffer from such confusion, or it may have to spend time and effort explaining that it isn’t the guilty party.  If a firm chooses a name like another’s, it could also face an infringement suit costing $1 million or more to defend, which is also very time-consuming and distracting to management’s attention.  

Once a name is chosen, trademark counsel should do a thorough search at the outset to help minimize the risks of confusion and infringement claims.  What is “infringement” is notoriously subjective, and trademark searching is an art. An experienced trademark lawyer won’t just give you a list of trademarks that came up in a search – he or she should give you an assessment of the risk and, where applicable, strategies for reducing it. Using a “low-cost,” cookie-cutter search service is false economy, and often will cost more in the long run.

When a firm is fixated on a particular name – whether because of its meaning, for sentimental reasons, or because a desirable domain name is for sale – that can complicate the selection process and increase expense.  Too often the name that seems “perfect” is unavailable – because someone else thought it was “perfect,” too.  There are workarounds like coexistence agreements, purchases of trademark rights, and licenses, but they always cost money and the firm often ends up with a name that’s far from unique.   

It’s best to avoid names that describe what the firm does, because the law generally doesn’t allow businesses to monopolize descriptive terms as trademarks.  Descriptive names like “Biotech Partners” or “Bay Area Ventures” can’t be protected as trademarks – if at all – unless they have developed enough recognition over time to have “secondary meaning” as brands.  Instead, choose a distinctive name.

What matters most is to select a unique and distinctive name that the firm can own exclusively.  Keep in mind that the meaning of a business name is not the one in the dictionary – it’s the meaning the people who make up the business put into it by developing a strong reputation.

Logos and Tag Lines are Trademarks, Too

Distinctive logos and tag lines also identify a business and its products, and they can be protected just like word trademarks.  Before investing in a logo or tag line, it’s important to do appropriate searching, and applying for registration as with the name to ensure that you are well protected. 

Benefits of Trademark Registration

Once the searching is done and the firm chooses a strong and unique name, it should take advantage of the protection of federal trademark registration.  While trademark rights in the U.S. come from using a mark to identify one’s goods or services, a federal trademark registration enhances those rights with a number of legal benefits.  They include:

• The nationwide right to use the mark for the services listed in the registration, with priority as of the filing date.  Unregistered or “common law” trademark rights only extend as far as the geographic area in which the business trades.
• A legal presumption that the mark is valid and the registrant is its exclusive owner.  This usually makes it easier and cheaper to pursue infringement claims in court.
• A public record of the registrant’s rights, which can discourage others from trying to adopt a similar mark.
• A defense against others’ claims of trademark infringement.  As noted above, infringement cases can cost $1 million or more to defend, and a registration can help a business defeat a claim early or dissuade others from claiming infringement in the first place. 
• Protection against registration of similar marks.  The Patent and Trademark Office will refuse registration of marks that it finds are likely to cause confusion with earlier-filed marks.
• Constructive nationwide notice of the registrant’s rights as of the registration date, which keeps later users from trying to claim that they adopted their marks in good faith. 
• A basis for seeking foreign registration of the mark – important for any business that operates outside the US.
• Enhanced monetary remedies when suing infringers in federal court.
• The right to use the ® symbol, denoting a federal registration. 

While it’s not necessary to have a lawyer file a trademark application, the process is filled with pitfalls and traps for the unwary, so it’s best to have experienced trademark counsel do it.  After an application is filed with the U.S. Patent and Trademark Office, an examining attorney will review it and search for conflicts with earlier-filed marks.  It’s not unusual for examiners to raise issues about the application.  Examiners may flag problems that may not exist in the real world – for example, an examiner may refuse a VC firm’s application because of a similarly named hedge fund or wealth management firm.  Experienced trademark counsel can help anticipate and avoid those issues or address an examiner’s concerns. 

Registrations will protect a mark for defined goods and services.  Because VC firms provide advice to their portfolio companies as well as capital, we typically apply to register their marks for business advisory services as well as venture capital services.  Where firms offer other services, like incubator services, educational seminars in a particular field, blogs, or podcasts, the trademark application should cover those, as well.

Protecting Your Trademarks Abroad

If you plan to conduct business outside the U.S. or license your mark to others, it’s important to protect your trademark by registering it in all foreign jurisdictions in which you plan to operate.  Otherwise you could be at the mercy of trademark squatters, infringers, and unscrupulous local partners.  International trademark protection doesn’t have to break the bank if done according to a well-thought out strategy. 

Policing Your Brand

Once you’ve invested time and energy in developing your good name, you’ll want to protect that investment.  If others adopt names like yours, that can cause confusion or harm to your reputation.  Your trademark counsel can subscribe to a watch service that will identify applications for similar trademarks so that your counsel can take appropriate and swift action to defend your marks. 

Your personnel and their contacts are on the front lines of your brand protection, so it’s important that they know what to do when they see a possible infringer.  There should be a point person to whom they can report possible infringements, and who can then alert counsel. 

If someone is infringing your trademark, it’s important to take quick action.  If you delay, and the infringer itself starts to become invested in the mark, it will likely be harder to get it to find a new name.  Also, if two businesses use a similar mark over a sustained period of time without substantial evidence of confusion, a court may decide that the marketplace has sorted out the difference between the two, and decide there’s no infringement.  As a result, the brand loses its uniqueness, and becomes less valuable. 

In Conclusion

Because it embodies the goodwill and reputation that a successful business develops over time, a trademark – whether a word, a logo, or a tag line – is one of a firm’s most important and valuable assets.  Choosing a distinctive trademark, searching to ensure others aren’t using it, and registering it are important steps for every VC firm to take.

[1] D. Hsu, What do Entrepreneurs Pay for Venture Capital Affiliation, The Journal of Finance (Aug. 2004), p. 1085 https://onlinelibrary.wiley.com/doi/pdf/10.1111/j.1540-6261.2004.00680.x (“Offers made by VCs with a high reputation are three times more likely to be accepted, and high-reputation VCs acquire start-up equity at a 10-14% discount.”). 

With that in mind, at a high level, there are three things to consider generally when structuring management fees: first, what is the amount of those fees; second, when in time do those fees start and end; and third, will the amount of fees reduce (i.e., “step down”) at some point in time reflective of perhaps a lesser level of work later in a fund’s lifecycle.

As to amount, management fees are typically based on an agreed percentage rate applied to an agreed capital base, and are usually described annually in the legal agreements (though in terms of cash payment they are most often divided up and paid quarterly or semi-annually).  In actively managed venture capital funds, the market rate is 2.5% of aggregate committed capital in the first part of a fund’s life.  This is contrary to say the buyout side of private equity where you often hear “2/20”, i.e. where the fee rate is often 2% instead of 2.5%.  Rates in venture capital funds are quite regularly 2.5% reflective of the fact that whereas a buyout fund may have a very large committed capital base and do 5-10 investments over its lifespan, a venture capital fund usually has a smaller capital base, often much smaller, and over time can make a quantity of investments on the magnitude of 2-3x that of a private equity fund.  In short, there is a lot to do, and where the capital base is more modest, management fees are not typically a source of a high degree of residual profitability over fixed expenses, if any.  With that said, in some very large venture capital funds (say $750 million and north), fees can sometimes drop to 2.25% or 2%, though depending on the size and nature of the organization, even these larger funds may often have a fee rate of 2.5%.  The preceding is widely applicable in the United States and Asia venture capital markets (as to USD-denominated funds); in Europe there may be more tendency for fees in venture capital funds to be in the 2% range, possibly reflective of a much smaller overall industry and an accordingly less degree of market term separation from private equity.

As to the start time for the payment of fees, they are often assessed from the initial closing (including retroactively for later admitted investors) though sometimes they are assessed beginning later, such as from the time of first capital draw or first investment.  This is somewhat dependent on the strategy in raising the fund and the expected time at which the team will start looking to place opportunities therein.  If the predecessor fund is out of dry powder and therefore necessarily the fund being raised will be the place where the next new opportunity is taken down, then there is significant justification for fees from the initial closing.  The team is after all “working” for the new fund already, in the sense they are out there sourcing deals for it; as such, the justification for payment of fees is clear.  In other situations, an existing fund may have remaining available capital for a couple of new deals, and there is an intent to put identified opportunities into the existing fund accordingly.  In this situation, the new fund is being effectively raised but put on the shelf, so as to be ready when capital is needed without any chance for a period of time without capital for new deals.  Where this is the case, a later inception of fees in the new fund may be warranted.

One also needs to consider when fees end.  This is a point that has been undergoing some change in the last 5-10 years, and may be subject to some negotiation.  There are three ending times that are most common: at the end of the natural term (say, 10 years in); at the end of any extensions to the term (say, 12 years in); or at the final liquidation of the fund (say, 13 years in).  In the last couple of years, we have seen increasing instances in which fees are paid all the way to final liquidation, albeit often at much lower rates than initially (see below, regarding fee step downs).  The theory here is that there is work to be done, someone needs to do it; and that is not free to provide, nor should it go unpaid for.  We see a number of venture capital funds with whom we work collecting fee to final liquidation on this basis, more in number than was the case some years ago.

Finally, there is the issue of the potential for fees to reduce (i.e., “step down”) at some point in time.  This is usually at the time that investments in new portfolio companies ceases, and the venture fund enters a period where it is doing solely follow-on investing and harvesting.  The theory in reducing the amount of management fee at that time is primarily that there is less work to be done, and secondarily, as a corollary thereto, that there is likely to be a successor fund providing a “full” fee base and therefore it is not necessary to collect high fees in the fund that has reached this level of maturity.  One way or another, most venture capital funds do have some “step down” concept.

A connected issue is, where fees reduce, how is that done exactly?  There are three ways the reduction in fees can be accomplished: the percentage rate can be reduced and the capital base can be left unchanged (a “rate step down”); the percentage rate can be left unchanged and the capital base can reduce (a “base step down”), or both the percentage rate and capital base can be reduced (a “double step down”).  In the years immediately following the reduction, say years 5-10 or 5-12, double reductions are quite uncommon and usually reflect quite a bit of lack of negotiating leverage on the part of the fund manager.  This is versus reductions during liquidation, where a double reduction is more common.

So, again focusing on what happens at or around year 5, in almost all cases it will be one or the other of a rate step down or a base step down.  Most venture capital managers will prefer a rate step down.  The reason is that this leads to a situation where one can state with specificity (at least from the time of final closing when the capital base amount is known) the exact amount, in dollars, of management fees in later years.  Since management fees are meant to be used for fixed expenses (think rent, equipment, hiring staff) and are usually consumed fully in furtherance of those expense requirements as opposed to leading to retained earnings, not knowing the dollar amount fees you will get in say year 6 (as would be the case where those fees are some percentage of a capital base not known until that time) is an extremely hard position for a manager.

With that said, while savvy investors understand this and will work to support the needs of the managers they invest in, they often prefer a base step down.  Their point of view is that no matter how low a percentage rate drops, it may be inappropriate to apply any rate to the full committed capital base later in the lifecycle when there are few remaining investments.  With that said, especially in smaller venture capital funds (say, $500 million and south), usually the method of rate step down prevails.  Sometimes, a compromise may be agreeing to a double reduction in the liquidation period to address the foregoing concern very late in the fund’s life.

It is important to get these concepts right.  We have found that getting them wrong can amount to “penny wise, pound foolish”, in extreme cases, hampering a manager’s chance of success.  What we mean by that is, investors put fund managers in business.  They pay a lot in fees to do that, no matter how negotiations on the above issues work out.  Fees are needed to compete for talent in the marketplace.  It is a shame to see negotiations to reduce fees result in a situation where the fund manager can’t hire and retain the “A” team from a compensatory standpoint.  Careful attention to market norms can assure the manager avoiding a competitive disadvantage, yet doing so in a way that is respectful of the investors’ perspectives on these matters.

The answer lies in a set of provisions that reside in the fund’s partnership agreement.  We generally refer to these as “LP governance rights”.  The common theme is that these LP governance rights represent ways in which LPs can take action if, in fact, they do become deeply concerned about the fund’s prospects or the conduct of the manager.

LP governance rights are best thought of as a suite of options.  Not all of them will exist in every fund agreement, but usually some of them will.  They can differ based on the duration of engagement between investors and the fund manager and the adherent level of trust that has developed over time amongst the parties, or for other reasons (including business leverage and precedence of prior funds).  It is safe to say that where investors are very demanding of attaching unusually strong LP governance rights to a deal, they probably have a heightened level of concern about issues of team stability, trust or just generally a lack of familiarity with the manager.  Certain investors may, internally and in light of their nature, be prone to requesting stronger than middle-market LP governance rights; for example managers of public pension or sovereign wealth assets may have strong legal or fiduciary reasons for such requests compared to private sources of capital.

So, what encompasses this suite of options comprising LP governance rights?  At a high level, there are three broad categories to be aware of: (1) provisions which can lead to the fund’s investment period ending prior to its scheduled time; (2) provisions which can lead to the fund’s entire term culminating early and the fund being completely shut down; and (3) provisions which leave both the investment period and overall term of the fund intact but cause the existing fund manager to be replaced with a new fund manager of the investors’ choosing.  Let’s examine each of these in turn.

Termination of the Investment Period

In a typical venture capital fund, an investment period will apply.  This is the period of time after closing, usually four to six years in duration, that the fund may make investments in brand new portfolio companies.  Beyond this time, only follow-on investments will be permitted.  The goal is to ensure that the fund can liquidate reasonably on-time, say after ten to twelve years.  That won’t be possible if investments in brand new portfolio companies, especially early stage ones, are made late in the fund’s lifecycle.  The investment period duration regulates this.

An investment period may end early if a fund becomes fully invested ahead of schedule, but from an LP governance perspective, there are two ways it might end even earlier.

The first is in association with a key person event, in which a certain number or particular persons of a select group of the fund’s investment personnel are no longer meeting their time devotion to the fund (usually substantially all business time) or are no longer managers of the fund.  For example, perhaps a fund is targeting 30 investments, and has five professionals expected to identify and nurture, on average, six deals each.  It might be the case that investors would tolerate some level of departures and still be comfortable with the team’s ability to fulfill the investment mission, but what if a supermajority of the five investment professionals has left and replacements have not been found and approved?  It may no longer be feasible to invest in 30 deals if these departures happen a couple of years into the investing cycle.  In many agreements, this happenstance, called a “key person event,” may call for the suspension of the investment period either automatically or by LP / Advisory Committee vote.  During this suspension period, the manager seeks to find replacement talent or otherwise formulate and propose some go-forward plan.   After exhausting efforts to find suitable substitute talent over a period of time, the fund’s investment period will terminate under the fund’s governing documents.  In this case, the remaining team will stay in place to guide the fund’s investments that have been made to fruition, but the investment period will terminate and opportunities in new portfolio companies cannot be pursued.

The second way an investment period may end earlier than scheduled is upon an investor vote.  This term is present in only a minority of deals to begin with, but where it is seen, it will almost always require bad conduct on the part of the fund manager team (“cause”, in industry parlance), usually proven in court, arbitration or a similar tribunal to the stage of final adjudication.  Very infrequently, it may be the case that a supermajority of investors may vote to terminate the investment period without any such cause.  It’s worth careful emphasis to highlight that this is a very uncommon clause, and one that most venture capital managers will not agree to.  The position is usually that such a punitive action should require wrongdoing and not be arbitrary, especially where venture fund managers by their lengthy mandate invest in and contract for long duration assets and obligations (offices leases, etc.) that can be difficult and costly to unwind.

Termination of the Fund

Whereas investment period termination is usually driven by a concern over the ability to make all of the contemplated investments, as reflected in a typical set of key person provisions, if concerns run deeper, the investors may in exceptional circumstances wish to completely terminate the fund.  If this occurs, the fund is liquidated and the securities – marketable and nonmarketable – are simply distributed in kind to the investors in connection with the winding up of the fund.

This remedy is in fact truly exceptional inasmuch as investors typically do not desire to hold private venture-backed securities in their portfolios.  This is what they hire fund managers to do, and they are often ill-prepared to take this on, especially if they are outside the domicile of the investments (like a UK pension fund trying to deal with U.S. portfolio securities).  In addition, the diffused, small positions that each particular investor may receive are not likely to carry the weight of the position as a whole that was previously held by the fund (think of things like the leverage to obtain a board seat or major investor rights); and the act of seeing the positions to fruition through follow-ons or if not disposing of them privately, perhaps in a secondary transaction at a discount, are not terribly appealing either.  So this remedy is reserved, in application, for the most serious situations.  Reputable fund managers need not lose much if any sleep that such a provision will be acted on.

The flip side is, in light of this sort of “natural bias” on the part of investors to call for application of the termination right, it is in fact often able to be exercised without cause.  In comparison to say a right to terminate the investment period or substitute a fund manager for no cause, the strong “downside” of enacting the fund termination serves as a natural check and balance.  The result is that in the industry, a majority of venture deals have no-fault termination rights.  These are usually on supermajority investor votes – perhaps as high as 85% in interest.  Sometimes, the right to terminate the fund in entirety on a lesser vote is seen where there is adjudicated cause and/or after a key person event – perhaps in these cases, on a 66% vote.

Replacement of the Fund Manager

The final type of LP governance right we see in venture capital deals involves an option for investors to replace the fund manager (often referred to as “GP removal”).  Where this happens, the fund will continue, but under the supervision of a new manager they choose.  The former manager is likely to retain some carried interest and possibly some transitional management fees, but won’t be involved in the going-forward management of the fund and ultimately will be likely to cede some economics, perhaps to a significant degree, to the new manager.

Some deals, especially in the case of emerging managers or managers struggling in fund raising, have some sort of removal and replacement right, almost all of which run off adjudicated cause.  In this case, following that sort of final determination in court of a serious bad act, a supermajority vote may lead to the right to remove and replace the fund manager; provided that in some deals where the bad conduct is resulting from a particular team member and that team member is terminated, the removal right may disappear (it being intended that an otherwise well-run organization shouldn’t be punished as a whole for basically “lone wolf” type conduct that isn’t pervasive in the firm).  Investors may ask for no-fault removal and replacement rights on a high supermajority vote – 85% or north, for example.  In reality, this type of provision is highly infrequent; a positive number yet approaching somewhere close to zero percent of deals we see today have this sort of provision.  As with no-fault investment period termination, most managers are simply unwilling to concede that they can be put out of business where there is no adjudicated bad conduct.

In the case of a removal and replacement right, whether for cause or otherwise, the departing manager is almost always afforded carried interest in the prior deals (often up to 100% though in some cases less) and sometimes a transitional amount of management fees permitting the outgoing manager to gracefully wind down operations.  These provisions are meant to be a deterrent to enacting the removal rights, such that those rights are invoked only where circumstances truly warrant it.

A Suite of Rights

In the end, most deals will have some collection of the above rights.  Having no such LP governance rights is rare, as is having everything listed above in any particular deal.  Fund managers and investors are well advised to cooperate to put in place a standard set of provisions encompassing some of the above and as the situational facts dictate.  In deals where provisions are too favorable for LPs, team retention issues may result.  That is to say, an excellent investment professional at the top of her game may not be satisfied to work at a firm where provisions can be enacted, especially on a no-fault basis, to effectively shut the company’s doors.

Some years ago, there was considerable concern with respect to a number of states that a fund manager’s information (be that pitch books, PPMs, partnership agreements, quarterly and annual reports or other materials) might be subject to disclosure to the general public upon demand. As it turned out, given how the laws have developed in this area, this has not proven to be a major concern today, as nearly all of the relevant laws have come to expressly provide, or at least have been interpreted by regulation or otherwise to provide, that essentially all of the sorts of highly sensitive information about themselves and their underlying portfolio companies that fund managers would most care about protecting from public disclosure now qualify for protection from such public dissemination (most frequently because such information is considered a “trade secret” in nature, and thus, protected by specific provisions in applicable state laws and regulations).

The type of protected information described above usually includes all portfolio company level information and all information about the strategy and terms of a fund’s offering. A number of states do permit the request by the public and subsequent dissemination of certain fund level (as opposed to portfolio company level) information, and some states go so far as to mandate its public disclosure even without a specific FOIA request from the public. For example, California requires that its public entity investors (CalPERS, CalSTRS, etc.) affirmatively disseminate to the public such fund level information, which is usually done by way of website. Fund level information varies by the location in question, but generally includes items such as name of fund, year of formation, aggregate capital commitments, the dollar amount of capital contributions, the dollar amount of distributions, the fair market value of the interest as of a specific time, the amount of fees (and sometimes carried interest) assessed, and so forth. Note, though, that the preceding is not reported on a portfolio-company basis, as information at the portfolio company level is generally viewed as trade secret.

Funds exist for a long period of time and these laws do change. California, for example, recently broadened the list of information deemed to be “fund level,” and thus, required for public disclosure. Accordingly, fund managers generally rely on two levels of protection to put them in the best position to disclose as little information as possible about their funds and the underlying portfolio companies. First, upon inception of a relationship, they analyze the current conditions of the investor in question with respect to what disclosure risks such investor poses to the fund manager (presently, for example, public investors in certain states are typically viewed as a bit too “leaky” to accept as investors, whereas the other states are viewed as mostly tolerable in our experience). Thus, concentrated planning for FOIA exposure issues during the investor intake phase is important.

Second, fund managers craft partnership agreement provisions which offer ongoing protection through several typical methods: (i) the confidentiality provisions are carefully crafted to provide that only a limited set of “fund level” information may be publicly disclosed by public agency investors or by fund-of-fund investors to their own public agency investors; (ii) the public agency investor is required to notify the fund manager of any FOIA requests and handle, or provide assistance for the fund manager to handle, resisting the request to the extent it is overbroad; (iii) the fund manager is permitted to demand the destruction or return of information from the investor if there is a later determination that there is a material likelihood of the public gaining access to it (this information being information beyond the broad fund-level scope, i.e. the type of information that is expected to remain confidential from public view); (iv) the fund manager, on a prospective basis, can stop providing sensitive information to the public agency (or fund-of-funds) investor if there is a non-permitted disclosure of information or there is a material likelihood or risk of the public gaining access to or being disclosed such information; and (v) in some cases, the fund manager may be able to cause a mandatory withdrawal of a particularly troubling investor.

In practice, a fund manager will need to decide whether it wishes to cross the line of accepting public agency investors or fund-of-funds investors with public agencies in them. Some managers determine that they do not even want fund level information available in the public domain and they elect to refrain, wholesale, from relationships with such investors. Other managers determine that they are fine with fund level information being publicly available, they accept these types of investors, and they rely on the above stated “typical protective provisions” to provide protection over the long life of the fund. No matter what course you may take, you will need to plan adequately for this issue in advance and determine the position your fund will take in respect of these sorts of prospective investors.