Primer: Structuring the General Partner and Management Company for a Private Equity or Venture Capital Fund

We are often asked by new and emerging managers about the fund itself: where to form it, what the management fee should be, how carried interest should work, what rights investors should receive, and what the partnership agreement should say.

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.