First-time Funds Series – Video #2: Fund Structures

Anthony Bishop (00:05): Hi everyone, and welcome to the second installment of our First-time Funds series. My name is Anthony Bishop, I'm an Associate in Torys' Private Equity group and I'm here today with my colleague, Venera Ziegler, a partner of the Private Equity group in our New York office.

In the first installment of our series, our colleagues discussed choosing a strategy and your target investors. Now that you've done that, you're going to want to consider the structure of your fund—and that's where we come in. Venera and I are going to discuss the fund structure, including the most commonly used structure in Canada and the US: The Limited Partnership. Venera, why don't you get it started with an explanation of what exactly a Limited Partnership is?

Venera Ziegler (00:42): Thanks Anthony. A Limited Partnership is the relationship between two or more partners that go into business together with a view to profit. Limited Partnerships are formed under the relevant Partnership Act and the rights and obligations of the partners are set out in a Limited Partnership Agreement—we'll discuss in detail in future episodes. A Limited Partnership has two types of partners: 1) has a general partner or has a limited liability and has full management and control of the business of the partnership; and 2) limited partners, the investors, who contribute capital but do not participate in the management of the business of the partnership and, as Anthony will explain further, have limited liability.

Anthony Bishop (01:27): Thanks, Venera. So within this construct, the general partner is the sponsor—the mind and management of the partnership—and the limited partners are the passive investors who provide the capital for the sponsor to invest. We usually recommend that in Canada, the general partner be a Corporation, and in the US, a LLC, and that such entity is a special purpose vehicle that has been formed specifically for its role as the general partner of the fund. This is done in order to isolate liabilities, given the unlimited nature of the general partner. Of course, there are other players within the structure as well.

Venera Ziegler (02:02): That's right, Anthony. Generally, especially in the US, the general partner will engage an investment manager to manage the fund. The general partner outsources some or all of its functions to the manager. The general partner or the manager receives an income stream to "keep the lights on" and pay its overhead expenses. Generally in the US, that is always the manager. If there is a manager, this income stream is the management fee. If there is no manager, this may take the form of a general partner distribution—a priority distribution to the general partner that is functionally equivalent to the management fee. While managing the partnership, the general partner or an affiliated entity, called a carry partner, will receive carried interest, which is the sponsor share of the profits. The carry partner is often itself a Limited Partnership or a Corporation, depending on the tax structure. In the US, the carried interest is often received by the general partner, but in Canada, it's common practice to have a separate carry partner. Each of the carry partner, the general partner, and the manager are usually owned by the same key individuals comprising the sponsor.

Anthony Bishop (03:15): Additionally, depending on the investor base, sponsors may elect to form a separate Limited Partnership known as a "parallel fund" in order to accommodate the regulatory tax or other investment requirements of certain investors. For example, if a sponsor anticipates having a number of non-resident investors, they may create a separate vehicle specifically for such non-resident, separate and apart from the resident investors in the main fund.

Venera Ziegler (03:43): Correct. As the name suggests, a parallel fund sits beside the main fund and makes investments and divestments in parallel with the main fund. Parallel funds have substantially the same terms as the main fund. Subject to differences to accommodate the tax, regulatory, or other investment requirements of the parallel fund investors. Now that we've discussed the various entities in the structure, Anthony, why don't you explain why sponsors use Limited Partnerships rather than other vehicles like Corporations or General Partnerships?

Anthony Bishop (04:17): Thanks, Venera. There are two primary reasons why sponsors use Limited Partnerships over other structures. One of the reasons, as Venera mentioned, is that limited partners received the benefit of limited liability, meaning their liability to the partnership is limited to the amount they commit to invest. For example, if a limited partner commits $100 to the fund, that $100 is generally the maximum that such limited partner will be liable for as a partner of the partnership. Once the limited partner has contributed that amount to the partnership, it will not be required to contribute anything further. Conversely, a General Partnership does not offer the benefit of a limited liability. Corporations, on the other hand, are similar to Limited Partnerships in that they do grant limited liability to its shareholders, but sponsors opt to use Limited Partnerships over Corporations for their tax characteristics. Which brings us to the second benefit that Limited Partnerships have over other structures.

Venera Ziegler (05:14): Yes, unlike a Corporation, a Limited Partnership is a flow-through entity, which means that when the partnership turns a profit, that profit is not taxed at the partnership level, but rather flows through the partnership and is taxed at the partners at the invested level.

These profits maintain their character, which means that if the profits are earned as capital gains, such as profits from the sale of securities, these profits will be capital gains in the hands of the partners. This is preferable because capital gains receive more favourable tax treatment rather than ordinary income.

Anthony Bishop (05:50): That's right. And as a final point, using a Limited Partnership as opposed to a Corporation allows a sponsor to take its share of the profits, known as carried interest, in the form of a distribution that maintains the characteristics of the underlying income (i.e., capital gains) rather than as a fee that is taxed as ordinary income.

Venera Ziegler (06:10): Exactly right, Anthony. And this concludes our discussion. We hope that this gives you a better understanding of the fund structure and the various entities involved. Thanks so much for tuning in and be sure to check out our next installment of the series featuring Shannon and Cal as they discuss the marketing of funds.