Legal Structures in Private Equity: Limited Partnerships vs. Limited Liability Companies
VerifyInvestor.com
Private equity (PE) investments continue to make a strong showing in the alternative investment space. For accredited investors, they provide a significant return on investment and are an excellent means of diversifying an investment portfolio.
The legal structures in private equity deals are usually either a Limited Partnership (LP) or a Limited Liability Company (LLC).
Which legal structure is utilized to establish and manage a private equity fund can play a crucial role in maximizing returns and minimizing taxes for private equity investors.
In this post, we will look at LPs and LLCs and discuss the advantages and disadvantages of each for purposes of private equity investment.
Of course, there are other legal business structures that can be used for private equity funds, but our discussion will focus on the two most common: Limited Partnerships and Limited Liability Companies.
Bear in mind that choosing the correct legal structure for a PE fund requires significant time, analysis, and research. The parties establishing the fund must undertake a detailed and careful analysis of the specific facts and goals of each PE transaction before determining which structure will work best for them. Investors also need to assess the potential impact a fund’s legal structure will have on taxes and return on investment over the life of the investment.
These are complex considerations for both fund creators and investors. Yet both fund creators and investors need to understand the impact the fund’s legal structure may have. Thus, it is essential that both fund creators and potential investors consult with experienced legal professionals, tax professionals, accountants, and other professionals, to determine what is right for their individual situation.
Our aim here is not to tell you which structure to use. That’s for you to decide. Rather, our purpose is to provide general educational information that can be used as a springboard for further investigation and analysis.
A Little Background on Private Equity
Private equity (PE) investments are an alternative to traditional investment vehicles. The term “alternative investments” refers to investing in the private market, and describes an enormous range of assets and investment strategies. While the products can vary widely, one common aspect of alternative investments is that they are not publicly traded.
Private equity is only one type of alternative investment. Frequently grouped with other alternative investment vehicles like venture capital (VC) and hedge funds, PE funds are distinct from both of these investment vehicles. PE’s distinguishing feature is that it affords accredited investors an alternative means of investing by providing opportunities for them to invest in privately held companies.
Since its beginnings in 1981, private equity has weathered a number of economic storms, reaching historic heights in 2021 before being thrown into flux by high inflation, rising interest rates, and war in Europe. Nevertheless, many believe that despite the many hurdles and downturns, ultimately, the future of private equity looks promising, and private equity is here to stay.
PE investments are typically held for long periods of time (often 5 to 10 years or more), making them illiquid investments.
In addition, because they are investments in private as opposed to public companies, PE funds are not registered with the Securities and Exchange Commission (SEC) and cannot be publicly traded. This means that the capital raised from accredited investors by PE firms and funds must come within one of the exemptions in the Securities Act of 1933.
Although a PE fund itself is not registered with the SEC, the Investment Advisors Act of 1940 regulates fund advisers. The Investment Advisors Act of 1940 requires fund advisors to register with the SEC.
The Most Common Private Equity Structures
As touched on above, private equity funds purchase and sell private companies. To do this, there are two main legal business structures generally used to create private equity funds. They are:
The Limited Partnership (LP), and
The Limited Liability Company (LLC).
While these two legal structures have some features in common, they are distinct legal business structures.
Partnerships are governed by state law.
A “partnership” is simply a business structure where two or more people agree to co-own and operate a business. The individual partners in the business can vary ownership interests, but the total percentages of all interests must equal 100 percent.
Partnerships can take several forms. Partnerships can be:
general partnerships (GP),
limited partnerships (LP), or
limited liability partnerships (LLP).
As can be seen, a limited partnership (LP) is just one form of partnership.
Each type of partnership varies with regard to the liability of the participants and the active management that each partner assumes.
For example, in a general partnership, all partners are general partners, and each takes an active role in the management of the business.
In contrast, limited partnerships are made up of both general partners and limited partners. The general partners run and manage the business. The limited partners have very little if any say in how the business is run and have almost nothing to do with the day-to-day operations. While the general partners make all the decisions regarding the business enterprise in an LP, they also have unlimited liability for the business’s obligations and debts. In contrast, limited partners have only limited liability.
LPs and LLCs have some features in common. These include:
ease of setting up the business (LP or LLC)
limited liability for members or partners
flexibility in assigning members’ or partners’ rights and responsibilities
both are pass-through structures for tax purposes
less formal requirements for documenting meetings
profit-sharing availability
These commonalities render both LPs and LLCs favorable structures for PE firms and funds.
Private equity funds are individual entities separate from the PE firm (most often the general partner) that establishes the fund.
Which business structure a fund takes, or should take, is a highly complex and complicated decision that can only be made by the parties establishing the fund.
But let’s take a closer look now at each one of these business structures to get a feeling for how they fit the needs of PE funds.
Limited Partnership (LP) Structure
To be a limited partnership, the business structure has to have at least one general partner, and at least one limited partner (frequently there are more of each).
For purposes of PE funds, the general partner is, in most cases, the PE firm that has the authority to make decisions for the fund and a management company (usually a subsidiary of the PE firm) that manages the fund. The investors are the limited partners.
The general partner is responsible for running the day-to-day operations of the fund and for making all decisions regarding the fund’s management.
The limited partners, on the other hand, share in the profits and losses, but typically have little to no say in how the fund is managed or run. Their participation is limited to providing capital for the fund.
In addition to being responsible for running the fund, general partners have unlimited liability for the debts and obligations of the fund. If, for example, there is a lawsuit or the fund incurs debts and obligations it cannot meet, the general partners will be held personally liable. That means that the personal assets (homes, cars, boats, etc.) of the fund’s general partners can be reached to pay the fund’s obligations.
On the other hand, the investors, as limited partners, have no personal liability exposure. Each limited partner’s liability is limited to the amount of his or her investment in the fund.
Limited partnerships, which are governed by state law, can be created in any state. With the exception of Louisiana, most states follow the Uniform Limited Partnership Act, which dictates what documentation is required, what registration fees must be paid, and what the reporting requirements are for limited partnerships.
In addition to registering the LP, a limited partnership must have a Limited Partnership Agreement (LPA). The LPA does not have to be filed with the state, but it is a critical document. The LPA is the organization’s operating agreement. It defines the rights and obligations of all the partners — both general partners and limited partners — in the limited partnership. Anyone investing in a PE firm that uses a limited partnership structure should pay careful attention to the LPA because it contains the full agreement between the parties regarding all aspects of the PE limited partnership.
Advantages of an LP Structure
Perhaps the most important advantage of an LP is the limited personal liability protection it affords to limited partners. In an LP, only the general partners have complete liability exposure. The limited partners (i.e., the investors) are liable only up to the amount of capital they invested in the fund.
Another major advantage of an LP is its pass-through (or flow-through) tax status. Rather than being taxed as an entity in and of itself, PE funds formed as limited partnerships “pass-through” their taxes to the partners (both general and limited) in the fund. This generally avoids a “double taxation” problem on investment returns.
In addition, because they are not active members of the business, limited partners do not have to pay self-employment taxes.
As noted previously, other advantages of an LP include the ease of forming the entity. In addition, unlike corporations, LPs do not have to comply with strict meeting and reporting requirements.
Disadvantages of an LP Structure
The same factor that is a benefit for investors — their limited partner status — can also be seen as a detriment.
Limited partners have little to no say in how the fund is managed or run. They are not allowed to participate in the day-to-day management of the business. As a result, investors unhappy with how the fund is being managed, probably can’t do much about it.
The downside for general partners in an LP is their unlimited liability. A general partner in an LP has no liability protection, thus putting his or her (or its) personal property at risk if liability is incurred.
Another potential downside is that the limited partnership structure can make it more difficult to transfer ownership or change management roles.
Limited Liability Company (LLC) Structure
The second most common fund structure for PE funds is that of the LLC.
An LLC is simply a business structure that affords limited liability to all owners (called “members”) of the company. An LLC is something between a corporation and a sole proprietorship.
Unlike an LP, which provides liability protection only for limited partners, all members in a limited liability company enjoy limited liability. Thus, if the company incurs debts or obligations it cannot meet, or incurs some other form of liability, each member’s liability is limited to his/her/its investment in the LLC.
Another difference between LLCs and limited partnerships is that all members of an LLC may participate in the management of the business.
State law governs the creation and operation of an LLC. Most states require an LLC to file a Certificate of Formation or Articles of Organization (or similar document) and to pay various filing fees. Yearly fees may also be required in some states.
Although not required in most states, an LLC should also have an Operating Agreement. This document defines the LLC’s purpose and addresses other important aspects of the business including (not limited to) business financials, members’ roles, and the rules for running the business.
Advantages of an LLC Structure
Again, the limited liability of an LLC is a major advantage of this legal business structure. Unlike an LP, LLCs have the additional advantage of providing limited liability for all members, not just some of them.
LLCs also have the advantage of being a pass-through (or flow-through) structure for tax purposes. In addition, LLCs are able to elect whether to be taxed as a corporation, partnership, or “disregarded entity.”
The flexibility of the Operating Agreement is another advantage of an LLC. Because it can be written to fit individual circumstances, the Operating Agreement works well for PE funds. It can be used to specify how the fund will operate, how profits and losses will be distributed, and when members can sell their interests.
Like LPs, LLCs are easy to establish and have less formal administration requirements (meetings, annual reports, minutes, etc.).
Disadvantages of an LLC Structure
Despite the pass-through advantages LLCs provide, they do pose a tax disadvantage. This is because LLCs are subject to self-employment tax. Owners employed by the LLC must pay self-employment tax on their share of the LLC profits — which can end up costing even more than taxes incurred as an employee.
Another disadvantage of an LLC is that a change in membership can cause the dissolution of the LLC. Unless specifically addressed in the Operating Agreement, in some states, if a member dies, declares bankruptcy or leaves, the LLC will be dissolved.
Finally, some investors do not like LLCs because they will be taxed on the LLC’s profits even if they receive no cash distribution personally.
The Right PE Investment Vehicle
Forming a PE fund is a complex and complicated endeavor. Choosing the right structure for your PE fund is a critical decision for owners and accredited investors alike. Every situation is unique, so be certain to consult with a securities lawyer and other necessary professionals.
At VerifyInvestor.com, we offer accredited investor verification services. As a leading resource for verification of accredited investor status in accordance with federal law, we make it easy for issuers to ensure that every single investor participating in their offering is an accredited investor. Our services are simple, confidential, secure, and reliable.