Question 1

What is private equity and how does it work?

Accepted Answer

Private equity involves investment funds that acquire equity ownership in private companies or take public companies private. PE funds pool capital from institutional investors (pension funds, endowments, insurance companies) and high-net-worth individuals to make investments in operating companies. The fund structure typically involves a limited partnership where the PE firm serves as general partner managing investments, and investors serve as limited partners providing capital. PE funds typically have 10-year terms with 5-year investment periods, generating returns through operational improvements, financial engineering, and strategic growth before exiting through sales or IPOs. Our California PE attorneys represent fund sponsors forming funds and executing transactions.

Question 2

What is a limited partnership agreement (LPA) in private equity?

Accepted Answer

The Limited Partnership Agreement is the governing document for PE fund structures, establishing the legal relationship between general partners and limited partners. The LPA addresses all material fund terms including capital commitments, capital calls, management fees, carried interest waterfall, distribution provisions, investment restrictions, LPAC governance, key person provisions, reporting requirements, and term/extension mechanics. LPA negotiation represents a critical phase of fund formation, with institutional LPs often requesting modifications through side letters. Our California PE attorneys draft comprehensive LPAs protecting GP interests while meeting institutional LP expectations and market standards.

Question 3

What is carried interest and how is it taxed?

Accepted Answer

Carried interest (or "carry") represents the general partner's share of fund profits, typically 20% of gains after returning LP capital and achieving hurdle rates. Carried interest has historically received favorable long-term capital gains tax treatment (currently 20% federal rate plus 3.8% net investment income tax) rather than ordinary income rates. However, IRC Section 1061 now requires a three-year holding period for carried interest to qualify for long-term capital gains treatment. California does not provide preferential capital gains rates, taxing carry as ordinary income at rates up to 13.3%. Our PE attorneys structure carried interest provisions optimizing tax treatment while addressing clawback obligations and vesting schedules.

Question 4

What are management fees in private equity funds?

Accepted Answer

Management fees compensate the GP for fund management activities, typically calculated as 1.5-2% annually of committed capital during the investment period and 1.5-2% of invested capital thereafter. Management fees cover operational expenses including salaries, office costs, travel, and general overhead. Fee structures vary across fund sizes and strategies, with larger funds sometimes negotiating reduced fee percentages. Management fee offsets require that transaction fees, monitoring fees, and other portfolio company fees reduce management fees, typically by 80-100%. Our California PE attorneys negotiate management fee provisions balancing GP compensation needs with LP fee sensitivity.

Question 5

What is a capital call in private equity?

Accepted Answer

Capital calls (or drawdowns) are notices from the GP requiring LPs to fund portions of their capital commitments for investments, expenses, or management fees. LPs typically have 10-15 business days to fund capital calls after receiving notice. Capital call mechanics in LPAs specify notice requirements, funding timing, default consequences, and cure rights. Defaulting LP provisions may include forfeiture of existing interests, forced sales at discounted valuations, or loss of unfunded commitment benefits. Subscription line facilities (capital call lines) allow funds to bridge timing between capital deployment and LP funding. Our PE attorneys draft capital call provisions ensuring efficient fund operations.

Question 6

What is a GP commitment in private equity?

Accepted Answer

GP commitment represents capital invested by the general partner alongside limited partners, demonstrating GP alignment with LP interests. Market standard GP commitments range from 1-5% of total fund size, though emerging managers may commit higher percentages. GP commitment may come from personal funds of GP principals, management company resources, or co-investment vehicles. Some institutional LPs require minimum GP commitment levels as condition of investment. GP commitment typically receives management fee and carried interest treatment consistent with LP economics. Our California PE attorneys structure GP commitment arrangements balancing alignment objectives with GP liquidity considerations.

Question 7

What is a waterfall distribution in private equity?

Accepted Answer

Waterfall provisions define the order and methodology for distributing fund proceeds between GPs and LPs. The typical American-style waterfall proceeds: (1) return of contributed capital to LPs; (2) preferred return (typically 8% IRR) to LPs; (3) GP catch-up bringing GP share to 20% of cumulative profits; (4) 80/20 split of remaining profits between LPs and GP. European-style waterfalls return all capital and preferred return across the entire fund before any carried interest distributions. Hybrid structures and deal-by-deal waterfalls represent variations addressing different economic arrangements. Our PE attorneys design waterfall provisions achieving desired economic outcomes while meeting institutional LP expectations.

Question 8

What are side letters in private equity?

Accepted Answer

Side letters are agreements between the GP and specific LPs modifying standard LPA terms for that investor. Common side letter provisions include most favored nations (MFN) rights, co-investment rights, reduced management fees or carried interest, enhanced reporting, ERISA representations, and regulatory accommodations. MFN provisions grant LPs the right to elect terms granted to other investors, creating practical limits on side letter concessions. Side letter management becomes increasingly complex as funds scale and LP bases diversify. Our California PE attorneys negotiate side letters balancing GP flexibility with LP accommodation while managing MFN implications.

Question 9

What is an LPAC in private equity?

Accepted Answer

The Limited Partner Advisory Committee (LPAC) provides governance oversight for PE funds, typically comprising representatives from the fund's largest institutional investors. LPAC responsibilities include reviewing conflicts of interest, approving valuation policies, consenting to GP affiliates transactions, and providing guidance on fund matters. LPAC members generally do not have fiduciary duties to other LPs and serve in advisory rather than decision-making capacity. LPAC meeting frequency, quorum requirements, and voting thresholds are specified in the LPA. Our PE attorneys structure LPAC provisions establishing appropriate governance while preserving GP operational flexibility.

Question 10

What is Form PF and who must file it?

Accepted Answer

Form PF is a confidential SEC filing required for investment advisers to private funds under the Dodd-Frank Act. Large private equity advisers (managing $2 billion or more in PE fund assets) must file Form PF annually within 120 days of fiscal year end. Smaller PE advisers file quarterly with 60-day deadlines. Form PF requires detailed reporting on fund structure, investment strategies, leverage, counterparty exposures, and portfolio company information. The SEC uses Form PF data for systemic risk monitoring and examination targeting. Willful misstatements on Form PF can result in enforcement actions. Our California PE attorneys ensure accurate Form PF compliance and examination readiness.

Question 11

How do private equity exits work?

Accepted Answer

PE exits convert portfolio investments into realized returns for distribution to investors. Primary exit strategies include strategic sales to corporate acquirers, sales to other PE sponsors (secondary buyouts), initial public offerings, and dividend recapitalizations. Exit timing typically occurs 3-7 years post-investment, though market conditions and company performance affect optimal timing. Sale processes may involve investment bank engagement, management presentations, due diligence facilitation, and purchase agreement negotiation. IPO exits require substantial preparation including financial statement audits, governance improvements, and SEC registration. Our PE attorneys execute exits maximizing value realization for fund investors.

Question 12

What is a secondary sale in private equity?

Accepted Answer

Secondary sales involve transfers of existing LP interests in PE funds, providing liquidity to selling LPs before fund termination. The secondary market has grown substantially, with dedicated secondary funds purchasing LP interests at discounts (or premiums) to net asset value. GP consent is typically required for LP transfers under LPA provisions. GP-led secondary transactions involve the fund selling portfolio companies to continuation vehicles managed by the same GP, providing liquidity to existing LPs while allowing the GP to continue managing select assets. Our California PE attorneys structure secondary transactions protecting seller and buyer interests.

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