Introduction
As the private equity fund industry continues to evolve, investors are becoming increasingly sophisticated, demanding stronger contractual safeguards and enhanced considerations to protect their interests. This trend is particularly relevant in the context of the issuance of the Practical Guide on Venture Capital and Private Equity by the Securities Commission Malaysia. The guide provides a comprehensive framework for best practices in fund structuring and governance, reflecting the growing emphasis on investor protection, transparency, and accountability. This heightened awareness has led to a more nuanced approach to fund agreements, where the rights and obligations of limited partners (investors) are carefully balanced against the operational flexibility and incentives of the general partner (fund manager). This dynamic interplay between investor protection and managerial discretion lies at the heart of modern private equity fund structuring, making it a fascinating area of legal and financial negotiation.
1. Structure of a Private Equity Fund
Private equity funds are like financial powerhouses, pooling money from institutional investors and high-net-worth individuals to invest in private companies. These funds often take controlling stakes in their target companies, aiming to boost their operations, profitability, and overall value. But how exactly does this work?
Key Players: General Partners and Limited Partners
At the heart of every private equity fund are two main players:
(a) General Partner (“GP”): Also known as the fund manager, the GP is the brains behind the operation. They are responsible for managing the fund, scouting investment opportunities, and making decisions to grow the fund’s value.
(b) Limited Partners (“LPs”): These are the investors—think pension funds, endowments, or wealthy individuals. They provide the capital but typically stay out of the day-to-day decision-making, except in circumstances where critical matters may directly affect their interests.
How a Private Equity Fund Structure Works?
The structure of private equity funds is designed to protect LPs’ interests while also incentivising GPs through performance-based compensation. Specifically, the GP’s compensation is typically tied to the fund’s performance, and this is to ensure that the GP is motivated to generate higher returns, which in turn benefits the LPs. GP’s compensation is not just a flat fee—it is performance-based:
(a) Management Fees: GPs typically earn a small percentage of the fund’s total assets (usually 1-2%) to cover operational costs.
(b) Carried Interest: The real incentive comes from a share of the profits (often 20%), known as carried interest. This kicks in only after the fund achieves a certain level of return, ensuring GPs are focused on delivering results.
A typical structure of a private equity funds together are as follows:
Contractual Framework
The rules of the game for a private equity fund are laid out in its contractual framework. These agreements define how the fund operates, who does what, and how everyone gets paid. But the specifics depend on how the fund is structured—whether as a limited partnership or a private limited company.
(a) Limited Partnership Agreement (“LPA”)
If a private equity fund is established as a limited partnership, the primary governing document is typically the Limited Partnership Agreement.
(b) Constitution and/or Shareholders’ Agreement
If a private equity fund is established as a private limited company, typically, the primary governing document is typically the Constitution and/or Shareholders’ Agreement.
In some cases, for a fund based on a private limited company, a separate fund management agreement is executed between the fund entity and the fund manager. Additionally, a subscription agreement is also typically entered into at two levels: first, between investors and the fund, governing their capital commitments, and subsequently, between the fund and its portfolio companies, setting out investment terms and conditions.
The following is a quick overview of the main agreements and their purposes:
2. Term of a Private Equity Fund
The term of a fund encompasses the full life cycle of the fund, from its establishment to dissolution. The duration is largely dictated by the fund’s investment strategy, as certain types of fund requires longer terms due to the extended period needed for early-stage investments to mature and achieve liquidity.
A private equity fund’s life cycle is generally divided into three distinct phases:
(a) Fundraising and Commitment Period
The life cycle begins with the fundraising and commitment period, which is often the most critical phase for establishing the fund’s capital base. This stage commences with an initial offering period of variable length, during which the GP solicits commitments from potential LPs. The first closing marks the formal launch of the fund, after which a defined subscription period—typically six to twelve months—allows for additional closings to accommodate new investors or increased commitments from existing LPs. Following the final closing, the fund enters its investment or commitment period, which generally spans three to five years. During this phase, the GP is authorised to deploy capital into new investments.
(b) Investment and Holding Period
Once the investment period concludes, the fund transitions into the holding period, often referred to as the harvest phase. This stage, which typically lasts five to seven years, is dedicated to managing and enhancing the value of portfolio companies. Follow-on investments in existing portfolio companies may occur during this phase, subject to the terms outlined in the fund’s governing documents. Notably, the GP may have the unilateral right to extend the investment period by one or two years, or such an extension may require LPs’ approval.
(c) Exit and Fund Dissolution
The final phase of the fund’s life cycle is the exit and dissolution period. During this stage, the GP focuses on realising returns by exiting investments through trade sales, initial public offerings, or other liquidity events. Proceeds from these exits are distributed to LPs, typically in cash, although in-kind distributions may occur if specified in the governing agreements. The fund’s termination is formally effected once all assets have been liquidated and distributed, marking the conclusion of the fund’s life cycle.
3. Capital Commitment and Capital Contributions
(a) Capital Commitments: To Promise to Pay
Capital commitments form the financial backbone of a private equity fund, representing the total amount of capital that investors, or LPs, agree to contribute over a specified period. These commitments are not transferred to the fund upfront but are instead drawn down as needed, typically during the fund’s investment period. This structure allows the GP to access capital in a controlled and efficient manner, tailored to specific funding requirements and operational needs.
(b) Capital Contribution: The Actual Payment
A capital contribution is the actual transfer of funds from an investor to the fund. This is where the rubber meets the road—investors send money based on their earlier commitment. The amount contributed by an investor typically dictates their ownership percentage, voting rights, and share of profits or losses.
Typically, capital contributions are made in proportion to each investor’s undrawn capital commitment to the fund. However, the structure and timing of capital contributions are not always straightforward, especially in cases where investors are subject to different fee structures or are excused from certain investments due to regulatory or tax considerations.
(c) General Partner Commitment: Skin in the Game
The GP does not just manage the fund—they also invest in it. Typically, a GP commits 1-2% of the fund’s total capital, which is drawn down alongside LP contributions. This ensures that the GP has a “skin in the game”, as they would not only receive management fees but also be entitled to distributions through carried interest if the fund performs well. This structure encourages the GP to act in the best interests of the fund and its investors.
4. Capital Call and Drawdown
When a private equity fund needs money to make investments or cover expenses, it does not just tap into a giant pool of cash sitting in a bank account. Instead, it uses a process called a capital call (or drawdown) to request funds from its investors or LPs.
What is a Capital Call?
A capital call, also referred to as a “drawdown”, is the process by which a GP or fund manager requests funds from LPs or investors to meet the financial needs of the fund. In simple terms, it is like a financial “rain check”. When investors join a private equity fund, they promise to contribute a certain amount of capital over time. A capital call is the GP’s way of cashing in on that promise.
From a strategic perspective, many funds adopt a “just-in-time” approach, calling only the amounts needed for immediate investments or expenses to minimise idle capital. While a GP may occasionally use existing cash reserves for investments, capital calls are the primary method for securing necessary funds from LPs or investors. As explained earlier, in some cases, LPs may be excused from participating in specific investments due to tax or regulatory restrictions.
5. Distribution and Distribution Waterfall
When a private equity fund starts generating returns, the big question is: Who gets paid, and in what order? The answer lies in the distribution process and the distribution waterfall.
What Is a Distribution?
Distributions are the payouts investors and fund managers receive when the fund sells an investment or exits a deal. These payouts come from the fund’s net cash flows—after accounting for expenses like management fees and operational costs. While most distributions are made in cash, some funds may distribute assets directly (e.g., shares in a portfolio company), though this is less common and often comes with restrictions.
Additionally, if the fund is structured as a private limited company, distributions will also be subject to an additional layer of regulation under the Companies Act 2016, which stipulates that distributions can only be made out of the fund’s profits, adding another dimension to the distribution process.
The Distribution Waterfall: Who Gets Paid First?
The distribution waterfall is like a layered cake. It defines the order in which profits are distributed, ensuring that investors are prioritised before fund managers. Here’s how it typically works:
European vs. American Waterfall Models
The distribution waterfall can follow one of two main models, each with its own pros and cons:
Note: To mitigate risks in the American model, funds often include a clawback provision, which requires GPs to return excess carried interest if the fund’s overall performance falls short.
6. Handling Defaults on Capital Calls
What happens when an investor fails to meet their capital call obligations? This is a critical issue for private equity funds, as it can disrupt the fund’s operations and strain relationships. Fortunately, the LPAs or other governing documents typically outline a range of remedies to address such defaults.
Common Remedies for Defaults
When an investor (LP) fails to fulfil a capital call, the fund has several tools at its disposal. These remedies can be applied individually or in combination, depending on the circumstances:
(a) charging a high interest rate on late payments;
(b) forcing the sale of the defaulting partner’s interest or shares at a discount; or
(c) reallocating capital contributions among non-defaulting investors.
Choosing the Right Remedy
The choice of remedy often depends on the specific circumstances of the default and the relationship between the fund manager and the defaulting investor.
(a) Temporary Illiquidity: If the investor is committed but temporarily unable to pay, the GP might extend the payment deadline or allow partial forfeiture.
(b) Deliberate Avoidance: If the investor is intentionally avoiding their obligations, stricter measures like forced sale or legal action may be necessary.
The Need to Strike a Balance
Fund managers must also consider the broader implications of their actions, as overly punitive measures could deter future investors, while leniency might set a problematic precedent. Striking the right balance is crucial, as the fund’s ability to replace lost capital and maintain investor confidence often hinges on the fund manager’s ability of handling of such defaults. Ultimately, the goal is to ensure the fund can continue executing its investment strategy without much disruption.
7. Dissolution of the Fund
Dissolving a private equity fund is like wrapping up a decade-long project—it requires meticulous planning to ensure every asset is sold, debts are paid, and investors get their fair share. However, this process is rarely straightforward.
Normal Dissolution: The Planned Exit
Most funds dissolve at the end of their term (usually 10–12 years) following a structured three-step process:
(a) Liquidate Assets: Sell remaining investments, ideally at peak value;
(b) Settle Liabilities: Pay off debts, legal fees, and outstanding costs; and
(c) Distribute Proceeds: Allocate remaining cash to investors via the distribution waterfall (priority order: return capital first, then profits).
Challenges: The Unplanned Exit
Market conditions, regulatory requirements, and the nature of the fund’s remaining investments can complicate the timeline. For instance, if market conditions are unfavourable, the GP may extend the fund’s term to avoid selling assets at a loss. Such extensions, often permitted under the LPA, allow the GP to maximise returns for investors. Yet, even with extensions, the ultimate goal remains the same: to liquidate all assets, settle liabilities, and distribute any remaining proceeds in accordance with the fund’s distribution waterfall.
Early Dissolution: When Things Go Wrong
While most funds dissolve at the end of their stated term, early dissolution can occur under specific circumstances. These may include situations such as:
(a) The bankruptcy or withdrawal of the GP, or misconduct by the GP, such as fraud or gross negligence, which can prompt investors to demand dissolution.
(b) In some other cases, the GP may initiate dissolution due to regulatory changes that materially impact the fund’s operations.
(c) Additionally, LPs may have the right to dissolve the fund without cause, typically requiring a supermajority vote of the investors.
Early dissolution introduces complexities, as the fund must liquidate assets prematurely, often under less-than-ideal conditions. This underscores the importance of clear drafting of dissolution clauses in the LPA, which outline the rights and responsibilities of all parties during this critical phase.
Conclusion
In conclusion, the private equity fund ecosystem is a complex web of legal, financial, and operational dynamics, shaped by the evolving demands of investors and the strategic imperatives of fund managers. As the industry matures, investors have grown more sophisticated, pushing for greater transparency, stronger protections of their interests, and more tailored contractual terms. From the intricacies of capital calls and distribution waterfalls to the challenges of dissolution and default management, every facet of a private equity fund is designed to balance investor interests with the fund’s operational goals. Yet, the model is not without its flaws—issues like regulatory compliance, handling illiquid assets, and ensuring fair profit-sharing underscore the need for ongoing refinement of the private equity fund contractual framework.
References:
- Michael Lewis, Venture Capital & Private Equity Funds Deskbook Series (Morgan Lewis, n.d.) https://www.morganlewis.com/-/media/files/special-topics/vcpefdeskbook/fundoperation/vcpefdeskbook_capitalcalls.pdf accessed 6 May 2025.
- ‘Terms of Private Equity Funds’ (n.d.) https://legacy.pli.edu/product_files/Titles/2802/19610_sample02_20150605160045.pdf accessed 6 May 2025.
- Securities Commission Malaysia, Practical Guide on Venture Capital and Private Equity in Malaysia (n.d.).
