Limited partner (LP)

Most domestic hedge funds use limited partnerships as their business structure. This arrangement creates a clear division of roles and responsibilities. The general partner runs the fund and makes all the investment decisions, but they also face unlimited liability for the fund's debts and obligations. Limited partners, on the other hand, invest money in the fund but receive important liability protection—they can only lose up to the amount they invested, as long as they stay out of the fund's daily operations.

Limited partnerships have become the standard structure for hedge funds because both fund managers and investors understand how they work. These structures have a long legal history, which provides predictability and clarity for all parties involved. Delaware has become the go-to state for creating these funds because it has developed extensive case law over the years that governs how these partnerships operate.

The limited partnership structure gives fund managers significant flexibility. The general partner can create different terms and conditions for different investors while still maintaining the basic legal framework. This allows funds to accommodate various types of investors with different needs and requirements.

Fund managers typically do not serve as general partners in their individual capacity because doing so would expose them to unlimited personal liability. Instead, they create a separate limited liability company (LLC) to act as the general partner. This protective structure means that if the fund faces legal problems or debt obligations, the managers' personal assets remain protected through the LLC's limited liability features.

This setup creates a useful separation between the investment management business and the fund's actual investment activities. Limited partners benefit because their financial exposure remains limited to only what they invested in the fund, regardless of what happens to the fund's operations.

Delaware law gives limited partners the right to obtain information that relates to their partnership interest. This includes access to details about the fund's business operations and financial condition, tax returns, lists of other partners, copies of the partnership agreement Partnership agreement A partnership agreement is the primary governing document for a hedge fund structured as a limited partnership. It establishes the relationship between general partners and limited partners. The agreement details rights, obligations, economic terms, and operational provisions for all parties involved. , records showing capital contributions, and other information about the partnership's affairs.

However, limited partnership agreements often include language that restricts a limited partner's right to receive certain types of information. These restrictions help protect the fund's trading strategies and other sensitive business information.

The Delaware Supreme Court has ruled that limited partners have a contractual right to access the list of other partners in the fund. General partners cannot simply decide to block this access on their own. The court noted that no federal law prevents Delaware from granting this right to limited partners.

However, the court also stated that general partners can restrict access to partner names and addresses, but only if they include explicit language in the limited partnership agreement under Delaware law Section 17-305(f). As a result, many fund sponsors now include provisions that clearly state limited partners have no right to obtain information from the fund's records, including information about other limited partners or the fund's trading activities.

Delaware law allows limited partnership agreements to grant voting rights to investors in various ways. Some funds give voting rights to all limited partners, while others limit voting to specific classes of investors. The voting structure can be based on the number of partners, the amount invested, or other arrangements that the general partner determines.

Limited partners who receive voting rights can only vote on specific matters. These typically include items explicitly listed in the partnership agreement, matters covered under Delaware law, or issues where the general partner specifically asks for investor consent.

Certain types of limited partners face special restrictions on their voting rights due to regulatory requirements. Limited partners subject to the Bank Holding Company ActFederal legislation that regulates bank holding companies and their activities, including restrictions on voting rights for investors who own more than 4.99% of voting interests in financial institutions. who own more than 4.99% of total voting interests can only vote up to 4.99% of their ownership stake. Additionally, limited partners that are registered investment funds under the Investment Company Act of 1940 Investment Company Act of 1940 The Investment Company Act of 1940 is a U.S. law that regulates companies whose main business involves investing in securities. Hedge funds typically use special exemptions under Sections 3(c)(1) or 3(c)(7) to avoid having to register under this law, which allows them to maintain the flexibility they need for their investment strategies and fee structures. generally hold non-voting interests.

Some hedge funds use master-feeder structures to accommodate different types of investors. In these arrangements, limited partners invest in domestic feeder funds Feeder fund A feeder fund is a type of investment fund that collects money from investors and then invests nearly all of that money into a larger "master fund." This structure allows different types of investors—such as U.S. taxpayers, tax-exempt organizations, and foreign investors—to all participate in the same investment strategy while using the fund structure that works best for their specific tax and regulatory needs. , which then pool their money and invest in a master fund that handles the actual trading and investment activities.

Each feeder fund owns a percentage of the master fund based on how much capital it contributed. Limited partners participate in the master fund's investment performance through their feeder fund's proportional ownership. This structure allows funds to serve both U.S. and offshore investors while maintaining a single investment strategy.

The most important rule for maintaining limited partner status is that limited partners cannot participate in controlling the fund's business activities. This restriction protects their limited liability status. If limited partners become too involved in managing the fund, they risk losing their liability protection and could become personally responsible for the fund's obligations.

This principle ensures that general partners maintain clear authority and responsibility for fund operations, while limited partners remain passive investors who benefit from professional management without taking on management risks.

Limited partnerships qualify as pass-through entitiesA business structure that does not pay taxes at the entity level, instead passing income and tax attributes through to its owners or investors who report them on their individual tax returns. for U.S. federal tax purposes. This means the fund itself does not pay taxes on its gains and losses. Instead, these gains and losses flow through to the limited partners, who report them on their individual tax returns.

This structure provides significant tax advantages because it avoids double taxation. In contrast, corporate structures face taxation at both the company level and the investor level when profits are distributed. Limited partners can benefit from favorable tax rates that may apply to different types of investment income.