Partnership agreement

Term: Partnership agreement Related terms: ["General partner (GP)", "Limited partner (LP)", "Management company", "Operating agreement", "Partner withdrawal", "Buy-sell agreement", "Dispute resolution", "Succession planning", "Management fee", "Carried interest", "Non-competition covenant", "Non-solicitation covenant", "Post-employment restrictions", "Garden leave", "Clawback"] Definition: Explanation:

A partnership agreement serves as the foundational governing document for hedge funds structured as limited partnerships. Most hedge funds choose the partnership structure because it provides tax advantages and operational flexibility. The partnership agreement functions as a comprehensive framework that governs how the fund operates, who has management authority, and how profits are distributed.

This agreement operates similarly to corporate bylaws combined with shareholder agreements, but it is specifically designed for the partnership structure. The agreement also governs hedge fund management companies, which are typically organized as partnerships themselves.

Partnership agreements operate at two distinct levels within hedge fund structures, and it is important to understand both.

At the fund level, the limited partnership agreement governs the relationship between the general partner and the limited partners Limited partner (LP) A limited partner (LP) is an investor in a hedge fund structured as a limited partnership who contributes capital but has limited liability (restricted to their investment amount) and no involvement in the day-to-day management of the fund. . The general partner is typically the management company Management company The management company is the entity that employs the investment professionals and staff operating a hedge fund, receives management fees and often incentive compensation, and bears the operational expenses of running the investment management business. that makes investment decisions and runs the fund's day-to-day operations. The limited partners are the investors who provide capital but do not participate in management. This agreement addresses management fees Management fee Management fee refers to a recurring fee, typically calculated as a percentage of assets under management, that hedge funds charge investors to cover operational and administrative expenses regardless of fund performance. , profit allocations, how assets are valued, and the procedures investors must follow to withdraw their money.

At the management company level, the partnership agreement establishes the internal relationships among the firm's partners. These are the individuals who own and operate the management company. This agreement covers how partners are compensated, how the firm makes decisions, and what happens when partners leave the firm.

Partnership agreements address numerous legal, tax, and business issues that fall into several key categories.

Compensation and profit-sharing: The agreement establishes annual compensation frameworks. It defines how profits are shared among partners and creates mechanisms for adjusting partner interests as the business grows or changes over time.

Equity participation: The agreement defines partners' rights to participate in proceeds if the firm is sold. This includes determining how much each partner would receive and under what conditions.

Franchise protection: The agreement implements vesting and forfeiture provisions to protect the firm's value. It includes restrictive covenantsContractual provisions that limit what departing partners can do after they leave the firm, such as restrictions on competing with the former employer or soliciting clients. that prevent departing partners from competing or soliciting clients and employees.

Governance and decision-making: The agreement creates frameworks that determine who has authority to make various decisions. It also addresses succession planning for key leadership positions.

Partner changes: The agreement provides efficient mechanisms for adding new partners and managing departures. It establishes predictable costs and procedures for when partners leave the firm.

Dispute resolution Dispute resolution Dispute resolution provisions specify the procedures, forums, and applicable law for resolving conflicts between the fund manager and investors, typically including mandatory arbitration clauses, governing law designations, and jurisdiction specifications. : The agreement establishes procedures for resolving conflicts between partners. These procedures are designed to protect the firm's reputation while keeping partners focused on investment management rather than internal disputes.

Having a well-designed partnership agreement that binds all partners is essential for protecting the firm's value and establishing a framework for sustainable operations. Hedge fund management businesses can generate substantial current income and build significant franchise value over time. However, partner departures can create serious problems for the continuing firm.

When the rights of departing partners or the firm's rights are unclear, conditions become favorable for legal disputes. These disputes may prove lengthy and costly. More importantly, they can damage investor confidence, which is crucial for a hedge fund's success.

Without a written partnership agreement, statutory or common law will govern the relationship between partners. This creates significant uncertainty about what legal frameworks apply and which courts have jurisdiction over disputes.

Under Delaware law and other state partnership laws, a partner who leaves the firm may retain their ownership interest and demand a buyout at fair value Fair value Fair value is the price that buyers and sellers would agree upon in a normal, competitive market transaction. This market-based approach serves as the primary method for valuing hedge fund portfolios under generally accepted accounting principles (GAAP). . This fair value calculation may include the goodwill value of the business, which for successful hedge funds can represent multiples of four to eight times annual earnings.

This buyout obligation can create serious problems for the remaining partners. Hedge fund businesses typically have uncertain cash flows that vary with market performance and investor redemptions. Banks are generally reluctant to lend money secured only by a fund management business. Therefore, these buyout obligations can prove burdensome or even fatal to the continuing firm's operations.

The process of designing partnership terms should be approached as an exercise in setting clear expectations. Each partner must recognize that they may find themselves on either side of future disputes. They may be a continuing partner interested in preserving and growing the business, or they may be a partner who voluntarily or involuntarily leaves the firm.

This dual perspective should inform the design of all agreement provisions. Compensation structures, departure mechanisms, and protective covenants must balance the interests of continuing and departing partners. At the same time, these provisions must protect the firm's ongoing viability and ability to serve its investors effectively.