Understanding Key Fund Terms

At a Glance

• This guide explains core fund terms: fund expenses, management fees, carried interest, and the distribution waterfall.

• It outlines how GP compensation works through management fees and carry, and how those terms are structured to align incentives with LPs.

• It introduces side letters, parallel funds, feeder funds, alternative investment vehicles, and co-investment vehicles as tools to address specific LP needs.

• A well-structured Limited Partnership Agreement (LPA) or LLCA balances GP authority with LP protections, investment strategy, and return mechanics.

• Understanding these concepts is essential for first-time fund managers and emerging LPs evaluating how a venture fund is designed and how returns are shared.

Overview

This guide focuses on two main categories of fund terms:

1. Economic terms – how money flows through the fund (fees, expenses, carry, and the waterfall).

2. Structural and governance terms – how the fund is set up, who can invest, and how specific LP needs are handled.

These concepts are typically set out in the fund’s Limited Partnership Agreement (LPA) or Limited Liability Company Agreement (LLCA) and related documents.

Economic Terms

Fund Expenses

Starting and running a venture fund involves a range of costs. Many of these fund expenses are paid from LP capital contributions rather than out of the GP’s pocket.

Fund expenses commonly include:

• Organizational expenses: Legal, filing, and other costs of forming the fund.

• Operational and administrative expenses: Diligence costs, legal fees for investments, compliance, and other routine expenses.

• Accounting and tax expenses: Tax returns, audits, and financial statement preparation.

Fund expenses are generally charged to the fund and reduce the overall capital available for investment (the fund’s “dry powder”). They are separate from management fees and typically do not include expenses solely related to the GP or management company (such as the GP’s office rent or partner salaries, unless specifically agreed).

Management Fees

Most venture funds charge an annual management fee to compensate the management company for operating the fund.

Typical features:

• Calculated as a percentage of committed capital (for example, 2% annually) during the investment period.

• Paid by the fund to the management company out of LP capital contributions.

• Used to cover operating costs such as team compensation, sourcing, travel, and general overhead.

Over the life of a fund, management fees can represent a substantial amount. For example, a 2% annual fee on a 10-year, $50 million fund can total around $10 million. Because this reduces investable capital, many agreements:

• Allow for fee reductions after the investment period (for example, stepping down to a lower percentage or basing the fee on net invested capital).

• Permit recycling of management fees, where certain fees paid can later be “recycled” into new investments, effectively increasing capital deployed.

Importantly, management fees are typically treated as an advance against overall fund returns. In many structures, these fees must effectively be “returned” through performance before the GP participates in carried interest.

Carried Interest and the Waterfall

Carried interest (carry) is the share of fund profits allocated to the GP, usually expressed as a percentage of the fund’s gains (for example, 20%). Carry is distributed according to the waterfall, which defines the order in which cash flows are distributed between LPs and the GP.

A simplified “European-style” waterfall often works as follows:

1. Return of capital: LPs first receive back their contributed capital (including the GP’s own commitment, treated like any other LP commitment).

2. Preferred return or hurdle (if applicable): LPs may be entitled to a minimum return (for example, 6–8%) before carry is paid.

3. Profit split: Once capital and any preferred return have been satisfied, remaining profits are typically split, for example:

   • 80% to LPs

   • 20% to the GP as carried interest

Example

• Fund size: $50 million

• Investment in Company A: $5 million

• Exit proceeds from Company A: $30 million

Total profit from this investment: $25 million ($30 million returned – $5 million invested).

If the fund is otherwise performing in line with its overall economics and is “in the money,” a basic profit split might look like:

• LPs receive:

  • $5 million return of capital, plus

  • $20 million (80% of the $25 million profit)

• GP receives:

  • $5 million (20% of the $25 million profit) as carry

Whether the GP may actually distribute this carry at the time of the exit depends on the overall fund performance and how the LPA defines interim carry distributions and clawback.

Valuation and Clawback

When exits occur before the full portfolio is realized, the LPA often allows interim carry distributions if:

• The portfolio, based on a reasonable valuation methodology, indicates that the fund would remain in a carry position even after later outcomes.

Common valuation approaches include:

• Last round valuation: Using the latest financing round valuation multiplied by the fund’s ownership.

• Comparable company model: Using valuation multiples from public peers, adjusted for illiquidity and other factors.

If later results show that the GP was overpaid relative to agreed waterfall thresholds, clawback provisions can require the GP to return a portion of prior carry distributions to restore the agreed LP-GP economics.

Hurdle Rates and Preferred Returns

Certain funds include additional performance thresholds:

• Hurdle rate: The GP is not entitled to carry unless the fund achieves a minimum return (for example, a 6–8% annualized rate).

• Preferred return: LPs receive all distributions until a stated annual return is met, after which carry may apply only to amounts above that threshold.

These mechanisms are designed to align incentives and ensure the GP participates in profits only after LPs have received a base level of return.

Structural and Governance Terms

Beyond economics, key fund documents address how the fund is run, what it can invest in, and how it accommodates different types of investors.

Fund Thesis and Strategy

While GPs typically have wide discretion within the fund’s strategic mandate, the LPA or LLCA usually includes a purpose clause describing:

• Target stage (for example, early-stage, growth).

• Target company type (for example, privately held, technology-focused).

• Sector or geography emphasis (for example, healthcare technology, B2B SaaS).

This framework:

• Sets expectations for LPs around how capital will be deployed.

• Provides boundaries for the GP’s investment activity.

LPs evaluate whether a GP’s thesis and strategy align with their own objectives, recognizing that they are committing to a blind pool where most investments are not yet known at the time of commitment.

Side Letters

As covered in more detail in the separate Side Letters guide, side letters are supplemental agreements granting specific LPs additional rights or modified terms.

They can cover:

• Additional information or reporting rights.

• Different fee or carry terms (for example, reduced management fees).

• Co-investment rights or capacity in specific deals.

• Provisions to address regulatory or policy constraints (for example, ERISA-related language).

Side letters are typically reserved for select investors (such as significant LPs or anchor commitments) and require careful tracking to ensure consistent administration.

Alternative Investment Vehicles

Certain LPs may face tax, legal, or regulatory constraints that make direct participation in the main fund impractical. In such cases, fund managers may use alternative vehicles, including:

Parallel Funds

• Established for LPs with distinct tax or regulatory needs (for example, non-U.S. investors).

• Generally mirror the main fund’s strategy and terms.

• Invest alongside the main fund, with allocations split pro rata based on committed capital.

Feeder Funds

• Organized as corporate taxpayers (for example, a corporation acting as a “blocker”).

• LPs invest into the feeder, which then invests into the main fund.

• The feeder pays applicable taxes, potentially simplifying tax obligations for certain LPs (such as specific non-U.S. investors).

Alternative Investment Vehicles (AIVs)

• Used for specific investments where certain LPs face unique constraints.

• Created to hold a single investment or subset of investments, rather than investing alongside the main fund in every deal.

Co-Investment Vehicles

• SPVs formed to invest alongside the fund in a particular company.

• Often used when the fund receives a larger allocation than it can take under portfolio construction constraints.

• May include existing LPs, new investors, or strategic partners who want additional exposure to specific companies.

Why These Terms Matter for Emerging Managers and LPs

For emerging managers, understanding fund economics and structures is critical because:

• These terms drive how you are compensated and how much capital you can deploy.

• They influence the kind of investors you can accommodate and how you build long-term LP relationships.

• They set expectations for performance, risk, and alignment over the entire life of the fund.

For LPs, these terms shape:

• How and when capital is called and returned.

• What net returns may look like after fees, carry, and expenses.

• How flexible the fund is in handling unique tax, regulatory, or policy needs.

Next Steps

If you are evaluating or designing a fund structure:

1. Map out your economic terms (fees, carry, expenses, waterfall) and ensure they align with your strategy and fund size.

2. Define your investment thesis and constraints clearly in the LPA and related documents.

3. Consider whether you need parallel, feeder, or co-investment vehicles to serve different LP types.

4. Limit side letters to truly necessary cases and ensure your operations can support any bespoke rights you grant.

To see how Sydecar can support fund and SPV formation, co-investment vehicles, and tax and reporting workflows in a standardized way, book a demo with a member of our team.