Equity management
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Designing a Phantom Option Plan for an NBFC
The total amount an investor (Limited Partner) has pledged to contribute to a fund over its lifetime. Committed capital represents a binding legal obligation, though it is typically not deployed all at once. Instead, capital is drawn down via capital calls as the fund identifies investment opportunities.
Let’s say an LP commits $10 million; he is obligated to provide the funds upon request. And capital is deployed in stages as and when needed.
A capital call is a formal request from the General Partner asking Limited Partners to provide part of their committed capital. Capital calls usually follow the investment schedule and must meet the notice periods set in the LPA, typically 7 to 14 days.
Most PE funds issue capital calls every 6-12 months during the active investment period, while VC funds may have irregular calling patterns aligned with deployment opportunities.
Drawn capital / PIC is the amount the LPs have actually invested in the fund. Unlike committed capital, PIC reflects the actual amount invested. This is used to calculate the management fees and performance results.
Calculation: Paid-in Capital + Uncalled Capital = Total Committed Capital
Uncalled capital is the portion of committed capital that the fund has not yet drawn down. Limited Partners need to be ready to provide this money in the future. It stays on their balance sheets as a potential obligation and is tracked throughout the fund’s life.
Capital commitment is the investor’s promise, as emphasised in the LPA. Limited Partners are obligated to provide capital that lasts throughout the fund’s term and beyond.
The smallest amount an investor may commit to a fund typically ranges from $500,000 to several million dollars, depending on the fund's strategy. Minimum subscriptions help fund managers maintain operational efficiency and ensure LP commitments reflect meaningful economic interest.
A payment made by the fund to its Limited Partners, returning either their contributed capital or profits generated from successful investments. Distributions occur when portfolio companies are exited or generate dividend proceeds and represent the primary means by which LPs receive returns on their investment.
The sequential order, as specified in the fund's Limited Partnership Agreement, in which realised returns from exits are allocated among LPs and GPs. The waterfall model is a set to share profits and protect LP capital
Typical Structure:
Note: Waterfalls can be structured on a "whole-of-fund" basis (European model) or a "deal-by-deal" basis (American model), which materially affects GP compensation timing.
20% above the preferred return threshold is the GP's share of the fund’s profits. Carried interest is the primary performance-based compensation and aligns with the GPs' incentives with LPs' returns. Carried Interest is totally different from the management fees.
Common practice is to pay 20%, but emerging managers might accept 10-15%, and top-performing firms can sometimes get 25% or more, depending on their past performance.
The management fee is an annual charge levied by the General Partner to cover the fund’s operating costs, including staff, compliance, and administration. It is usually 1.5 to 2% of committed capital or assets under management, and is paid regardless of how the fund performs.
Management fees are usually collected quarterly or annually from the fund’s bank account. This regular schedule helps Limited Partners plan for expenses.
Performance fees are similar to carried interest and are paid to the general partner for returns above predetermined targets. Unlike the management fees, performance fees depend on the results and link the GP’s pay to the investment’s success.
The preferred return is the minimum rate Limited Partners must get before the General Partner can earn carried interest. This rate is usually set at 8 to 9% per year and acts as a benchmark to protect LPs by requiring strong returns before the GP shares in profits.
The hurdle rate ensures that General Partners earn carried interest only if they create real value above the preferred return. This helps align the interests of investors and fund managers.
Return of capital is the first step in the distribution process, where Limited Partners get back their original investment before any profits are shared. This approach protects LPs by making sure they recover their money first.
The GP catch-up lets the General Partner receive all profits for a period, rather than just their usual share, until their total profit reaches the agreed percentage. This helps balance out differences from earlier deals.
Example: If the carry rate is 20%, but early deals generated high returns, causing GP participation to exceed 20%, the catch-up allows the GP to receive profits at their standard 20% rate on subsequent distributions.
A Clawback provision requires the GP to give back the excess of carried interest to the LPs if, at the end of the fund, they received more than they should have based on the actual results. This will protect the LPs from GPs keeping profits that don’t align with the fund’s overall performance.
Clawback provisions are important because, if the market drops or late-stage investments do poorly, they can require General Partners to return a large portion of earlier profits.
An escrow account is a separate account that holds part of the General Partner’s carried interest as security in case a clawback is needed. Usually, 25% to 100% of GP distributions are kept in escrow until the fund ends to ensure the money is accessible.
Distribution recycling means reinvesting money from successful exits into new investments instead of paying it out to Limited Partners right away. This lets General Partners use capital more efficiently and keeps LPs invested in the fund.
General Partners of the fund manage and decide on investments, handle administration, and communicate with the LPs. GPs also invest their own money alongside the Limited Partners, aligning their interests and earning management fees and carried interest based on their performance.
General Partners are responsible for implementing the fund’s strategy, overseeing portfolio companies, complying with regulations, and reporting to investors.
A passive investor providing capital to the fund with limited liability (capped at their investment amount) and limited decision-making authority. Limited Partners rely on the GP's expertise and actively monitor fund performance through regular reporting and investor meetings.
All parties' i.e., limited partners' and general partners' rights, responsibilities, and procedures are outlined in this extensive legal document that governs the fund’s operations. Capital commitments, distribution waterfall terms, fee structures, GP obligations, LP governance rights, clawback clauses, and dispute resolution procedures are all outlined in the LPA.
Document Length: LPAs are typically 50-150+ pages reflecting the complexity of PE fund structures and the need to address numerous contingencies.
Subscription agreements are documents executed by an LP upon formally committing capital to the fund, incorporating the LPA and including the investor’s accreditation status, investment authority, and risks.
A private bilateral agreement that changes the fund terms for a particular LP and GP. Most-favoured nation clauses, fee reductions, improved reporting, co-investment rights, and board observation privileges are examples of common side letter clauses. To prevent unintentionally creating conflicts or claims of preferential treatment, side letters must be closely monitored.
Governance: The majority of LPAs mandate that side letters adhere to fund economics, side letters that are overly advantageous may lead to conflicts with other LPs.
A fund vehicle that invests in other professionally-managed funds rather than directly acquiring companies. FoF structures provide LP diversification across multiple GP strategies and sectors but introduce additional layers of fees (both the FoF management fee and underlying fund fees).
A fund vehicle where Limited Partners commit capital without prior disclosure of specific portfolio company investments. This structure grants GPs maximum flexibility to pursue opportunities as they arise in the market. Most institutional PE and VC funds utilise blind pool structures.
Advantage: Enables GPs to undertake time-sensitive trades while preserving competitive advantage without needing LP approval for each trade.
A new investment fund structure is formed when a current fund is nearing the end of its term, but holds promising companies in its portfolio which need further time for development. The GP responds by giving the current investors an option of either exiting through secondary sales facilitation or rolling over into a continuation fund.
The per-share valuation of a fund is calculated as: (Total Assets - Total Liabilities) / Number of Units Issued.
NAV is a measure of current estimate of its worth and is calculated usually on a quarterly basis by an independent organization. It is communicated regularly to LPs. Regular NAV reporting to LPs provides transparency into fund performance and portfolio valuation.
The annualized discount rate equalizing the net present value of all cash flows to zero. IRR accounts for both investment magnitude and timing of cash flows, making it the preferred metric for comparing investment returns across different time periods and fund strategies.
Application: IRR is the standard for benchmarking fund performance against peers and comparing against alternative investment options.
The proportion of cumulative cash distributions to cumulative capital infused by Limited Partners. DPI is an indicator of actual returns achieved on investment, showing how much cash has been returned to LPs in actuals. A DPI of 1.5x implies LPs have gotten back 1.5 times their capital in cash distributions.
Formula: Cumulative Distributions Received / Cumulative Capital Paid-In = DPI
It is a measure of overall return that takes into account both realised distributions and the net value of portfolios, measured as a multiple of paid capital. TVPI helps to present a complete picture of an investors or a fund’s performance because it takes into account both realised and unrealised values.
Formula: (Cumulative Distributions + Current Unrealized Value) / Cumulative Paid-In Capital = TVPI
The current unrealised value of the remaining portfolio investments, in terms of paid-in capital. RVPI reveals the potential for value creation that is left in the portfolio investments of the fund, which is reflected in the LP’s expectations of future distributions.
Formula: Current Unrealized Portfolio Value / Cumulative Paid-In Capital = RVPI
Gross return multiple - total return inclusive of realised and unrealised, divided by capital invested. MOIC is less accurate than IRR but much simpler, as returns are not discounted for their time value.
IRR vs MOIC: While IRR accounts for timing differences, MOIC focuses on the magnitude of the absolute value created.
The J-curve or the normal performance trajectory of PE funds initially reports returns as negative, as upfront management fees and expenses lower returns in the fund cycle; returns then improve as portfolio companies mature and successful exits generate profits. Understanding the J-curve helps LPs maintain realistic return expectations during a fund’s early years.
The first closing is when the initial batch of Limited Partners’ subscriptions is locked in, marking the start of capital inflows into the fund. First closing does not mean that the fund is closed to new Limited Partners; in most instances, funds remain open for several months.
The time limit after which no further Limited Partners can enter the fund. The final close of a fund indicates the finished stage of fundraising and the full commitment of the GP to the management activities of the investment.
The phase during which the GP actively solicits capital commitments from LPs. Fundraising typically requires 12-24 months for institutional PE funds and involves developing materials, conducting investor presentations, completing due diligence, and negotiating terms.
The period in which the GP is actively investing in portfolio companies, which, in general, is for approximately 3-5 years in the case of buy-out funds. The fund then phases out and starts working on the portfolio optimization to exit strategies after this period terminates.
The final stage of a fund’s life is when the investment period has elapsed, and the GP will start harvesting assets through exits. The harvest stage will feature fewer new investment transactions, along with increasing distribution transactions due to the exits.
The estimated time between acquisition and the exit of the portfolio companies. The most common hold periods are: 5-7 years for buyout investments, while venture investments can be held for 7-10 years due to the need to create value and mature the market.
The typical lifespan of a fund is usually 7-10+ years for a PE fund. The lifespan of a fund will include the investment period, harvest period, as well as the wind down activities. Extensions of the term of the fund are possible in the majority of LPAs after approval by the LPs.
The act of a prolonged term of the fund, usually by a period of 1-3 years, in order to give the portfolio businesses more time to develop. Such extensions require LP approval, which may have new economic terms for the existing LPs.
Capital is committed but not yet deployed into portfolio investments. Dry powder is the reserve of capital held by the fund for future acquisitions and is one of the most important metrics for capturing the deployment pace and remaining investment capacity of the fund.
The price at which an asset would exchange between a willing buyer and willing seller in an arm's-length transaction. For publicly traded securities, fair value is typically the market price. For private companies, fair value requires professional judgment and is often supported by comparable company analysis or recent transaction data.
Marking securities at their current market price when such prices can be observed (usually for marketable securities) or at the estimated market price when the price cannot be observed. Most fund accountants value the portfolio companies at current realistic market values instead of acquisition cost.
The ratio of company value to a financial metric (typically EBITDA or revenue) used as a shorthand for valuation. If a company is valued at 10x EBITDA, the valuation equals 10 times annual EBITDA. Valuation multiples vary significantly by industry, growth rates, and market conditions.
A commonlyused proxy for operating cash profitability in valuing private companies. It removes the impact of capital structure, tax rates, and accounting policies and allows comparison of normalised performance across portfolio companies.
Usage: EBITDA multiples are the main valuation framework in PE with acquisition and exit multiples having immense importance in return calculations.
The equity multiple used by a fund to purchase an LBO investment. The Entry multiple is contingent upon market conditions at the point of purchase and determines performance improvements required for a favourable exit multiple.
The multiple at which the portfolio company is actually sold. The expansion of exit valuations relative to entry valuations is the key driver of PE portfolio returns, creating value for the portfolio company.
An increase in the valuation multiple from entry to exit, which significantly adds to PE returns. Multiple expansion refers to a situation where the market places a higher multiple or valuation on the firm at the time of exit than at the time of entry.
An individual or entity meeting SEC-defined criteria—typically $200,000+ annual income ($300,000+ for married couples) or $1,000,000+ net worth (excluding primary residence). Accreditation determines eligibility to invest in most private funds and is verified through standardized documentation.
An investor meeting heightened sophistication requirements—typically $5,000,000+ in investments or $25,000,000+ in net worth. Qualified purchaser status qualifies investors for additional private fund opportunities with higher complexity or risk profiles.
This form is to be submitted within 15 days after the first receipt of capital from private funds. Disclosure of Form D helps the SEC monitor private offerings. Filing Form D does not mean approval or endorsement by the SEC.
Requirement: Failure to file the form D within the stipulated time periods qualifies as a compliance violation.
State securities rules pertaining to intrastate offerings and interstate offering provisions. There are state regulations and rules to be complied with at the state level. National distributions for offering funds must comply with the Blue-Sky Laws.
Regulatory frameworks requiring funds to verify investor identity, understand investor financial backgrounds, and prevent facilitating money laundering or terrorist financing. Most funds implement sophisticated KYC/AML procedures complying with federal requirements and fund compliance policies.
A business in which the fund has invested. Portfolio companies range from early-stage startups (in VC funds) to established businesses (in buyout funds) and are the primary vehicles through which funds generate returns.
An acquisition made by a portfolio company that seeks to enhance business operation, revenue or market share. Add-on acquisitions are one of the major tools private equity uses to create value, as they leverage management infrastructure to integrate new assets.
Borrowed capital used to finance portfolio company acquisitions, typically representing 40-60% of transaction value. Leverage amplifies equity returns in positive scenarios but magnifies losses during downturns, requiring careful debt structuring and covenant management.
A transaction in which a portfolio company takes on additional leverage to fund a dividend distribution to equity holders, namely the fund. Dividend recaps permit the fund to return capital before full exit, but they do increase portfolio company financial leverage and risk.
Cash and short-term assets are required for the portfolio company’s day-to-day operations. Changes in working capital requirements materially impact fund returns and require careful management during portfolio company growth.
When a portfolio company exits, the profits or losses actually received are “realized gains/ losses”. This represents actual cash generated and becomes final upon exit.
Estimated profits or losses from portfolio companies not yet exited. Unrealized values are subject to revision as company performance evolves and exit opportunities develop.
A company’s acquisition is typically financed with debt, where the company’s assets serve as collateral, and the buyer paying a small amount of equity. LBOs are the foundational PE transaction type and typically require significant operational improvements to service debt and generate attractive returns.
Investing in established, profitable companies to fund expansion initiatives while maintaining founder involvement and company culture. Growth capital providers accept lower leverage and longer hold periods than buyout investors in exchange for sustainable growth opportunities.
Investment in early-stage, high-growth companies with significant risk tolerance and long hold periods (7-10+ years) in pursuit of substantial returns. VC returns are typically concentrated in a small percentage of portfolio companies that achieve exceptional success.
For existing fund LP interests, a trading market that enables the LP exits before fund termination. Secondary prices typically reflect discounts to fair value, reflecting illiquidity and remaining fund duration.
When used as a verb, “Sponsoring” a transaction means assuming ownership and management responsibility, with the GP or the investor controlling a fund or transaction.
LPAC is a representative group of LPs providing non-binding advice to the GP on governance matters, conflicts of interest, and significant decisions. Typically, it includes representatives from major LPs and meets periodically to discuss the fund strategy and operations.
An LP's request to exit its fund investment prior to fund termination. Most funds restrict redemptions to fund exit or specific dates, limiting early LP liquidity.
The Lock-up Period is typically 5-7 years for PE funds. It is a contractual restriction that prevents LP redemptions for a specified period. Lock-ups corroborate the stability of the capital for fund deployment and portfolio company management.
An LP investment in a specific portfolio company alongside the fund, typically at favorable terms (excluding fees and carry). Co-investment provides LPs with enhanced exposure to promising opportunities.
A side letter provision ensuring that if another LP receives more favorable terms, this LP automatically receives equivalent terms. MFN clauses reduce incentives for GPs to provide divergent terms and ensure consistent treatment of similarly situated LPs.
