What Is an Investment Partnership and How Does It Work?
Explore the fundamental structure of an investment partnership, clarifying how capital, management, and risk are allocated between its different partners.
An investment partnership is a business structure created to pool capital from multiple investors. This collective capital is then deployed into various assets, such as real estate, stocks, or bonds, with the goal of generating returns. These partnerships are a common vehicle for accessing investment opportunities that might be unavailable to individuals, particularly in specialized areas like private equity and hedge funds. The structure brings together investors who provide the financial backing and a manager who provides the expertise, allowing for the pursuit of a focused investment thesis over a set period.
Core Structure and Key Roles
An investment partnership has two distinct roles: the General Partner (GP) and the Limited Partners (LPs). The GP is the active manager of the partnership, responsible for executing the investment strategy. This involves sourcing deals, conducting due diligence, making all buying and selling decisions, and managing the partnership’s assets on a day-to-day basis.
A defining characteristic of the GP is their unlimited liability, meaning their personal assets could be at risk to satisfy the partnership’s debts and obligations. This structure is intended to align the GP’s interests with those of the partnership, as they bear the ultimate financial risk for their management decisions.
Conversely, the Limited Partners are passive investors who provide the majority of the investment capital. Their role is strictly financial, as they commit a certain amount of capital to the partnership but have no involvement in the daily management or investment decisions.
The primary benefit for LPs is limited liability. Their financial risk is confined to the amount of capital they have invested in the partnership. Personal assets of the LPs are shielded from the partnership’s debts and losses beyond their investment commitment, making the structure attractive for diversifying portfolios.
Economic and Operational Mechanics
The funding process begins with capital calls. When the General Partner identifies an investment opportunity, they issue a “capital call” to formally request a portion of the capital that each LP pledged. This allows the GP to draw down funds only when needed, minimizing idle cash.
When an investment generates returns, profits are distributed to partners through a process known as the “waterfall.” First, all contributed capital is returned to the LPs. After LPs have been made whole, the remaining profits are split between them and the GP.
The GP’s compensation has two primary components. The first is a management fee, an annual fee charged to LPs to cover operational costs, typically ranging from 1.5% to 2.5% of assets under management.
The second component is carried interest, or a performance fee, which is the GP’s share of the investment profits. A common “2 and 20” model includes a 2% management fee and 20% carried interest. This fee is earned only after LPs receive their initial investment back, plus a minimum “preferred return” or “hurdle rate.”
Once this threshold is met, the GP receives their share of any additional profits. For example, on a $10 million profit from a fund that has already returned all LP capital and met its preferred return, the GP would receive $2 million and the LPs would receive the remaining $8 million.
Taxation of Investment Partnerships
Investment partnerships use pass-through taxation, so the entity itself does not pay income taxes on its profits. Instead, all income, gains, losses, and deductions are “passed through” directly to the individual partners. This avoids the double taxation that occurs in a corporate structure.
Each partner is responsible for reporting their share of the partnership’s financial results on their personal tax returns. To facilitate this, the partnership provides each partner with a Schedule K-1 (Form 1065). This document details the partner’s specific share of income and loss for the tax year.
The K-1 separates different categories of income, such as ordinary business income and capital gains, because they are subject to different tax rates. Partners use the information from the K-1 to report these amounts correctly on their own Form 1040.
Partners must also track their “tax basis” in the partnership, which is their economic investment for tax purposes. It starts with the initial capital contribution and is adjusted each year for contributions, profits, distributions, and losses. Tracking basis is important because distributions are tax-free up to the basis amount, and it determines the gain or loss recognized when a partner sells their interest.
Formation and Key Documentation
The creation of an investment partnership involves establishing a formal legal structure and preparing documents that define its operation. The first step is choosing the appropriate legal entity, which is most commonly a Limited Partnership (LP) or a Limited Liability Company (LLC).
Two central documents govern the partnership: the Partnership Agreement and the Private Placement Memorandum (PPM). The Partnership Agreement is a legally binding contract among the partners that details their rights and obligations, the economic arrangements like the distribution waterfall, the investment strategy, and the term of the partnership.
The Private Placement Memorandum is a disclosure document provided to prospective Limited Partners. It details the investment objectives, risks, the GP’s track record, and the terms of the partnership. The PPM gives potential investors the information they need to make an informed decision and to comply with securities regulations.