8 Legal Red Flags for LPs
A deep dive on what LPs should look for in legal documents
Happy Thursday!
I’ve written in depth on the three pillars of LP investments, but LPs can’t forget that a deck will never tell you everything you need to know from a legal perspective. Said another way, an investment might look great on the deck, but once you get to the legal docs your head will start spinning - not due to the length!
Today we’ll get through the top 8 things to look for as an LP.
I teamed up with Michael Huseby (an investment funds attorney and Managing Partner at TIL Partners) on this one, who you can follow on X, LinkedIn, or subscribe to his newsletter.
1. GP Receives Carry Before LP Return of Capital
This is one of the clearest economic red flags. If the distribution waterfall allows the GP to earn carried interest (aka promote) from capital events (most commonly a sale or refinance) before LPs have received a full return of invested capital, the structure is no longer profit-sharing – it’s priority compensation and capital shifting.
Absurd! But both Michael and I have seen it. In fact I’d recommend reading a few of these before you continue:
The waterfall might say cash from any source is distributed 50/50 among the GP and LPs, without the first step in the waterfall being a return of capital to LPs.
What this would allow would be a bizarre situation like this:
1. First, LP contributes $100.
2. Second, fund immediately distributes the $100 which, pursuant to the waterfall, would mean $50 to the LP and $50 to the GP.
Note that in some real estate funds and syndications, there are dual waterfalls where cash flow from operations is split 80/20 without a return of capital step … this would be different from their capital event waterfall, as we described it above. A split on cash flow waterfall is less problematic, so long as proceeds from sales and other dispositions contain a “return of capital” step to the LPs before the GP starts taking carried interest.