8 Legal Red Flags for LPs

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:

• Don’t budge on return of capital

• Return of capital strikes again

• Six reasons to put down a deck

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.

2. Excessive/Unrestricted Affiliate Fees

Real estate platforms often use affiliates for functions like property management, development management, construction, leasing, and more. Contracting with an affiliated entity is not inherently problematic. In many cases, the affiliated service provider might offer better, cheaper alternatives to third parties.

The red flag appears when the GP can hire affiliates without disclosure, set fees unilaterally, and make adjustments without LP consent.

In practice, all affiliated fees should be clearly disclosed in the offering documents of the fund or syndication, and any deviations should require approval from the LPs. As a diligence matter, you can confirm with the GP that all affiliated fees are disclosed.

3. No GP Removal “For Cause”

In real estate funds, assets are illiquid and capital is locked up for years.

If the GP commits fraud, engages in gross negligence, willfully misrepresents performance, or otherwise violates the law, there should be an ability for LPs to kick out the GP. Otherwise, the LPs may be left without a practical governance remedy.

While a GP removal right isn’t always present, it’s something to clearly understand prior to investing if you’re an LP.

4. Overly Punitive Consequences for Declining “Optional” Capital Calls

Real estate funds often include “optional” capital calls for capex overruns, rescue capital, or refinancing shortfalls. Basically, the GP says “more money please!” to the LPs.

Most real estate syndication documents have a procedure for these capital calls. However, some documents contain extremely punitive dilution for LPs that don’t elect to invest more than they originally intended.

Look out for punitive economic dilution, loss of voting rights, and other forfeitures. LPs shouldn’t be unfairly penalized for the GP needing to raise more capital than was originally intended.

A ton more on the topic of capital calls here:

• Two part series:

• Is my investment distressed?

• My deal is distressed, now what?

• 6 steps to a successful capital call decision

• Do sunk costs matter in capital calls?

• Will a rate cut(s) save distressed investments?

• Minimum Viable Capital Call

5. American Waterfall With No Carried Interest Clawback

Deal-by-deal (American) waterfalls are common in real estate. In these structures, the GP can take carry from winning investments before LPs receive a return of all capital from all investments (as would be the case with a netted (European) waterfall.

The vast majority of real estate funds with an American waterfall have a “clawback” at the end of the fund life that requires the GP to return excess carried interest from the winning investments to compensate the LPs for the losing investments.

An American waterfall with no clawback means the GP can make a bunch of money from carried interest while the LPs actually lose money and never receive a return of their original invested capital.

A bit more on this topic here.

6. Side Letters That Affect Other LPs’ Economics or Liquidity

Side letters (special deals between the GP and an individual LP) are common in real estate funds and syndications, but they’re problematic when they negatively affect other LPs.

Examples of provisions to look out for include:

• Certain LPs getting preferential redemption rights (those LPs can get out early)

• Certain LPs not being subject to fund-wide expenses (causing other LPs to bear those expenses)

• Certain LPs having the ability to approve exits

Side letters aren’t per se a problem. For example another LP receiving a carry or management fee discount doesn’t negatively affect other LPs. But as an LP, you might ask the GP as a diligence matter whether any side letters with other LPs exist.

I actually just wrote on whether side letters are beneficial to LPs recently - so this one was timely!

7. Investments in Other GP-Sponsored Deals or Vehicles

Always look out for affiliated sales and other transactions. In addition to the fees mentioned in point #2 above, funds and syndications might invest in, purchase from, or sell to GP affiliates.

These sorts of transactions are always something to diligence carefully, and they should be disclosed by the GP. Many times there are pretty significant conflicts of interest, which you’ll need to pick up on and analyze as the LP on either side of the trade.

As a diligence matter, pay close attention to how these transactions are valued, and whether a third-party appraiser or valuation firm is involved. Otherwise, the GP might be using an inflated/deflated value to benefit at the expense of LPs.

8. Deviations From What Was Marketed

As a general rule, the GP must invest in accordance with the marketing materials they prepare to solicit investments. Otherwise, they run the risk of engaging in securities fraud.

So if they start changing the investment strategy, levering up materially above what they originally modeled, or seeking preferred equity from outside sources to rescue an investment (which would sit in front of your common equity unexpectedly), you should give them a call.

Sometimes a slight pivot might be beneficial given market conditions, but wild moves should be cause for concern. Be sure to understand what explicit rights the GP has within the legal documents before you invest, but also recognize that there will always be an element of trust in these transactions (which is why the #1 of 3 pillars is the sponsor themselves as opposed to the deal).

Have a wonderful rest of the week, I hope this was helpful!

When you’re ready, I could help you in 2 ways - my email is aleksey@gplpmatch.com:

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