Private market investment opportunities have grown substantially over the years, luring prospective investors with potentially lucrative returns. But while private markets have piqued the curiosity of investors, it still remains an ambiguous asset class. 

If you’ve thought about investing in the private markets, you’ve likely come across the concept of funds - vehicles that offer many benefits to investors, like access, diversification, and professional management. 

But learning the ins and outs of private funds can be confusing - you’re faced with new entity structures, transaction documents, and terminology never seen before.

Whether you’re considering your first fund commitment or looking to dial in your private market knowledge, this post will walk you through the fundamentals of how funds operate and what you can do to get involved.

What is a private fund?

At its core, a private fund is a pool of capital raised from investors to invest in or purchase private companies (i.e., companies that are not traded on the stock market). These funds are typically categorized as venture capital funds, which invest in high-growth technology startups, or private equity funds, which invest in or purchase stable, enduring businesses. 

Private funds are legal entities, typically established as a limited partnership or limited liability company. Within a fund, you have two core groups of stakeholders - Limited Partners (LPs) - who are passive investors, have limited legal liability, and provide most of the equity capital in a fund - and General Partners (GPs) - who are responsible for sourcing deals, performing due diligence, making investment decisions, and eventually exiting those investments 

This relationship between LPs and GPs is the backbone of every private fund, both in venture capital and private equity.

Understanding the GP and LP relationship

The GP-LP relationship is structured to align economic incentives and is governed by a legal contract called the Limited Partnership Agreement (LPA). This document outlines everything: how much the GP gets paid, how returns are split, what rights LPs have, and what happens if something goes wrong.

The GP earns two types of compensation: a management fee and carried interest.

The management fee is typically 1.5% to 2.5% of committed capital, paid annually to cover operating costs. Think salaries, office rent, due diligence expenses—all the things required to run a professional investment firm.

Here is an example of what this clause can look like in an LPA.

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Then there’s carry, short for “carried interest.” This is the GP’s share of the profits, often 20%, but only after LPs have received their money back plus a minimum return (usually around 8%). That minimum threshold is called the preferred return or hurdle rate and is common among private funds to ensure investors receive a minimum pre-determined return and to align economic incentives between the GP and LPs of a fund.

The order in which distributions are split between LPs and GPs is referred to as a “waterfall,” which we’ll cover further below. 

This setup gives the GP strong motivation to generate returns. If the fund performs well, they participate in the upside, but only after LPs earn the preferred return they are entitled to. If the fund doesn’t perform well, GPs still generate their management fees to pay for fund expenses and salaries, but won’t get any performance bonuses. 

Capital cycle of a private fund

When an investor commits to a fund, they’re not wiring the full amount on day one. Instead, the GP issues capital calls as needed, which often occur over the first few years of the fund’s life. This staged funding approach gives the GP flexibility and allows LPs to keep unused capital invested elsewhere in the meantime.

Here’s what a capital call clause could look like in an LPA. 

Once investments are made, the GP’s job is to help portfolio companies grow in value—through operational improvements, add-on acquisitions, talent upgrades, or strategic positioning. Over time, the GP begins to sell those positions (called exits) and return cash to LPs.

The timing of those cash flows is mapped out in a structure known as the waterfall. It dictates who gets paid, and in what order. In most cases, LPs receive their original capital back, plus the preferred return, before the GP receives any carry.

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Some funds divvy up profits on a deal-by-deal basis (called an “American waterfall”), while others structure their profit distributions based on the activities of the whole fund (referred to a a “European waterfall”). In the European case, the GP doesn’t earn carry until the entire fund clears the preferred return. Most institutional investors prefer the latter (it’s more conservative and aligns everyone for the long game).

What happens over a fund’s life

While some private funds are considered “evergreen”, meaning that they are open-ended funds with no fixed end date, most private funds are not evergreen. They often have a defined lifespan - typically around 10 years - and will occasionally grant extensions.

The first few years are known as the investment period, when the GP is actively raising and deploying capital into new deals. After that, the focus shifts to value creation and exits. Returns tend to come later in the fund’s life, which is why private equity is considered an illiquid, long-term asset class.

The general timeline looks something like this:

• Years 0–3: Fundraising, capital calls, early investments 
• Years 4-6: Value creation; the fund’s portfolio grows as companies scale 
• Years 7-10: Exits, distributions, and winding down the fund

Because cash is called and returned in stages, it’s common for investors to reinvest into new funds over time to maintain exposure. This is why seasoned LPs often commit to multiple vintages (i.e., subsequent funds which begin in later years) from the same manager.

Due diligence tips for LPs 

Not all funds are created equal. If you’re considering investing in a private fund, there are a few things to look for beyond performance projections.

• Track record: Has the GP generated real, realized returns? 
• Strategy clarity: Does the GP have a clear, repeatable playbook? 
• Skin in the game: How much of the fund’s capital is the GP committing personally?
• Alignment: Do the fund terms ensure the GP wins when LPs win and not before?
• Transparency: Will the GP share regular updates, audited financials, and full disclosure on fees?

Also, take a look at governance terms in the LPA - things like the key person clause (which pauses investing if a named team member leaves) or the no-fault divorce clause (which gives LPs the power to remove the GP under certain conditions). These don’t get discussed much in fundraising materials, but they can materialize in real life.

How Zest can help

Zest is digitizing private market transactions, building tools to streamline how entrepreneurs, funds, and investors transact. Our platform is designed to save you time and reduce administrative costs, simplifying the end-to-end transaction process.

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Get started with Zest today.

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