What Is a Private Fund? How Private Funds Work

A private fund pools money from multiple investors and is overseen by a manager who makes decisions under a written agreement. Unlike a mutual fund sold to the general public, a private fund is generally offered only to certain eligible investors, often through a private placement. A private placement is a sale of interests that is exempt from full public registration, made by the issuer through its own offering documents.

Many private funds are organized as limited partnerships. The general partner (GP) manages the fund and carries management responsibility. The limited partners (LPs) contribute capital and generally do not take part in day-to-day decisions. This limited partner vs general partner split is the core of the private investment fund structure, and the details are set out in the fund's partnership agreement.

Eligibility often depends on SEC Rule 501(a), which defines an accredited investor. Categories include certain income or net worth levels, holders in good standing of Series 7, Series 65 or Series 82 licenses, and knowledgeable employees of the fund. The August 2020 amendments also added spousal equivalents, and entities or family offices with over $5 million in investments or assets, as well as registered investment advisers and exempt reporting advisers. Offerings typically rely on Rule 506(b), which prohibits general solicitation, or Rule 506(c), which allows general solicitation but requires that all purchasers be accredited and that the issuer take reasonable steps to verify their status.

Private funds have traditionally been structured as closed-end vehicles. Investors commit capital for a set term, and the fund generally does not allow redemptions on demand. Open-end funds, by contrast, may accept new money and permit withdrawals on a schedule set out in their documents. Which structure a fund uses affects how easily an investor can access capital.

Capital usually moves in stages. An investor makes a commitment, and the manager then issues capital calls (also called drawdowns) when the fund needs money for investments or expenses. Later, distributions may return proceeds to investors as the fund realizes investments, according to the order described in the fund's documents. Timing can be uncertain and varies by fund.

Investors have typically reviewed the offering documents, the partnership agreement and the subscription materials with their own attorneys, accountants and financial advisers. Many private funds report taxable results on a Schedule K-1 rather than a Form 1099. Some funds invest in companies that may involve Section 1202 qualified small business stock (QSBS), but tax treatment depends on individual circumstances.

The right fund manager may help you understand how a particular private fund is built, in plain language, before you decide anything. A first conversation is generally an educational discussion about the structure, the terms and how the fund describes its own approach. It is not a recommendation, and any offering is made only through the issuer's own documents.

Useful questions to ask include: How is the fund structured, and is it closed-end or open-end? How and when are capital calls made, and what happens if an investor cannot meet one? How and when might distributions occur? What fees and expenses apply, and how are they described in the documents? What reports will limited partners receive, and will I receive a K-1?

You may also ask how the manager communicates, how conflicts of interest are handled, and what the main risks are. Good managers are generally willing to explain these topics clearly. Bring your own licensed attorney, accountant and financial adviser into the process, since only they can speak to your circumstances.