The growth of private lending funds has accelerated dramatically, with more sponsors than ever launching debt vehicles to meet investor demand. While the opportunity is substantial, the structural decisions made during fund formation can determine whether a fund thrives or collapses under its own complexity. Geraci LLP has spent years advising fund sponsors on the legal architecture of debt funds, and certain recurring mistakes continue to surface. Here are three of the most consequential pitfalls to watch for when building or restructuring a private lending fund.
Overexpanding the Fund’s Investment Mandate
Perhaps the single most damaging structural error a fund sponsor can make is creating an investment mandate so broad that it loses coherence. The temptation is understandable: a wider mandate theoretically opens more doors for deal flow and revenue. In practice, however, an overly expansive mandate creates significant legal and operational challenges that can undermine the entire fund.
Consider a fund that attempts to encompass traditional private lending, commercial real estate development, marketable securities, international loan origination, and cryptocurrency investments all under one vehicle. From a compliance perspective, each additional asset class introduces its own regulatory framework. Fee structures must account for dramatically different risk profiles. Distribution models become unwieldy. Disclosure obligations multiply, particularly when investments cross into territory governed by the Investment Advisers Act of 1940 and the Investment Company Act of 1940.
Beyond the legal complexity, the practical consequences are equally problematic. Investors evaluating a fund expect to understand what they are investing in. A sprawling mandate creates confusion about risk exposure, expected returns, and the sponsor’s actual area of expertise. When an investor cannot clearly articulate what a fund does, capital raising becomes significantly more difficult.
The economic risks compound this problem further. When a fund’s strategy spans multiple asset classes without properly modeling the economics for each, the sponsor risks promising returns it cannot deliver. Misaligned fee structures and unrealistic yield expectations lead directly to investor disputes and, ultimately, litigation.
The solution is disciplined focus. Define a clear investment thesis, structure your economics around that thesis, and resist the urge to make the fund a catch-all vehicle.
Creating Unnecessarily Complex LP Class Structures
Offering multiple limited partner classes is a common technique for attracting investors at different commitment levels. Larger investors receive preferential economics or enhanced liquidity rights, while smaller investors accept more standard terms. In concept, this tiered approach makes strategic sense and can be an effective capital-raising tool.
The problem arises when the class structure becomes so granular that the differences between tiers are effectively meaningless. Fund sponsors sometimes create four, five, or even six LP classes where the after-tax difference in returns between adjacent classes amounts to less than 50 basis points. At that point, the complexity of maintaining multiple classes, including separate accounting, reporting, and compliance obligations, far outweighs any marketing advantage.
Each additional LP class also increases the operational burden on the fund manager. Distribution waterfalls become more complicated. Investor reporting must be tailored to each class. And any modification to fund terms requires analysis across every class to ensure consistency and fairness.
The better approach is to limit LP classes to two or three meaningfully differentiated tiers. Each class should offer a clear and tangible benefit that justifies the additional administrative overhead. If you cannot articulate a compelling reason for an investor to choose one class over another, consolidation is the smarter path.
Structuring Compensation in Ways That Create Investor Conflicts
Most fund sponsors understand the importance of keeping management fees within market norms. However, one area that has generated increasing scrutiny in recent years involves origination fees and how they are allocated between the fund and the fund manager.
Historically, it was standard practice for the fund manager, acting as the originator, to retain all origination fees generated by loans made through the fund. This arrangement was widely accepted. Over the past several years, however, Registered Investment Advisers and institutional allocators have begun challenging this structure as a potential conflict of interest.
The argument centers on incentive alignment. When a fund manager retains all origination fees, the economic incentive shifts toward originating new loans rather than managing existing assets for optimal performance. Whether one agrees with this characterization or not, it has become a meaningful objection during the capital-raising process, particularly when courting RIA-managed capital.
Fund managers who intend to raise capital through RIA channels should anticipate this objection and address it proactively during fund formation. Options include sharing origination fees with the fund, capping origination fees as a percentage of assets under management, or structuring a fee offset mechanism that credits origination income against management fees.
Building a Debt Fund That Attracts and Retains Capital
These three structural issues represent some of the most frequently encountered challenges in fund formation for private lenders. Each one is avoidable with proper planning and experienced legal counsel. If you are evaluating an existing fund structure or planning a new vehicle, the attorneys at Geraci LLP can help you design a fund that balances sponsor economics, investor expectations, and regulatory compliance. Contact our Corporate and Securities team today to discuss your fund formation needs.
