What Does Limited Partner (LP) Mean?
In the context of private equity, a limited partner (or LP) is a third party investor in a private equity fund. Private equity firms raise private funds in general partnerships where they manage the capital as the general partner. Investors are then canvassed for investment commitments up to a specific allocation for the fund. The investors who commit and subsequently invest in the fund become limited partners of the general partnership. As limited partners, they are passive investors with the income and expenses flowing directly to their hands to be taxed in the year when they accrue. The general partnership may pay out distributions from the cash flow generated by the investments (either via dividends or their sale) on any given year.
Divestopedia Explains Limited Partner (LP)
Limited partners only need to commit to the capital they will invest in a fund in order to participate. When an investment is identified, the general partner places a "cash call" based on every limited partner's commitment percentage.
While limited partners are passive investors, they have many ways to ensure their financial objectives are aligned with those of the general partner which manages the fund. Most of these ways are embedded in the general partner's 2 and 20 compensation mechanism. The 20 refers to the carry that the general partner earns only on the total returns that exceed the preferred return to the limited partners.
For example, if a fund earns 25%, the limited partner would get the first 8% (the preferred return) and 80% of the incremental 17% (the GP would get the other 20% of the incremental 17%). This ensures the GP only gets a carry when the limited partner earns its hurdle rate return. Furthermore, the limited partner can ensure the GP doesn't get more than the agreed carry by including clawback provisions in the compensation arrangements. Clawback provisions ensure that some carry is returned if some investments under perform after carry has been paid during the life of the fund.