Dealing with defaults

Before you get medieval on your wayward LP, pursue a policy of discourse and tact. By David Snow, Editor

Private equity investing, typically marked by cooperation among many partners, thrives only in markets that benefit from a rule of law, and therefore it might be said that among the things that all serious participants in this industry agree on, near the top is the sanctity of the capital call obligation, which requires a limited partner to act quickly and totally to numerous GP requests for money over the life of a fund.

In short, once you've signed up for a limited partnership, you really do have to wire in money when the GP asks for it-no ifs, ands or buts about it. Failure to honor a capital call is seen by many as among the most egregious violations of the partnership agreement, and as such the legal language surrounding this contingency is among the strongest of the LP documents.

The standard penalties applied to an LP who defaults on a capital call are draconian. Among them: f An interest penalty begins accumulating on the unpaid amount, often at a rate of prime plus 2 to prime plus 6 percentage points

  • ? The defaulting LP no longer has voting rights in the partnership
  • ? The defaulting LP loses the right to receive reports from the GP
  • ? The defaulting interest in question is automatically sold
  • ? The capital account of the defaulting LP is slashed in value, with that value automatically distributed to the ?good LPs
  • The most ominous of the default provisions found in private equity partnership agreements is language that says something to the effect of, ?The GP may choose any other remedies to penalize the defaulting LP. A lawyer who represents institutional private equity investors refers to this open-ended option as ?getting medieval, such are the many unimaginable and painful surprises in the defaulters dungeon.

    Default provisions are draconian enough to keep LPs focused on the seriousness of their obligations to the partnership. But in most situations where the threat of default looms, implementing or even threatening medieval remedies is neither necessary nor the most efficient policy for keeping the partnership in good operating condition.

    According to legal experts, as well as investor relations professionals at private equity firms, before the letter of the law is applied, the spirit of partnership investing should first be pursued in the form of dialogue, education and seeking to help the LP with what is most often a problem that can be solved outside of the default provisions.

    All professionals interviewed for this article said the overwhelming number of threatened and actual defaults in their years of private equity fund management had come from high net worth individual investors. People, distinct from institutions, are exposed to life events that can prevent them from honoring a capital call: people can get divorced and suffer related declines in net worth; people die; they can suffer business and investment losses that evaporate the capital they had planned to use for draw downs.

    Peskier still, people are prone to change their minds when markets change, and unfortunately individual investors are also most likely to be unaware of the penalties for walking away from a fund commitment. They may be similarly unaware that the GP must approve any transfer of their partnership interest. Finally, while many high net worth individuals are extremely sophisticated and savvy investors, some have been known to become aggrieved more easily than other types of investors, and to act on perceived slights by refusing to honor capital calls.

    It is important for a private equity firm to have a policy on how to respond to defaults or the threat of defaults. But because most of these situations involve individuals – often confused, angry or financially distressed individuals – the policy needs to be responsive to various scenarios and personalities. For lack of a better term, it should be touchy-feely, at least in the initial stages.

    An investor relations professional who currently works at a fund of funds says that in his many years in the private equity industry, he has never placed an LP in default. But he has on many occasions received warning or notice that an LP was about to default. Each case was different, but the IR pro says that in all cases the issue was resolved short of placing the LP in actual default.

    ?You work with people, as long as they're reasonable, says the IR pro. ?As the sponsor of investment funds, you don't want to be the bad guy.?

    This IR pro says he was working at a fund of funds in the early 2000s as the tech bubble was collapsing: ?I remember fielding a lot of calls from LPs saying, ?I don't want to fund this thing – what are the penalties?? he says. ?A lot of them were dotcom executive types who were investing in our deals with funny money. They woke up one day and they weren't worth $100 million; they were worth $1 million.?

    With regard to an LP who simply cannot afford to respond to a drawdown, the IR pro says his firm's policy is to first seek to help the LP by arranging a sale of the interest in question. A discreet offer is first sent to the existing LP base – a usually appreciated signal that these investors enjoy access to investment opportunities before outsiders. If a transfer cannot be arranged within the fund, says the IR pro, then the opportunity is presented to outside buyers. ?A good GP ought to have a list of approved secondary players, he says.

    In ?the old days of 2001 and 2002, default-destined LPs had few good alternatives but to accept the interest-transfer terms of the G P. Those that could have sought better deals for themselves were often totally unaware of the limited secondary market options they had. ?We'd usually tell them that we'd take over their payments, sort of like what the bank does when it repossess your car, remembers the IR pro. ?We'd say, We'll give you 30 cents on the dollar for your NAV and the defaulting LPs would take it, he says.

    Now, the secondary market, even for smaller partnership interests, is better developed, and individual-investor LPs are more likely to be aware of their options, and not accept a ?take it or leave it ultimatum from the GP. That said, if an investor feels that the GP has responded to a pending default with a good faith effort to transfer the interest at something near a market valuation (see guest article p. 20), he or she may be entirely satisfied.

    Limited partners, especially high net worth individuals who haven't taken the time to study their default provisions, are not always reasonable. At this point, the touchy feely stuff ends and the tough love begins. The LPs are informed explicitly about the default penalty provisions and that these are an option. ?I've never put an LP in default, but I've certainly threatened it, says the IR pro. ?If people become unreasonable, I turn them over to the lawyers. After that they come to their senses.?

    The threat of default almost always comes amid poor fund performance. In these situations, angry LPs are often sophisticated enough to allege more than simple bad luck. An attorney who advises institutional investors on partnership matters says he has seen numerous instances where institutional LPs have pondered a default threat because they believed the GPs had gone off-strategy essentially breaching their fiduciary duty

    But the legal source says he consistently warns his clients that ?the leverage is with the GP in default matters, no matter how blatant a violation of the partnership agreement an LP sees. ?An LP has a Hobbesian choice at that point, he says. ?We always advise our clients that unless there's something egregiously wrong, you should pay your capital accounts.

    Here again, a private equity firm facing a default-threatening LP is advised to first choose dialogue and flexibility While in most cases an LP will be unable to ultimately succeed in using breach of fiduciary duty as a justification for a unilateral default, the spectacle of it all can cause reputation damage to the GP. While it may seem unfair to the GP, an aggrieved LP – especially an institution -should in many cases be given the same treatment as one that simply can't pay for lack of funds. The legal expert says he has worked on cases where ?an LP will go to the GP and say, look, you're violating the partnership agreement left and right. The GP might say, you know what? If you go away quietly you can go away. They can't give them their money back, because that would be a distribution in preference to that one LP. But the GP might be able to buy the interest or arrange for its transfer. In today's robust private equity market, LPs are more likely to beg to get into a fund than out. But cycles can turn on a dime, and investment atmospheres can suddenly become imbued with politically inspired activism or regulatory zeal. A prudent private equity fund manager will therefore always be ready to gingerly respond to an LP who hears the capital call, but won't respond.

    Letter of the law
    Below are excerpts of the default penalty provision language from the PPM of a US fund of funds, the identity of which is being obscured.

    The Members agree that prompt payment of a Capital Call and of any amounts required to be paid by the Members?is of the essence, that failure of any Non-Managing Member to make such payment or the Manager to fulfill its Manager Funding Obligation will cause irreparable harm to the Company and the other Members, and that the amount of damages caused by such harm will be difficult to calculate. Accordingly the Members agree that if a Non-Managing Member shall fail to fund a Capital Call or fulfill any of its obligations?within twenty (20) days of the due date set forth in the Funding Notice or other applicable notice, or such other longer period as the Manager may in its sole discretion permit, or the Manager fails to fulfill its Manager Funding Obligation, such Member shall be in default.

    Upon any such default, the Manager will have the option, but not the obligation, of offering the opportunity to assume the remaining unpaid Capital Commitment (?Default Interest?) of the defaulting Member in the Company to the non-defaulting Members, on a ?first-come, first-served basis. If the Manager offers the opportunity to assume the defaulting Member's Default Interest to the non-defaulting Non-Managing Members, it will do so by means of a written offer. Any non-defaulting Non-Managing Member may accept such offer by providing written notice to the Manager to such effect within twenty (20) days after the offer has been made. Any such written acceptance of the offer must specify the portion of the Default Interest the accepting Non-Managing Member is willing to purchase. If no such notice is received by the Manager from a non-defaulting Non-Managing Member within twenty (20) days after the offer has been made, such Non-Managing Member shall be deemed to have rejected the offer. The Manager will also be permitted to assume the Default Interest or to assign its rights to assume the Default Interest to one or more Affiliates. If there remains an unassumed portion, the Manager may offer such remaining Default Interest to third parties. Any Member and any third party that assumes the Default Interest of a defaulting Member will be allocated any income or gain (and receive related distributions) that would have been allocated to the defaulting Member had the Member not defaulted.

    A Member that fails to make its required Capital Contributions to the Company when due will thereafter share in losses of the Company, if any, to the extent of its Capital Account, but not share in any income or gain, and will be subject, in the sole discretion of the Manager, to one or more of any of the following: (i) having its return of capital, if any, withheld until the dissolution of the Company, (ii) being prohibited from participating in any future draw downs of its Capital Commitment and (iii) facing forfeiture of its interest and redistribution of its Capital Account pro rata among the remaining Members.

    The remedies provided in this Section 3.4 are in addition to and not in limitation of any other right or remedy of the Company provided by law, at equity or under this Agreement.