In the beginning weeks of the covid-19 crisis in Europe and the US, GPs struggled to imagine large LPs defaulting on capital calls. But, at least in Europe, the defaults have already begun, according to one source.
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“I have seen two European LP defaults since the crisis started and more are likely to happen,” said Eamon Devlin, partner at MJ Hudson. When asked to name or identify the kind of investors that defaulted, Devlin declined to comment. Other European sources have related a market rumor, which has not been verified, that a “large” pension fund defaulted. No verifiable reports of defaults on subscription line facility-backed commitments have been made.
Market players have suggested that selective defaults could arise because of the denominator effect, but LPs are also getting hit with a dry-up of distributions as realization events slow, and in some cases GPs use ‘recycling’ clauses to reinvest the distributions they would have made. “Suddenly [LPs’] distributions are going through the floor,” Devlin said. “At the same time, GPs have increased their capital call rates. Some LPs weren’t expecting draw-downs until summer this year on any of their funds.”
Devlin also said that there have been very early discussions among GPs of creating, effectively, ‘bad funds’ – the private fund equivalent of ‘bad banks,’ in which a separate entity is created for non-performing assets.
GP remedies for an LP default are highly punitive (see box out). But there are a number of situations in which a denominator effect-minded or liquidity-crunched LP might more easily walk away. New funds (especially those of new managers) where no capital has yet been called are relatively painless to cut ties with. And older funds, where LPs have received much of their invested capital and distributions already, might also be vulnerable. That’s even truer for end-of-life funds, in which the remaining, unsold assets are often of lower quality than the ones that have already been realized.
In a matter of days, the idea of LP defaults has begun to be taken more seriously by firms. That’s in part because no one really knows how many defaults there were during the last great crisis in 2008. “It’s commonly said there were very few LP defaults during the GFC,” Devlin said. “But it’s not like there’s a database that says how many LP defaults there were. These are almost NDA situations.”
Two US-based CFOs recently said that high-net-worth investors posed the greatest risk of default – especially those residing in areas badly affected by covid-19 – but that those would be relatively small. Both characterized a HNWI default as a logistical issue, not an issue for the fund’s ability to operate.
One of the CFOs likened LP liquidity to toilet paper; there isn’t necessarily a shortage of it in this crisis, but “people are buying more than they need; eventually there will be a shortage. If it goes on for long enough, a liquidity crisis is inevitable.”
‘Eventually’ was the operative word for CFOs talking to Private Funds CFO; and a number of possible strategies for managing around a small default were floated, including going out to other investors to call more capital from them on a pro rata basis, extending the use of a subscription credit line for longer, or even making a loan from the GP to the fund.
But many people don’t – or didn’t – expect defaults from large institutional players. “Most institutional investors have money; they know how to do this,” said one of the CFOs. But the idea has begun to take higher priority in recent days. “Last week I raised the issue with the managing partner, and he sort of laughed. Today he’s asking, ‘How soon can you get that cap call out?’”
That firm, and reportedly many others, are calling sooner and for more money than even they anticipated days ago. And some are reportedly giving their LPs extra time, beyond the average 10 days, to give the firm time to find a solution should an LP be facing liquidity problems.
Private Funds CFO obtained the GP remedies clause of one fund’s LPA. Several market players agreed that the terms, described to them in phone conversations, were boilerplate and widely used. Among them:
- That the GP give an LP five business days to pay the call. Others have said that 10 is more typical, and as reported above, one is giving LPs extended notice
- The GP can accrue and collect interest daily on the called amount
- As long as the defaulted amount isn’t paid, the GP can withhold all distributions and apply them as an offset to the defaulted amount
- The GP can assist the defaulting LP in finding a buyer of all or part of the defaulted interests
- The GP can sue to collect
- The GP can force an up to 80 percent haircut on the LP’s interest, giving the other LPs the option to acquire that portion. If no other LPs want to buy it, it can be offered to a third party. One person remarked that the haircut can often be higher than 80 percent
- The GP can reduce the defaulting LP’s commitment to the amount of capital paid before the default date, but allow it to remain an LP in the fund
- If the defaulting LP retains some or all of its interest after the date of default, the GP can take one or more of these actions:
- Rescind the right of the defaulting LP to any distributions except liquidating distributions
- Liquidating distributions can be limited to their value, at the date of default, excluding unrealized gains, less pro rata allocations of all expenses after default date
- If, after applying allocation of expenses, the balance is not reduced to zero, and the LP’s commitment was reduced to the amount of capital called before the default, the GP can allocate management fees equal to the LP’s original commitment, pro rata (ie, if the GP reduced the LP’s commitment, they can charge management fees as if they hadn’t)
The remedy rub
While GPs can apply any or all of such remedies, some may be difficult to employ. GPs can, for example, sue the defaulting LP. But since the crisis of 2008, sovereign wealth funds have become a larger and larger investor base in private funds – and many enjoy immunity from lawsuits. In the US, the Foreign Sovereign Immunities Act is commonly interpreted to provide such immunity to SWFs.
Devlin points out that while GPs might opt to give their LPs extra time to pay, if they have the means, they are likely to have to get their subscription credit line lenders’ consents as well – subscription lines are collateralized by the LPs’ callable capital.
And if there are multiple defaults in a single fund, GPs are meant to treat each defaulted investor in the same way, to be equitable, Devlin says. That means special treatment of large, relationship LPs may not be an option, at least from a legal realist perspective.