Limited partner defaults in private equity: Risks, remedies and practical considerations (2024)

Over the last year, both public and private markets have faced significant headwinds, leaving investors uncertain and fund sponsors reevaluating the pace and direction of their portfolio investments. In particular, private fund investors are closely examining their holdings due to liquidity pressures from fewer exits, higher borrowing costs and downturns in other asset classes causing overexposure in allocations to private markets (commonly referred to as the “denominator effect”).

One result of these challenges is the increasing risk of defaults by limited partners (LPs) in funding their capital call obligations. While generally rare due to the associated reputational damage and legal ramifications for LPs, in certain circ*mstances LPs may have little choice but to default on their capital commitments, particularly when faced with an unanticipated liquidity crunch.

The limited partnership agreement of the fund (LP Agreement) will generally set out the requirements of an LP to contribute capital up to its specified commitment, which the fund’s sponsor can draw upon as needed to make investments and pay the fund’s expenses. If the LP fails to make all or any portion of a capital contribution within a prescribed period after receiving a capital call notice from the sponsor, that LP will have defaulted on their capital call obligation and the sponsor can avail themselves of certain remedies (in some cases, only after the expiry of a cure period) under the terms of the applicable LP Agreement.

Remedies

It is not uncommon for an LP Agreement to set out a myriad of remedies available to a fund sponsor to address an LP’s default following a capital call, which can be exercised in combination with one another. These remedies often provide a sponsor with considerable flexibility to address the particular circ*mstances of the default, especially considering the identity of, and the sponsor’s relationship with, the defaulting LP. While the available remedies vary from fund to fund and depend on the terms of the applicable LP Agreement, they will often include one or more of the following:

• Sale of LP interest to non-defaulting LPs: Fund sponsors can offer non-defaulting LPs the opportunity to purchase the defaulting LP’s interests in the fund, often at a discount to the fair value of the defaulting LP units. Typically, the offer is first made to all non-defaulting LPs on a pro rata basis according to their respective ownership interests in the fund. Any of the defaulting LP’s units that are not purchased by the non-defaulting LPs may sometimes then be offered to a third party. A sale of the defaulting LP’s interest is often preferred by the sponsor as the size of the fund remains the same.
• Forfeiture of partnership interest: A fund sponsor can declare all or any part of the defaulting LP’s interest in the fund as forfeited and cancelled without payment or other consideration. The distributable proceeds that would otherwise be owing to the defaulting LP pursuant to its ownership of units in the fund could then be reapportioned among the non-defaulting LPs.
• Reallocation of capital: The sponsor may issue a subsequent capital call to the non-defaulting LPs to fund the shortfall caused by the defaulting LP. The funding by non-defaulting LPs of the shortfall would typically be capped. The sponsor may also set off the amount of the unpaid contribution against any distributable proceeds that are then owing to the defaulting LP.
• Modification to the capital call: The aggregate amount of the capital call that is subject to the LP default can be reduced by the amount of the unpaid contribution. Alternatively, the capital call can be cancelled entirely.
• Suspension of LP rights: The LP Agreement may provide for the suspension of the defaulting LP’s voting rights on matters that are subject to the consent of LPs, such as the amendment of the LP Agreement or the wind-up of the fund. The sponsor can also suspend the defaulting LP’s right to receive distributable proceeds from the fund.
• Interest: Interest on the overdue contribution amount can be charged to the LP. This remedy is typically adopted where the defaulting LP funds its capital contribution at some point after the applicable drawdown date.
• Other remedies available at law: The LP Agreement will typically provide that the remedies that are set out in the agreement are not exhaustive and that the fund is entitled to exercise any other rights and remedies that are provided by law. Namely, the fund could initiate a claim against the defaulting LP for damages resulting from the non-payment of its capital contribution or for specific performance in order to obligate the LP to fund its contribution.

The sponsor’s choice and use of available remedies will depend on the particular circ*mstances and the sponsor’s objectives at the time of the default. Most often, a sponsor will be concerned with obtaining sufficient funds to close the portfolio investment for which the capital call was made, replacing the commitment of the defaulting LP and managing the relationship(s) with the defaulting LP(s) as well as other LP investors. With respect to managing these relationships, a sponsor should consider how its treatment of the defaulting LP(s) might set a precedent for the treatment of any future LP defaults and, in addition, what implications its actions may have on fulfilling its standard of care as manager of the fund.

Practical considerations and other takeaways

A fund sponsor will often only turn its mind to the contractual remedies for an LP default at the fund formation stage when the LP Agreement is being drafted or when an LP actually defaults or indicates its intention to default following a capital call. However, during the fund’s commitment period, a sponsor should consider taking practical steps to mitigate the risks of LPs’ default on capital contributions. Likewise, fund investors would be wise to ensure that the fund’s sponsor is taking proactive measures to minimize the potential for LP defaults so that the value of their investment in the fund is protected. These practical steps for sponsors include the following:

• Provide drawdown notices as soon as practicable in order to give sufficient time for LPs to arrange the funding required to make their respective capital contributions and to give time for the sponsor to address any potential shortfall in the event of LP defaults. If the fund plans to make a portfolio company investment but does not yet have all the information required to be included in the capital call notice, the sponsor could consider issuing an advance, preliminary capital call notice to LPs with a formal notice to follow that contains all of the prescribed information.
• Set up bridge financing or alternative sources of liquidity in the event that short-term borrowing is necessary to fund a capital call shortfall. The availability of subscription lines of credit for private equity funds has expanded in recent years to ease the administration of deploying capital.
• Defer or waive management fees as a way of prioritizing available cash to make investments and to satisfy other fund obligations. If the sponsor manages more than one fund, the management fees received from other funds may be sufficient to support the operating expenses of the sponsor.
• Facilitate the buyout of an LP’s interest through the secondary market if the LP is experiencing intractable liquidity challenges. This approach is often preferred by sponsors and LPs alike as it minimizes the financial and reputational impact on the LP and preserves the availability of capital for the fund to deploy. It is not uncommon for sponsors to establish relationships early on with secondaries funds and other participants in the secondary market so that they can more readily transact in an LP’s interest.
• Communicate with LPs regularly and monitor publicly available information for indications of any default risk in respect of one or more LPs. An open and continuous dialogue with LPs can help a sponsor detect early warning signs of an LP’s financial health and preempt defaults by facilitating a secondary transaction where appropriate. At the same time, visibility into the fund’s deal pipeline can help LPs anticipate future cash outlays.

An LP default, or potential default, can create significant issues for a fund and divert the sponsor’s time and attention away from its investment activities. A sponsor would be well advised to implement practices designed to mitigate a default, or the effects thereof, and to have a plan in place before any default occurs. This process starts with anticipating and providing for flexible default remedies in the LP Agreement and then reviewing those provisions and applicable side letters from time-to-time to ensure the sponsor is well positioned to address and manage default risk if and when the issue arises. The second-order effects of an LP default (e.g. the ramifications of an LP default on a fund’s credit facility covenants; fiduciary or contractual limitations on a sponsor’s ability to participate in default remedies; and the acquisition or disposition of a defaulting LP’s interest or capital account) should also be carefully considered with the advice of counsel.

If you have any questions, please feel free to contact co-authors Mark Mahoney, Alex Eckler and Cindy Qi.