In last month’s article, we looked at what happens when an investor in a private equity fund defaults on its obligation to meet capital calls. In this article, we examine some of the other issues arising from an LP default for the fund, its manager, investors and financial regulators.
If an investor fails to meet a capital call which is required to enable the fund to pay for an acquisition, this has potentially serious consequences for the fund. It can throw off the (usually very tight) deal timetable and cause the fund to overrun any deal exclusivity period. To avoid this, the manager will be compelled at high speed to make up the funding gap from alternative sources.
The manager may be forced to borrow money to bridge the shortfall, or else face the costs of delay – in an acquisition, this could mean losing the deal, with the associated financial and reputational impact. Emergency borrowing also obliges the management team to spend precious time and resources negotiating with debt providers. Debt comes with its own costs, including interest and bank fees; and investors would typically end up subordinated to the lender in priority until the loan is repaid.
To ensure that the fund does not lose an investment opportunity, the manager may require the remaining investors to meet the shortfall resulting from the default.
This could have the effect of putting the manager in breach of certain investor-specific investment limitations (notably that not more than a specified percentage of an investor’s commitment be invested in a particular asset or strategy), which may be part of the main body of investment restrictions in the LPA or else be agreed privately in a side letter. Some LPAs state that breaches in such circumstances are not actionable; obviously, such a provision may be contentious. As a drafting point, managers may prefer such restrictions to be calculated as percentages of overall fund commitments, rather than of an individual investor’s commitment, giving more leeway to reallocate drawdowns after a default.
The manager may meet the capital call itself or ask one or more investors (or a third party) to do so. In recognition of the funder’s contribution, it may be granted a preferential right to distributions with respect to the underlying investment.
As we discussed last month, when dealing with an investor who has defaulted on a drawdown request, the manager has a wide selection of remedies at its disposal, including disenfranchisement, mandatory sale of the defaulter’s interest in the fund (typically, at a discount to market value), forfeiture of the defaulter’s interest, and litigation.
Although the defaulter is plainly in the wrong, the manager nonetheless treads a fine line – to ensure that the fund is managed equitably while at the same time not hampering its ability to fundraise in the future with an overly aggressive approach. One manager, which sued its biggest investor, and then failed to raise a successor fund admittedly, ruefully, that this had not been the best investor relations strategy. Other well-known managers have taken a proactive approach in difficult times, voluntarily agreeing to reductions in the size of their funds, although care needs to be taken to ensure that all investors are on board: some may believe that one party’s distress is another’s opportunity, and the manager should be making the most of any market turmoil.
Most LPAs give the manager wide discretion to take one or more courses of action against a defaulting investor. Historically, few LPAs actually require the manager to do so. As a result, in some circumstances, investors felt that managers were treating some defaulting investors with kid gloves; in subsequent fund negotiations, they pushed for a provision whereby the manager must act against the party in default within a certain timeframe.
Mandatory action, though, could see the manager fall foul of insolvency laws. If an investor is subject to insolvency proceedings, these can impose a moratorium on any legal proceedings against the investor, putting the manager in a difficult position where it must breach either the LPA or the relevant insolvency laws.
Investors will be concerned to see that defaults are dealt with firmly and equitably, and that the manager is not tempted to put its ongoing commercial relationship with an investor or its group before the interests of the fund. As a result, a practice has arisen whereby the manager will notify the Advisory Board of a default, without necessarily identifying the investor concerned but highlighting any links to the manager, and unless consented to by the Advisory Board or due to insolvency laws, taking one or more actions within a certain time period. This focus on transparency and flexibility gives investors comfort that the manager should act in the best interests of the fund.
For an LP facing a liquidity crisis, developments over recent years mean that it should have a more flexible toolkit to address defaults. The first is the widespread acceptance of the secondary sale process, enabling an investor to exit before the end of the fund’s term. That said, if the market is pricing in steep discounts to NAV, there are other solutions, some involving structured finance where, for example, a provider might agree to meet upcoming drawdowns in return for a preferred return out of all distributions coming from the underlying fund. This allows the LP to meet forthcoming capital calls without having to sell (which may be at a discount), and thus maintains its interest in future growth in the fund’s value.
Many GPs now utilise subscription line facilities whereby, instead of drawing cash from LPs to make investments, the GP borrows the money from a bank on a short-term basis, typically secured against LPs’ obligations to meet capital calls. At maturity, the GP repays the loan using capital freshly drawn down from investors.
The use of subscription lines enables investors to plan their drawdown profiles with more certainty over longer time horizons. At the same time, managers are better able to meet short funding deadlines or to increase their bids at corporate auctions without the need to go back to investors for additional cash. In the event an investment aborts at the last minute, they also avoid managers having to return the drawn down cash to investors.
As a result, investors are generally favourably disposed to subscription lines. However, some have pointed out that subscription lines lower the overall returns to the fund (due to the interest costs, arrangement fees and associated expenses), while artificially boosting the IRRs and potentially increasing or accelerating the payment of carried interest to the GP. Managers have also been accused of “having their cake and eating it”, by deeming amounts borrowed under subscription lines as equivalent to capital contributed by investors for the purpose of calculating management fees, whereas preferred return only starts to accrue at the actual point of drawdown from investors. From a macroeconomic perspective, some commentators have expressed concern at the effect of the additional leverage in the system.
Given the increasing size of the private funds sector (more than $7 trillion in assets under management at the last count), regulators are considering whether it poses any systemic risks. The issue of defaulting investors is an area on which more than one regulator has alighted. The key concern is the opaque nature of the industry: it is in neither the GP’s nor the LP’s interest to disclose a default, and so there is no easy way to gauge the level of defaults or the direction of travel.
Some commentators have suggested that regulators should maintain a register, allowing them to access a snapshot of the health of the industry at any given time, akin to the requirement on hedge funds to disclose certain short positions in companies. This, though, is more difficult than it might appear: it would be necessary to standardise the definition of a default for regulatory purposes, which might not match that in the underlying fund’s legal documentation. Where a fund is domiciled in an offshore location, with a manager in a second location, and affiliated and third-party investment advisers in still more jurisdictions, it is not immediately obvious which regulator should have oversight.
The legal tools which the manager has at its disposal will facilitate some kind of resolution to defaults, but one should not underestimate the expense or disruptive effect on the fund.
Prevention is better than cure. When one thinks of fund due diligence, conventional wisdom says it’s the investor sizing up the manager – the management team’s track record, investment thesis, the performance of any underlying portfolio of assets and, ultimately, past returns will be examined under a microscope. But savvy investors should also keep an eye on the financial health of their fellow LPs. And that’s even truer for the manager. LPs with good financial covenant strength are handy for the manager when assembling a collateral package for the fund’s subscription line facility. With many pension fund investors having to grapple with growing funding gaps as liabilities outpace asset returns in today’s low interest rate environment, funding risk may become more of an issue in the future.
One piece of LP feedback during the GFC was the variability in the quality and quantity of information flowing from managers: the ones who gave investors visibility of their deal pipeline and potential capital calls seemed very much in the minority. It is advisable for the manager and investors to keep their relationship well-oiled, by maintaining a continuing dialogue, so that they can spot potential funding hazards further down the road. This will help to build mutual confidence in the good times – and it might just help to save some heartache in the bad.
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