Subscription credit lines, for all their bad press, rarely go into default. As one fund finance provider told Private Equity International: “We haven’t seen money lost in this industry before.”

Société Générale’s capital call facility for Abraaj Group‘s flagship Private Equity Fund VI is a rare example of one that has run into problems. Its dispute with limited partners could set a precedent for any future unpaid facilities.

What happened?

APEF VI launched last year with a $6 billion target. It raised $3 billion and reportedly acquired KFC’s Turkey business with a capital call facility from SocGen before the fund’s operations were suspended in February. This followed revelations that LPs in Abraaj’s $1 billion global healthcare fund had hired an auditor to trace money.

Although investors were “purportedly released” from their commitments to the vehicle, SocGen has appointed receivers to issue drawdown notices to these LPs for their pro rata share of the amounts outstanding under the facility, according to documents prepared by joint provisional liquidators Deloitte and PwC seen by PEI.

The “released” LPs are disputing the validity and enforceability of these claims.

“If there’s an LP that doesn’t or can’t pay there are a whole load of fairly nasty things that happen to them in terms of its investment in the fund, most of which it won’t want”
Fund finance lawyer

A number of LPs – mostly Abraaj-related entities – had already defaulted on a capital call facility held with British bank Barclays at some point before the JPLs were brought in. The defaulted proportion of this facility was to be paid using management fees raised from a drawdown notice issued by the JPLs to LPs in Abraaj’s LatAm, Turkey, Pakistan and Africa funds, PEI reported in October.

How credit lines work

A subscription credit line bridges the gap between the time an investment is made and when the general partner draws down capital from its LPs. The facility is usually repaid in six to 12 months when the GP calls capital and settles the balance.

A lender’s security is typically the right to demand the capital direct from the investor and a charge over the fund’s bank account into which LPs pay their commitments. If for any reason the GP fails to repay the facility, the bank itself can call upon the LPs directly and withdraw the owed money from the fund’s account once they have paid.

“If there’s an LP that doesn’t or can’t pay there are a whole load of fairly nasty things that happen to them in terms of its investment in the fund, most of which it won’t want,” said a London-based fund finance lawyer who wished to remain nameless. This can include confiscating part of the LP’s stake.

“It basically involves punishing the investor and, as a last resort, sometimes forfeiting all the investments the LP made in the fund,” the lawyer said.

An investor in default may seek to sell its interest in the fund, along with its liability for future commitments, to a secondaries buyer, the lawyer noted. “In an enforcement scenario GPs can force a sale of the defaulting investor’s stake. The bank theoretically has all the rights the fund has as part of its security, so it also has the ability to forcefully sell.”

What might happen next?

APEF VI completed one investment before it ceased operations, so its LPs could in theory sell their position. These buyers might be expected to pay the outstanding commitment.

If the LPs disputing SocGen’s drawdown notice are unwilling to sell their position, one option may be to do so by force. If the lender does not, for whatever reason, have the right or desire to sell, it might seek to pursue the matter in court.

“Banks have not generally been required to enforce before and it’s a little bit of a new and open book as to how they might,” the lawyer said. “Theoretically the security they have should give the ability to force a sale on the secondary market, and then it’s a question of whether anybody actually wants to buy it.”

Cost is not the only reason a protracted legal process may be unappealing.

“LPs want to seem easy to work with,” the fund finance provider added. “I might be less willing to lend to a fund with investors that have been known not to honour their commitment. There’s a reputational stigma.”

Société Générale and Deloitte declined to comment.