Suing your supporters

Although the notion of a private equity firm suing its limited partners has until now seemed extremely unlikely, a recent lawsuit filed in Delaware may be a sign that more sponsors will take a harder line against cash-strapped investors in the future.

The issue arose after New York-based CapGen in early March took the rare step of suing two of its LPs – Chalice Fund and WK CG Investment – for allegedly failing to make the required capital contributions to three funds raised in 2007 and 2008. CapGen is seeking payment of the outstanding commitments with interest, as well as a court order requiring the LPs to meet all future commitments.

The case has attracted attention in the industry mainly due to its novelty. “There are only a handful of cases that deal with a sponsor suing its LPs for defaulting on a capital contribution,” says Andrew Wright, a partner at law firm Kirkland & Ellis. “Mainly, this is because we have historically seen few defaults in the private equity industry – as we have never seen a period like this – and also because there are other alternative remedies available in a private equity fund's partnership agreement.”

Such remedies typically include forfeiting all, or a portion of, the defaulting investor's interest in the fund, assisting the LP in obtaining a credit line to fund capital calls, or finding a buyer for the interest. While CapGen had such remedies at its disposal under its funds' partnership agreements, it still opted to pursue legal action against Chalice and WK CG.

The timing of the suit and the size of the LPs being targeted has raised eyebrows. For one thing, CapGen – which declined to comment on the issue – filed the lawsuit less than three months after the capital call was first issued and less than two months after it was first due.

Meanwhile, Chalice and WK CG are two of the smaller investors in the three funds, as their respective commitments of $3.5 million and $1 million – some of which had already been paid – were well below the average commitment of between $6 million and $7 million. In fact, a WK CG investment partner told the Wall Street Journal that his firm only owed $200,000 on the latest capital call and said he wanted to talk with CapGen about making a schedule of payments so he could stay in the fund.

Although GPs in the past have avoided the courtroom due to the legal costs, potential distractions and adverse publicity, CapGen may have decided that targeting two small LPs could be the best way to send out a message while not alienating larger investors. “It puts everyone on notice that the GP is going to take these things seriously and enforce default provisions,” Wright says. “Maybe they want to take a hard line with their LPs and make it clear that no one is going to get special treatment.”

He adds that in light of the current economic environment, it is “certainly more likely” that the industry will see more lawsuits like this, although it should normally be a course of last resort.

One LP not invested with CapGen says the suit could represent a double-edged sword for the firm. “On one hand, it is bad for the GP since it makes them out to be very litigious and LP-unfriendly – which can't be good for fundraising the next time around,” he says. “On the other hand, it can be good for the GP in the short term, since it acts like a warning flare to other LPs which may be considering default options.”

Another LP says that, due to the uncertainty of going through the courts, it's best for the GP to work on a payment plan with the LP or seek a secondary sale. “I would guess there is much more to this story with CapGen,” he says. “Given the times, these suits may occur more often – but still should be rare.”