Limited partner defaults tend to become a focus of attention and discussion during periods of market dislocation. Economic pressures may mean investors are unable or unwilling to fund their drawdown obligations, although, even in a downturn, this is rare. There have not been many LP default situations during the covid-19 crisis so far, and, perhaps, few may transpire. Nonetheless, managers should be aware of the issues raised by LP defaults. Here are six practical tips to help prepare in case this difficult situation occurs.
- Have a clear definition of a ‘default’. If an investor fails to pay a drawdown notice on time this may not necessarily constitute a “default” under the limited partnership agreement. Many LPAs are flexible and allow the investor time to make the late payment (without the default provisions being triggered). If the investor’s non-payment persists then the LPA may provide the manager with the option or obligation to issue a “default notice”. This is a formal notice requiring the investor to pay the overdue amount by a specified time and failure to do so would ordinarily constitute a formal “default”. However, as LPAs are crafted in different ways, it is important to check the agreements to determine exactly when a default will have occurred and if any steps are required of the general partners before that is the case.
- Managers need be alive to their duty to all investors. If an investor is late in paying a drawdown notice, the manager may seek to find a pragmatic solution (including allowing the investor to make the late payment). Such a course of action may be in the best interests of fund investors as it avoids triggering the default provisions, which may be costly. However, the manager needs to be alive to their duty to act in the interests of all investors when considering timing and actions with any defaulting investor.
- Appoint legal advisers at the right time. The manager should consider instructing legal advisers after an investor has failed to fund a drawdown notice and certainly before it issues a default notice. Litigators may need to be involved to craft a strategy and to get the benefit of litigation privilege (as opposed to narrower legal advice privilege). It may make sense for insolvency lawyers to be involved if the non-payment has arisen due to the investor’s insolvency.
- Check your documentation. Does the manager need to inform lenders and insurers of a potential or actual default under any lending agreements or insurance policies? (And how is default defined in these other documents?) Do investors have a right to be notified of a default, or do they have rights of pre-emption under the LPA or any side letters?
- Be aware of the content of a default notice. Think about what the notice needs to say and any requirements as to how it should be served. We expect the notice should specify the amount of interest being claimed (both the total amount up to the end of the notice period but also the daily rate in case it is paid early). We would also expect the notice to include the expenses incurred in preparing the notice, assuming these are payable by the defaulting investor under the LPA. Be aware that if the interest rate charged is too high a court may deem this to be a penalty and therefore unenforceable.
- Sale of the interest is an option. If the investor has failed to pay the amount(s) specified in the default notice, a “default” will have formally arisen. The manager normally then has a number of options available, including sale of the defaulting investor’s interest. If it wishes to sell the defaulting investor’s interest, the manager should consider obtaining a benchmark market price for that interest, unless the LPA specifically prescribes how the price will be determined. The manager should also consider whether the payment mechanism (for example, cash upfront or a promissory note) is appropriate in the circumstances.
Investor defaults can be complex and time consuming so please speak to one of our experts if you need to navigate this tricky terrain. This is one of the few situations in which we hope not to hear from our clients.
Helen Parsonage is a partner and Dan Faundez is an associate director, both in the investment funds team at Osborne Clarke. Parsonage specialises in fund formation in the alternative assets with a particular focus on private equity and venture capital funds. Faundez acts for sponsors and investors in relation to the structuring, formation and operation of private investment funds across various asset classes.