Private Fund Investor Defaults – Consequences and Practical Solutions

Whilst the true, long-term impact of the worldwide coronavirus pandemic remains to be seen, the global financial markets have already experienced a huge wave of turbulence. The prospect of a significant effect on the closed-ended private funds market is looking increasingly likely, if not already being felt. 

Stresses at the Portfolio Level

Whilst private equity fund investments generally have the virtue of being able to withstand short-term economic volatility as assets are held for the long term, operational concerns at portfolio level due to, amongst other things, supply chains being delayed and employers having to contend with employment-related issues (including a duty of care towards employees working remotely) are already apparent. Consumer engagement is down in certain sectors (and, in some cases, prohibited), which is fuelling and further perpetuating many uncertainties and concerns in the market. As a result, many portfolio companies require the support of additional injections of capital.

Stresses at the Fund Level

The global pandemic is also affecting the ordinary course of business at the "fund level" in parallel to that of underlying portfolio assets, both in terms of raising capital and sourcing investment opportunities. The current circumstances, including "lockdown" and ongoing "social distancing" measures, are presenting challenges to raising capital, not least due to the restrictions on travel and face-to-face meetings. The ability for fund managers to source investments and undertake due diligence on new portfolio companies has also been hindered.

These factors have contributed to a reluctance of some investors to enter into new, long-term capital commitments at this time, as they adopt a "wait and see" approach to further fund investments. 

That being said, there have still been a number of new funds being raised and successfully reaching their first close, despite the current challenges, including, in particular, those that had started the fundraising process before the crisis hit.

Calling Committed Capital

Of course, under a typical closed-ended fund arrangement, investors will make a "capital commitment" at the outset, which represents the maximum amount that they agree to invest in the fund over a fixed period of time. The fund manager will periodically call the investor's capital commitment in tranches each time an investment opportunity is to be made, or fund expenses or fees are to be paid. 

Raising committed capital is therefore only one part of the equation. Being able to rely on and call that capital is another. Although investor default in the private fund context has historically been quite rare, investors in certain sectors or of certain types may currently be facing increasing financial pressure, heightened liquidity constraints and cash flow deficits due to the unique social, economic and political circumstances imposed by the coronavirus pandemic. This is giving rise to potential concerns over the possibility of investor defaults.

Investor Default and Remedies

If an investor fails to fund a call on its capital commitment, there will usually be a grace period for them to remedy their default, failing which the fund manager may pursue a range of punitive and remedial discretionary actions, which may include: 

• allowing the defaulting investor more time to advance their capital, perhaps with added interest and with the obligation to pay or reimburse costs incurred in connection with the shortfall;
• forcing a sale or transfer of the defaulting investor's interest to other investors or third parties at a discount;
• redeeming the defaulting investor's interest without payment or for the nominal value paid with a non-recourse promissory note payable after the fund is wound up;
• requiring full or partial forfeiture of the defaulting investor's interest in the fund and, in the case of a partial forfeiture, diluting their economic interest in the fund and their ability to vote on fund matters going forward (including a loss of their advisory committee seat, if applicable);
• withholding and redirecting distributions otherwise due to the defaulting investor, applying them as an offset to the defaulted amount; and/or
• calling additional capital from non-defaulting investors to make up the deficit (up to the amount of their remaining uncalled commitments).

The governing document for the fund will typically contain a power of attorney allowing the fund manager to execute any legal documents on behalf of the defaulting investor to achieve a default remedy.

Impact of Default

A default will inevitably result in reputational damage to the defaulting investor and may affect their ability to participate in future funds. For the other fund investors, it can be burdensome if, as a consequence of the default, they are required to fund the forfeiture. 

The fund itself may also suffer in a number of ways as a result of an investor default, the extent of which will of course depend on the size of the defaulting investor's capital commitment in proportion to the fund overall. An investor default can impact the fund's liquidity as there will be a reduced amount of capital available to make investments and otherwise manage the fund. It may mean that there are insufficient funds to pay the management fee and it may even cause the fund to take on indebtedness to cover the shortfall in funding. These consequences may make it difficult for the fund to achieve its intended portfolio objectives and may affect the fund manager's reputation.

Practical Steps

It is therefore prudent for both investors and fund managers to consider what steps can be taken to mitigate the risks associated with an investor being unable (or unwilling) to meet its capital commitments. Below are some suggested practical steps – note, the key point being the importance of two-way communication between fund manager and investor.

Fund Managers

Review the fund's governing documents and credit agreements to consider the impact of an investor default and what immediate tools they have to hand in the case of an investor default occurring.

Be transparent with investors and give as much notice as possible of planned capital calls, preferably beyond the typical 10 business days' notice included in most fund documentation, and consider whether giving informal notice of planned capital calls, to determine if an investor default is likely, might be appropriate.

Consider what planned expenses can be saved or investments delayed (perhaps with an extension to the fund's investment period) and what additional measures may be helpful to source capital to survive the volatility in the market (for example, undertaking additional indebtedness or extending time limits on outstanding borrowings to provide day-to-day working capital and add liquidity to portfolio companies).

Consider whether other sources of capital are available to the fund to avoid calling capital from investors, such as short-term borrowing and fund-level preferred equity.

Investors

 Take steps to increase liquidity or rebalance portfolios to the extent possible and necessary before getting to the stage of a possible default.

Review the fund's governing documents and credit agreements to consider the impact of default and what immediate tools the fund manager has to hand in the case of an investor default occurring.

If capital is so constrained that funding capital commitments look impossible, consider notifying the fund manager and exploring alternative solutions with the fund manager, such as:

• a redemption opportunity (if and to the extent permitted);
• a sale of all or part of their interest in the fund to the fund manager/its executives or one or more of the other existing investors in the fund;
• a sale of all or part of their interest in the fund to a third party on the secondaries market; or
• seeking other sources of liquidity for the investor, such as preferred equity from a third party in respect to the investor's interest in the fund.