Prolonged troubles in the economy have increased the potential for limited partner defaults in private equity funds. Most fund sponsors are already aware of the more obvious issues related to defaults, including the general partner's fiduciary duties in connection with its exercise of remedies, the enforceability of remedies in different jurisdictions, and the potential for regulatory problems that arise as the total size of a fund changes and the percentage interest of some limited partners increases. This article addresses three more subtle issues that have not previously been fully explored relating to a very common private equity fund default remedy - the general partner's ability to reduce a defaulting limited partner's capital account and share the forfeited portion with non-defaulting limited partners.
Effect on Other Limited Partners of General Partner Discretion
As defaults grow more common, all limited partners are paying more attention to the potential remedies that a general partner has under the partnership agreement. Non-defaulting limited partners in particular are becoming increasingly aware that they could benefit from the general partner's exercise of some of these remedies. For example, if a limited partner defaults, the general partner may cause it to forfeit as much as 50% of its capital account balance, with the non-defaulting limited partners succeeding to the forfeited portion. This can be quite a windfall for a nondefaulting limited partner when a large institutional partner defaults.
In some cases, limited partners have even written to a general partner to “remind” the general partner of their expectation that the general partner will strictly enforce its remedies against defaulting limited partners, including by imposing a capital account forfeiture and shift. Historically, general partners may have shied away from exercising the full extent of their rights against a defaulting limited partner in order to preserve an existing relationship with the defaulting partner. However, now that limited partners are aware that they can potentially benefit from the default of another partner, they may pressure general partners to exercise the full extent of their discretion under the default provisions of the partnership agreement.
Most partnership agreement default provisions afford the general partner very broad discretion over which remedies, if any, are exercised. Thus, while the increased pressure on a general partner to exercise remedies might at first appear to limit a general partner’s freedom, it may in fact enable them to exercise their discretion more liberally. This is because general partners that might otherwise have been lenient on a defaulting partner in order to maintain a good relationship will now have a justification for much stricter treatment - the other limited partners are watching and holding them accountable. This enables general partners to enforce the default remedies under the partnership agreement, including by reducing a limited partner’s capital account, without being seen as unnecessarily punitive.
Calling Temporary Cash Funds
Limited partners that are invested in numerous private equity funds, but that suddenly face a diminished supply of available capital, may strategize over which funds’ capital calls they will default on and which they will honor. Obviously, where a partner has funded the majority of its commitment to the fund, the threat of losing half of its capital account will probably be significant enough to discourage the limited partner from deliberately defaulting in that fund. However, where a general partner has not yet called any capital, or where the capital accounts are minimal, the prospect of a capital account forfeiture may not be especially ominous for limited partners. As a result, one way to deter defaults might be for the general partner to call a certain amount of capital in advance to be held as “Temporary Cash.” Many partnership agreements contain provisions permitting such calls to be made without reference to a specific investment, but rather to be held in reserve and used if and when the general partner identifies an investment. Because capital called as Temporary Cash would increase a limited partner's capital account by the called amount, the potential loss for a limited partner who later defaults is that much greater. An added benefit of this approach is that it can enable a general partner to anticipate a default by a specific limited partner prior to calling capital for an investment. For example, if a general partner makes a call for Temporary Cash and a partner defaults, it is likely that that same partner will also default on a call for an investment. This initial default puts the general partner on notice that the fund may need to secure additional capital in order to be able to complete an anticipated investment.
Aggregation of Partnerships and AIVs with Respect to Default Remedies
General partners sometimes establish alternative investment vehicles (commonly known as “AIVs”) for investments that could create adverse tax consequences for certain limited partners and/or the general partner if they were made directly by the main fund. Many of these arrangements, drafted before the heightened sensitivity to defaults, do not aggregate the AIV and the main fund for purposes of imposing default remedies. Thus, a default by a limited partner on a capital call to an AIV would lead only to a reduction in its capital account in the AIV, and not a reduction in its capital account in the main fund. Consider, however, a situation where some limited partners have invested in all investments through the partnership, but others hold half of their investments through the partnership, and half through the AIV. If a limited partner with investments in the AIV defaults on a capital call by the partnership, the general partner could then reduce such limited partner's capital account in the partnership, but would have no ability to reduce such limited partner's capital account in the AIV. Despite the AIV having been put in place for tax and not other reasons, a defaulting limited partner with all of its investments held through the partnership will forfeit more of its capital than a defaulting limited partner who invests primarily through the AIV, even when the economic magnitude of the default is exactly the same for both limited partners - an odd result. The equitable fix would be to cross default the interests in the AIV with the interests in the main fund; however, before introducing a cross default, one must consider several issues, including the tax effect of such aggregation, the potentially different results under the law governing the main fund and the law governing the AIV and, finally, how the benefit of a capital account forfeiture is shared among limited partners of the main fund and the AIV.