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Helping small limited partners in need - proactive solutions for defaulting LPs

The general decline across the financial markets has had a marked effect on the private equity industry. Many investors are now reluctant to honour their capital commitments to the asset class. Ian Charles of Cogent Partners assesses the options for general partners and limited partners who find themselves in this predicament.

During the five-year period from 1997 to 2001, private equity funds raised an unprecedented $878bn for new investments. One of the many interesting trends that emerged during the late 1990s and early 2000 was the significant amount of capital committed by individual investors. According to Venture Economics, more than 12.6 per cent of the capital committed to private equity funds from 1997-2001 came from individuals, including corporate executives, successful technology entrepreneurs, ultra high net worth individuals and other friends of the private equity firms. In some recently established venture firms, it is not uncommon for individual investors to represent more than 60 per cent of a fund's total commitments.

The dramatic growth in capital commitments by individual investors was driven primarily by large public equity gains, a healthy IPO market and growing distributions from technology-focused venture capital funds. The robust economic environment and unstoppable growth of the technology industry made it much easier for investors to enter into limited partnership agreements, unconcerned about their ability to honour those obligations in the future. For individual investors anticipating early fund distributions and growing stock portfolios, the economic changes over the last two years could not have been more devastating. The significant decline in the public stock markets, massive amounts of corporate layoffs, dramatic decline in private equity distributions and uncertain economic prospects have left many of these individual investors unable or reluctant to honour their capital commitments and contractual agreements with the funds' general partners and other limited partners.

Most limited partnership agreements provide the general partners with certain legal remedies for defaulting LPs, including the reduction or redistribution of the defaulting LP's capital account, a forced sale, and the right to file suit against the limited partner to force them to honour their contractual obligations. The general partner may have a fiduciary duty to take some type of action because failure to respond to the problem ignores the general partner's fiduciary duty to the other limited partners in the fund and may encourage other LPs to default.

A common remedy provides the general partner the right to reduce the defaulting limited partner's capital account and redistribute the proceeds to the other LPs, or to eliminate the LP's capital account if they are declared to be in default. This is a less stressful solution than most because the capital account adjustment is easy to execute, and the right to do so is clearly defined in most agreements. Occasionally, the threat of a capital account adjustment is enough to compel the LP to honour its financial commitment. However, if the limited partner remains in arrears, the general partner is still left without the contributed capital. Further, the amount of capital to redistribute to existing LPs may be insignificant, especially for relatively uncalled funds or funds that have experienced significant write-downs in valuation.

A forced sale requires the general partner to market small partnership interests to the existing limited partners and/or a dedicated secondary buyer. If the general partner is able to place the interests, the fund receives its capital, and the general partners can refocus their attention on their investment activities.

This solution may be problematic for both the limited partner in arrears and the general partner. If existing limited partners are uninterested in increasing their allocation to the fund, it is time-consuming and distractive to market a small partnership interest to secondary buyers. Further, because the due diligence necessary to value a private equity interest is the same regardless of the size of the commitment, secondary buyers are uninterested in a small commitment unless it can be purchased at a very steep discount. The limited partner may receive little or no cash, net of legal expenses.

Another option available to the general partner is filing suit to have the judicial system force payment. If the general partner is successful, the fund will receive the capital contribution. However, many individuals in the fund have personal and professional relationships with one or more of the funds general partners. As such, many firms are hesitant to litigate against a friend who may already be experiencing financial setbacks. For smaller commitments, the legal expenses and time consumed by the legal battle may make litigation an economically unattractive option for general partners and the remaining limited partners who ultimately foot the legal bill and bear the cost of litigation's distractive effects on the general partners.

A potential resolution is to coordinate an aggregated sale of interests from limited partners who are in arrears or who have communicated a desire to place their future obligations with another party. The limited partners benefit from an increased likelihood that a transaction can be arranged if transacting on the smaller interest is problematic. Even when a transaction is available, a sale of a larger basket of interests will improve the economics for the sellers, both through incremental pricing and a sharing of legal fees. The general partner increases the likelihood that the purchaser will be a private equity investor looking to establish a long-term relationship and replaces a group of individuals with an institution of higher credit quality.

Limited partners can preserve value by proactively attempting to coordinate a pooled sale of interest in a fund. Optimally, once a limited partner determines that future capital calls are unwanted, asking the general partner if any other limited partners have expressed a similar philosophy can begin the sales process. Similarly, when general partners receive indications from limited partners desiring liquidity, and the general partner is interested in a new long-term investor, putting the limited partners in contact with each other or with a common advisor can assist all parties in reaching their goal: the interests placed with parties willing and able to make capital calls, with little distraction for the general partnership and fair pricing for the sellers.

Copyright © 2002 Cogent Partners. All rights reserved.

Cogent Partners is a private equity-focused investment bank dedicated to serving the needs of the private equity community. Cogent Partners represents sellers in traditional and securitised secondary transactions, conducts detailed portfolio assessment and pricing analysis, and provides fairness assessments for secondary buyers and sellers. For more information on Cogent Partners or the private equity secondary market, please visit the firm's website at www.cogent-partners.com