Understanding LPA Default Remedies

Executive Summary

A subscription credit facility is secured in part by the fund’s and its general partner’s (“GP”) right to call unfunded capital commitments from the fund’s investors, to receive capital contributions once funded and to enforce default remedies against investors who fail to fund. The default remedies in a fund’s limited partnership agreement (“LPA”) significantly impact the health and stability of the subscription credit facility because they incentivize investors to fund their capital contributions and help to provide adequate security for the facility. In this Legal Update, we explain common LPA default remedies so lenders can protect themselves in the event an investor defaults on its obligation to fund a capital contribution.

Background

LPAs include default remedies that may be enforced against an investor that defaults on its obligation to fund a capital contribution. If a fund defaults under a subscription credit facility, the lender has the right to step into the shoes of the GP to call capital from the investors for the repayment of the facility. Because the lender can also enforce default remedies under the LPA if the funds’ investors fail to fund their capital contributions when called by the lender, lenders need to understand the typical default remedies and how they apply.

What to Know about Typical LPA Default Remedies

LPAs include several default remedies that come into play if one of the fund’s investors defaults on its obligation to fund a capital contribution. Common default remedies include:

Overcall Rights: The GP may issue an additional capital call on non-defaulting investors to make up a shortfall caused by the defaulting investor’s failure to fund a capital contribution. Overcall rights are not necessarily a remedy that incentivizes an investor to fund its own capital contributions, but are a remedy that lenders may rely on nonetheless in order to recover capital contributions from other investors.
Default Rates for Unfunded Amounts: The defaulting investor remains obligated to fund the relevant capital call and the GP may elect to charge interest on the unfunded amount at a punitive rate until paid.
Damages: If an investor’s default causes damages to the fund, the LPA may stipulate that the defaulting investor is responsible for any damages suffered by the fund as a result of its default. For instance, if the fund has committed to making an investment and an investor’s failure to fund its capital commitment results in broken deal fees or delay-related expenses, the defaulting investor may be held responsible for these additional costs.
Withholding Distributions: The GP may withhold distributions from a defaulting investor and use such withheld distributions to offset amounts owed to the fund by the defaulting investor.
Forced Sale of Investor’s Interest: The GP may elect to sell the defaulting investor’s interest at a reduced amount (e.g., a 50% discount) to non-defaulting investors or other persons.
Capital Account Cram-Down: The GP may elect to reduce the defaulting investor’s capital account by a specific amount (e.g., 50-100%).
Forced Transfer: The GP may elect to force a transfer of the investor’s interest in the fund.
Participation in the Fund: Defaulting investors typically lose the right to vote on or consent to most, if not all, fund actions or participate on the advisory committee (if applicable). Additionally, investors’ rights under side letters are often contingent on the applicable investor not being a defaulting investor.
Other Remedies: LPAs will typically include a “catch all”, reserving the GP’s right to pursue any remedies at law or in equity, including suing for specific performance of the investor’s capital commitment.

Most Important Default Remedies for Lenders

Each of the LPA default remedies listed above seek to incentivize investors to fund capital contributions and provide a mechanism to make a lender whole in the event of a default; however, from a lender’s perspective, two of the remedies are most beneficial and impactful. These include:

Cram-Down/Forced Sale: This remedy is important to lenders because it allows them to act without investor cooperation or court intervention. In the event of an investor default, a cram-down or forced sale provision enables a lender to act unilaterally to sell the defaulting investor’s interest or reduce the Investor’s capital account. Not only does the lender have greater control over pursuing its remedy, but these provisions also incentivize investors to fund their capital call obligations because the consequence for default is a significant or complete loss of their invested capital rather than simply incurring penalties or fees.
Overcall Rights: This remedy enables a lender to recoup losses from other investors in the investor pool by calling on non-defaulting investors to fund additional capital contributions to compensate for a shortfall caused by a defaulting investor’s failure to fund. Typically, borrowing bases are structured so that even if overcalls are subject to limitations, over-collateralization protects the lender if a small portion of the borrowing base investors default.

An important consideration for lenders when considering LPA default remedies is that remedies may be limited depending on the fund structure. For example, if the fund is structured as a separately managed account, or an “SMA”, default remedies under the LPA will be tailored to account for the fund only having one limited partner and important remedies such as a forced sale, capital account cram-down, or overcall may be unavailable. In this case, lenders will need to rely on the strength of other remedies as incentives for the investor to fund capital contributions.

Key Takeaways

LPA default remedies are critical to incentivizing investors to meet their capital commitments and ensuring adequate security for the facility. When negotiating a subscription credit facility, lenders should clearly understand the relevant LPA default remedies so they can mitigate the potential risks of an investor default due to failure to fund capital contributions.