Many public and private market participants predict the economic effects of the COVID-19 crisis will be long term and widespread. In this regard, given that many health experts are expecting we may soon encounter a second wave of the virus that may be even more damaging than the first one, now may be a good time for sponsors of private equity funds (PE Funds) to consider the impact the crisis may have on its PE Funds arising out of certain likely effects on PE Fund investors (Limited Partners). During the financial crisis of 2008-2009, investors in PE Funds experienced illiquidity in various parts of their portfolio that were previously thought to be liquid. Large declines in the valuations of public market securities can leave investors overallocated to PE Funds, given that PE Fund valuations generally do not decline as quickly as the public markets. In addition, dividends and other distributions from investments may be delayed or terminated altogether. At the same time, these market dislocations may generate significant investment opportunities for PE Funds while also creating the need to provide various forms of short-term financing to their portfolio companies to float them for a period of time. Ultimately, this may result in Limited Partners being asked to provide new capital to PE Funds at a very inopportune time.
The purpose of this memo is to briefly identify certain issues that PE Fund sponsors and Limited Partners may face as a result of an economic fallout due to the COVID-19 crisis, and to propose important considerations both PE Fund sponsors and Limited Partners should contemplate when evaluating their options. It is important to note that every PE Fund’s organizational document is heavily negotiated and therefore inherently individualized, and requires a fulsome review to ensure that the PE Fund’s actions are appropriate. In addition, the sponsors of PE Funds are subject to certain fiduciary duties and must ensure compliance with such duties. PE Funds and Limited Partners should seek immediate legal advice in the event a Limited Partner defaults or indicates its desire to do so.
In general, PE Funds should have several options available to them in the event a Limited Partner defaults on a commitment.
1. Declaring a Default:
Section 17-306 of the Delaware Revised Uniform Limited Partnership Act (RULPA), to which many PE Funds are subject, expressly permits a partnership agreement to provide for specific remedies in the event of a Limited Partner’s default on its obligations. Many partnership agreements do specify remedies, which often include provisions authorizing the PE Fund sponsor to take certain actions, such as:
- Accruing interest on default amounts;
- Prohibiting a defaulting Limited Partner from making further contributions, receiving distributions or having a representative serve on the PE Fund’s advisory committee;
- Reducing the defaulting Limited Partner’s capital account balance;
- Providing non-defaulting Limited Partners notice of a Limited Partner’s failure to call capital, and giving the non-defaulting Limited Partners the option to purchase all of the defaulting Limited Partner’s interest in the fund at a specified price; or
- Covering a defaulting Limited Partner’s shortfalls in any manner, including by (i) requiring non-defaulting Limited Partners to make additional pro rata capital contributions, (ii) giving the opportunity to the non-defaulting Limited Partners to fund shortfalls outside of their own capital commitments, or (iii) admitting additional Limited Partners in order to fund the capital calls.
2. Other Options:
However, given that a PE Fund’s relationships with its Limited Partners and the goodwill it establishes are the backbone of a PE Fund’s structure and success, many PE Funds work to cultivate strong relationships with their Limited Partners over the course of many years. PE Funds may therefore be reluctant to declare a Limited Partner in default of its obligations as imposing significant penalties on a Limited Partner that is temporarily unable to satisfy its obligations can irrevocably harm the PE Fund’s relationship with that Limited Partner. Sponsors of PE Funds may have several other options, including those listed below, but it is important to note that unless a partnership agreement specifies otherwise, obtaining the consent of all partners to take any such action may be required under Section 17-502 of RULPA:
- Working with the Limited Partner to adjust the terms or timing of its commitment;
- Presenting other Limited Partners the opportunity to provide funding (typically on a pro rata basis);
- Utilizing alternatives for unfunded commitments, i.e., third-party investors or debt;
- Decreasing the size of the fund;
- Delaying or reallocating upcoming distributions to cover the defaulted capital commitment; or
- Subordinating the defaulting Limited Partner’s interest to that of the non-defaulting Limited Partners.
In addition, in order to maintain its relationship with a Limited Partner and to help the investor through this unprecedented time, a PE Fund sponsor may be able to excuse the default of a commitment through the use of any excuse/exclusion provision (collectively, the Excuse Provision) that may be set forth in the PE Fund’s partnership agreement. An Excuse Provision allows the general partner of the PE Fund to excuse a Limited Partner from its obligation to fund (or to provide a refund if a contribution has already been made) where certain requirements are satisfied. Depending on the terms of the partnership agreement, a deficit caused by an excused capital contribution can be handled in a variety of different ways, such as a pro rata division by the other Limited Partners. An Excuse Provision generally may be relied upon in the following scenarios, often enumerated as follows:
- If funding a commitment would render a Limited Partner in material violation of a law, government regulation or court order to which it is subject;
- If funding a commitment would render a Limited Partner in violation of ERISA or Internal Revenue Code regulations;
- If funding a commitment would cause a substantial likelihood of a material adverse effect on the PE Fund, any of the Limited Partners or any portfolio investment;
- If funding a commitment would subject a Limited Partner to any legal, tax, or regulatory requirement that could be expected to impose a material restriction or limitation on the Limited Partner, or could be expected to expose the Limited Partner to liability; or
- If funding a commitment would impose a disclosure or compliance obligation on a Limited Partner that is burdensome or would require the Limited Partner to divulge proprietary, confidential or sensitive business information.
The full extent to which the COVID-19 pandemic will impact the global economy, PE Funds, investors and investment opportunities is yet to be seen. It will be important for both PE Funds and Limited Partners to protect themselves, to compromise and to collaborate. This memo speaks to only some of the options PE Funds and Limited Partners may have if a default on an obligation occurs, and all options should be discussed with counsel before any action is taken.