April 14, 2020

What risks should a GP consider at the level of LPs?

In times of major economic transformations, investor default is not unlikely. Investor default may be due to financing shortages at LP level, e.g. if an LPs underlying investors default or if the LP fails to raise funds as planned to honor the capital commitment. Also, an LP may deliberately go into default to adjust capital allocation.

If an investment is immediately available for the fund, an overcall to the remaining LPs may be possible. The aim of the overcall is that the remaining LPs close the gap caused by the default in the short term. However, most LPAs foresee certain restrictions for overcalls and – if the default cannot be resolved – overcall reduces diversification.

Another possibility may be bridging the default amount with a bank loan by the fund.

Subsequent to investor default, LPAs typically provide for certain remedies against the defaulting LP, including sale of the interest and removal at steep discounts. However, this can be a time-consuming and contentious process. The GP and other LPs may have a right of first refusal. In the past, many of these special situations have been resolved by a managed sale to a "willing" other LP or third party.

GPs may also face elevated scrutiny from LPs and LPs may look for other ways to restrict future drawdowns. Such may include no-fault early termination of the investment period, no-fault removal of the GP or no-fault termination of the fund's term. GPs may want to understand what is in their fund documentation and build blocking minorities amongst friendly LPs.