Private Equity Fund Law

The Legal Protections Funds Have When Investors Fail

Many institutional investors and high net worth individuals have fallen on hard times, opening up the possibility of limited partners failing to meet capital requirements for private equity funds.  When a limited partners goes bankrupt, the general partners of the fund may also take a loss.  An important case in bankruptcy involved the limited partners of several private equity funds who sought and received recognition of insolvency proceedings commenced in the British Virgin Islands.

According to the NY Law Journal, in the event that an investor fails to meet a capital commitment, the manager of a private equity fund has the following recourse:

(i) offering the defaulting limited partner's unfunded commitment to another limited partner or a third party,

(ii) withholding distributions to the limited partner,

(iii) offsetting distributions to the limited partner against unfunded capital calls,

(iv) compelling forfeiture of all or a percentage of the limited partner's interest in the fund,

(v) charging interest to the limited partner on the unfunded amount until such amount is satisfied, and

(vi) initiating a lawsuit against the defaulting limited partner.

However, a limited partner under bankruptcy protection may be sheltered from some of these actions, according to §362 of the Bankruptcy Code.  Section 362 gives automatic stay to many actions based on pre-bankruptcy agreements and often a bankruptcy court order is required to enforce any capital calls agreed upon before the LP filed for bankruptcy. 

The problem in limiting the fund's ability to enforce capital calls or forfeit the defaulting party's stake is that it may inhibit the fund's investing.  If an investor cannot pay the capital commitment then a deal may have to be put off or canceled entirely.  The NY Law Journal says that this restriction on the general partner from enforcing capital calls "could detrimentally effect a fund's ability to make investments in portfolio companies or satisfy expenses, and thereby interfere with the fund's operations."

There seems an unfair advantage given to the defaulting party if the investor receives all the benefits of the partnership agreement without fulfilling the entire obligation.  Luckily, the NY Law Journal suggests several ways to remedy this unfortunate situation:

• Negotiate With the Debtor/Limited Partner:  Often the defaulting investor values his stake in the fund and will be willing to negotiate different terms or a suitable compromise so that he can keep his partnership interests.
• Relief from the Court: As previously noted, by appealing to the bankruptcy court for relief, a general partner may be able to still make capital calls or other remedies.  The GP will have to show that by not receiving the investors' capital the fund is suffering and the court may lift the stay.
• Setoff or Recoupment: The Journal explains: "Section 553 allows a creditor to offset a debt owed to it arising before the commencement of a case against a claim of the debtor against the creditor also arising prior to the commencement of the case.
  Alternatively, the general partner may exercise the equitable remedy of recoupment, pursuant to which a creditor reduces the amount of debt owed to a debtor by the amount owed by the debtor to the creditor. Recoupment is an equitable defense; it is like setoff in the sense that one obligation reduces another, but in the case of recoupment the obligations arise out of the same transaction." 
• Assumption or Rejection of the Partnership Agreement: "The general partner also may make a motion with the court seeking to compel the debtor/limited partner to assume or reject the partnership agreement (or other fund governing agreement) pursuant to §365 of the Bankruptcy Code."

The Journal also suggests several ways to protect the fund against this situation in the pre-bankruptcy period, see this article for the full explanation of each measure.

• Automatic Triggering of Capital Calls
• Setoff/Recoupment Provisions
• Covering Shortfalls in Capital Contributions
• Cross-Default Provisions
• Capital Calls Secured by Partnership Interests

It is important for General Partners to consider the unfortunate possibility that investors will default on obligations to the fund. I am not a lawyer, but the authors of the piece that this explanation of private equity and bankruptcy courts is based on are Richard F. Hahn and Michael E. Wiles are partners, and Bryan R. Kaplan is an associate, with Debevoise & Plimpton.  Disclaimer: consult a legal professional before following any of the preceding suggestions.  Source


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Tags: private equity law, legal protection, bankruptcy, bankruptcy court, private equity laws, buyout law, general partners, partnership agreements, limited partners, partnership, capital calls, commitments

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