In the current economic climate, one of the hottest subjects in private equity has to do with the way the private equity funds, deal, if at all, with limited partners who refuse to honor their commitments and reject capital calls. We have dealt with this subject in prior Buzzes; and there is other useful material on the subject, including "When Limited Partners Default ," by Allen Weingarten and Jay S. Rand, partners in the law firm of Morrison & Foerster LLP's New York office and "Time to Review Your Defaulting Partner Provisions,"  by Jay K. Hachigian of Gunderson Dettmer in Boston.
As these materials indicate, the managers of private equity funds facing this problem have responded in a variety of ways. Some have postponed capital calls so as not to deal with the issue until the climate improves. Others have reduced capital commitments across the board. Some have adopted the "just say no," attitude and applied the Draconian sanctions set out in most limited partnership agreements. None of these solutions have proven to be entirely satisfactory; and, therefore, the "lab" at VC Experts, in an effort to solve this problem, offers the following scenario:
Advisors Fund LP is a first time venture fund organized in 1999 with commitments from ten investors each for $10 million, meaning a total commitment of $100 million. The fund has a typical limited partnership agreement with 50 percent of its commitments invested and an unpleasant track record, with both realized and unrealized losses. The general partner ( GP) has drawn $50 million, no liquidity events have occurred and the $50 million in contributed capital has been consumed in (i) paying the management fee and expenses; and (ii) investments which have now shrunk in value to $30 million. For simplicity's sake, the GP has no capital account and each investor has an equal capital account, each now with a paper valuation of $3 million. (Assume the valuation is reasonably reliable, validated by a third party.)
Assume 10 limited partners, most institutional but some high net worth individuals, a couple of whom are nowhere near as high net worth as they once were and are pleading poverty. At least one institutional investor is a state employee pension fund, the political steward of which deems it in his or her best interests to make waves for the benefit of his or her political career. The general partner calls a meeting of the limited partners, and makes a proposal. The general partner leads off on stating that "there are a lot of good buying opportunities out there right now and it would be a dirty shame not to take advantage of the low prices and attractive deal terms presented by ample portfolio opportunities." Moreover, since a number of the funds are not buying, the selection of deals is even more attractive as well. The GP wants to call another $5 million, in addition to a call for the management and expenses; but storm signals are up. A few investors are truculent and saying, in effect, "sue me for the money." If the general partner allows one limited partner to cancel its commitment without penalty, there is a real possibility of a 'run on the bank,' meaning all the limited partners require (whether they are legally entitled to or not) equal treatment. The general partner is reluctant to sue; and, applying the several sanctions may not stick and/or get the fund back up on an even keel.
The remedy in the Advisors LP Agreement includes an interest charge on unpaid capital contributions; a 50 percent haircut on the current capital account; plus the inability to participate in future profits from additional investments. Several of the companies in the portfolio have not been marked down and, indeed, show promise; but they will "hit the wall" unless follow-on investments are made by Advisors Fund. (In light of the culture of the business, it will be very hard for Advisors Fund to pull in other VCs to make the necessary follow-on investments unless Advisors Fund itself plays in the follow-on rounds. "If it's not good enough for you, it's not good enough for me.")
The GP is concerned that, if it lets out the two most vociferous and defiant investors, that waiver will create a 'run on the bank' and all the investors will insist on relief from future capital calls. The GP does not deem liquidation of the fund at this point in anybody's interest, because none of the positions are liquid; in fact, several companies, which are on track but need follow-on investments, are unlikely to get the necessary plasma to keep going and reach the expected happy ending if the fund simply closes shop and runs out the string. Most of the investors are not irrevocably angry with the GP; they recognize the managers were blindsided (like everyone else) by the suddenness and precipitousness of the meltdown. However, they have their own constituencies to satisfy and are concerned that, if they continue business as usual, their bosses (and the beneficiaries for which they are fiduciaries) will complain that they failed to take any positive, pro-active action of the sort which investors in other funds are (according to the public press) undertaking. The situation, in a word, is fraught with issues which might be described as psychological and not directly rooted in economics.
Any limited partner electing to walk realizes that, while it has a scheduled commitment of another $5 million which it might avoid, it still has $3 million at stake inside the limited partnership, which the GP is prepared to eat away at ... first by cutting the same in half, then by charging an outlandish interest rate on the unpaid capital commitment and, finally, by charging management fees and partnership expenses for the next eight or so years. The likelihood is that, if the parties cannot reach an understanding, the LPs will wind up with nothing. In other words, by failing to honor the $5 million future commitment, they will have sacrificed $3 million in current, presumably realistic, valuations, which means that, given the $2 million writedown, they will have lost their entire $5 million investment. Is there an elegant way out of this problem, which would not only save face but give a chance for the talented managers of the GP to attempt to recoup their losses and make everybody happy?
The answer, I suggest, is to offer to turn the fund into a "pledge fund." I think the pledge fund works for the following reasons, and in accordance with the following continuation of the scenario. The GP proposes the following plan to the limited partners:
If (i) you will renew your commitment, which already exists as a legal matter, to honor limited capital calls in order to pay your share of the 2 percent management fee ($2 million a year) plus your share of partnership expenses which are the responsibility of the fund (let's say $250,000) and (ii) you all do it unanimously, we will release all of you from your unconditional obligation to honor your commitment and fund future capital calls for investment. However, we will not liquidate the fund, because it would be uneconomic to do so, and we will not charge any of the Draconian remedies set out in the partnership agreement. Your capital accounts will remain as they currently stand. We will then use the remaining period of the fund's life to investigate additional investment opportunities, either follow-on investments in our existing portfolio or new portfolio companies ... at least, in the case of new opportunities, until the investment period expires. We will present each opportunity to each of you, or to a committee established by you as a group, for your review; and each of you will be given the opportunity on a case by case basis either to fund your proportionate share of each proposed investment or to pass. With respect to those limited partners who pass, there will be a pro rata expansion of the opportunity to the limited partners who want to play to invest and take up the slack. Thus, for example, if there a $5 million capital call (and leaving aside the management fee and expenses for the moment) and that capital is entirely to be invested in a new portfolio company, then each of the ten investors has the opportunity to put up $500,000. If two investors elect not to play and the fund is, therefore, $1 million short, that $1 million will offered quickly to the other eight limited partners ... and, if a shortfall, to the members of the general partner. If, at the end of the day, there are unsubscribed units, either the portfolio company will cut back its appetite (which often happens in this business as portfolio companies raise rounds of financing) or the GP will attempt to corral other investors to fund the difference. Note that this is not a situation in which Advisors Fund elects not to play at all; it is playing to the tune of $4 million, versus $5 million, to be sure; but $4 million is 80 percent of the total investment opportunity open, so Advisors Fund has serious 'skin in the game.'
The scheme anticipates shortening the time period for responses so that Advisors Fund can avoid the issue of timeliness (with respect to new investments; follows-ons are not a problem in this context). It is true that a pledge fund requires that the decision to invest be passed under the noses of multiple potential investors and not just the management of the GP; therefore the investment process is clumsier and, presumably, attenuated. The protocols built into Advisors Fund on a going forward basis, accordingly, contemplate a series of quick and dirty drop dead dates for the limited partners to act within ... fill or kill in, say, 10 days or less from the date of notice of a new investment opportunity is sent out. All the limited partners are accredited investors, the model assumes, and, therefore no specific quantum of disclosure is required; it will be up to the GP to get adequate information out to the limited partners or their advisors so that they can make up their minds.
The assumption, it should be recalled, is that the limited partners are not totally disenchanted with the GP's management, or maybe not disenchanted at all. However, they need to be able to go back to their headquarters and boast that they have been able to negotiate material changes in their favor in the structure of the fund. Simply standing pat is not acceptable to the home offices of the limited partners. If worst came to worst, a limited partner could theoretically pass on every investment opportunity ... indeed could make up its mind to do so (sneakily, of course) when it executes the new round of agreements. However, the obligation to continue to pay a non-trivial management fee and partnership expenses makes the 'lie in the weeds' strategy, if you will, adopted by crafty limited partner (attempting to achieve a de facto withdrawal from the fund), less than economic.
The principal advantage to a limited partner is the ability not only to review individual deals but also to take advantage, if the climate indeed changes, of improving economic conditions. Assume, for example, that the IPO market comes back prior to the scheduled liquidation of the fund. Assume that the follow-on investments actually are sound and the portfolio rebounds. Assume the GP is right that there are bargains galore in the post meltdown environment ... and, as I mentioned, assume the alternative is defiantly to tell the GP take its capital calls and go jump in the lake, which will likely mean the loss of the limited partners' entire investment. Forgetting for the moment the time value of money, a 2 percent management fee on a $100 million, means $200,000 per GP, a year for the next, say, seven years or a total of $1,400,000 (and I'm leaving aside the limited partner's share of fund expenses). The question for each limited partner is, then, whether it puts $1,400,000 at risk, balanced against (i) the likely outright loss of $3 million in the limited partner's capital account plus (ii) the opportunity to see and review an additional $5 million worth of deals, a good portion of which may well go into deals with which the GP is intimately familiar because the investment is of the follow-on variety.
Of course, the scheme mentioned is not going to work in every instance. Again, it is dependent on residual good will between the limited partners and the GP. If the limited partners are totally disenchanted, then nothing works. But if, realistically, the limited partners understand that no one was immune to the NASDAQ meltdown, then this strategy overcomes the various exogenous problems a limited partner faces in staying in harness for the remainder of the capital calls.