Aftermath of the Bubble: The Defaulting Investor

Daniel P. Finkelman, Testa, Hurwitz & Thibeault, LLP

Historically, private equity funds have devoted significant time and effort to obtaining capital commitments from their investors, but paid little attention to the collectibility of those obligations. The reasons for that are straightforward:

  • Investors were either well-financed institutions or "old family money", and, therefore, unlikely to default on their commitments, and
  • A significant part of the commitment, usually between 25% and 50%, was payable at the initial closing.

Today, fund investors are a more diverse lot and subscriptions are called on a "just-in-time" basis. As a result, more recent vintage funds that attracted individual "new economy" investors are now facing the need to deal with defaulting limited partners whose personal fortunes have plummeted overnight. What options are available to these funds?

Check the Agreement

The first step in the process is to check the limited partnership agreement or other governing instrument for the fund. In the absence of any provision in the agreement, the sole options are to sue the defaulting limited partner or help him find a buyer for his interest. Many agreements, however, specify remedies and procedures for dealing with defaults. A well-thought-out default provision should give the fund managers a variety of options, because no single remedy will suit all fact patterns. The Delaware limited partnership act expressly authorizes multiple default options, including reducing, eliminating or subordinating the defaulting partner's interest, a forced sale or redemption.

Defined Penalty Provision

Ideally, a default provision should offer at least one simple option with readily determinable results. One example is to give the defaulting investor a severe "haircut" on his existing capital account based upon a fixed percentage of his original subscription. Thus, if the investor has a $1 million subscription, the default charge could cut the investor's capital account back by 50% of his subscription ($500,000) and provide that the reduced capital account become the new basis for the partner's allocation of future gains and losses. Any forfeited amounts would then be allocated pro rata among the non-defaulting partners. In addition, the provision could defer all distributions to the defaulting partner until the fund is liquidated. Advantages to this type of approach are that:

  • It is self-executing, so it involves little time or expense on behalf of the fund managers to implement,
  • The mere threat of the haircut can result in the investor coming up with the money, and
  • It provides a benefit to the non-defaulting partners.

However, this approach has very limited persuasive power if the default is early in the fund's life and the investor has little contributed capital at risk, as is the case with many vintage 2000 or 2001 funds.

Other Options

In that case, assuming there is no buyer for the interest in the secondary market, the fund's recourse is to sue the investor to force him to make the payment, with interest. This is not an appealing option, given the time and expense involved, particularly if the investor's overall stake in the fund is small.

Another option would be to allow the fund managers to sell the defaulting partner's interest at a steep discount and without his consent. Again, however, if relatively little of the capital commitment has been paid, it may be difficult or impossible to find a buyer who will assume the unpaid portion of the commitment obligation.
Finally, the manager could allow the defaulting partner to continue in the fund without penalty, but only to the extent of his paid subscription. The disadvantage of this approach is that it may have the effect of encouraging additional partners to default and, in any event, it does not accomplish the fund managers' primary goal of collecting all of the committed capital. In addition, under Delaware law a fund manager is not permitted to compromise a partner's obligation to make his agreed-upon contributions unless all partners agree or the partnership agreement specifically gives the manager that authority. It is important to remember that fund managers always have a fiduciary duty to act in the best interest of the fund and all of its partners. That being the case, it would generally be unacceptable to let a partner "off the hook" on his commitment without penalty.

Other Issues to Consider

Ideally, the limited partnership agreement should address any other issues that may be affected by an investor's default. For example, will the default cause a reduction in the amount of the management fee, which is almost always based on aggregate subscriptions? Will the defaulting investor continue to have any voting rights under the agreement? What impact will the default have on investment limitations, such as investing in foreign companies, or ownership limitations, such as for bank holding companies, that are calculated as a percentage of total subscriptions?


A limited partner default or threatened default can present a tremendous drain on fund managers' time and attention. Managers should have an action plan in place before a default occurs.

  • Survey limited partners and other institutional investors for potential purchasers of secondary interests.
  • Understand all alternatives available under operative partnership agreements and the legal ramifications of each course of action.
  • Carefully follow the precise terms of the partnership agreement when implementing any notice, default or penalty provisions.

Finally, fund managers should keep in mind the "lessons learned" in dealing with defaulting partners over the past year as they formulate provisions for new fund documents that will provide the greatest level of flexibility in dealing with any future default situations.

This article is reproduced with permission of Testa, Hurwitz & Thibeault, LLP. For more information about Testa, Hurwitz & Thibeault, LLP, please contact or visit the firm's web site at

© 2002 Testa, Hurwitz & Thibeault, LLP. All rights reserved.

Daniel P. Finkelman, Partner