How to assess and respond to investor’s delay or default in payment of its capital commitment?

03.04.2020 How to assess and respond to investor’s delay or default in payment of its capital commitment?

By Associate Partner Karina Andriukaitienė

COVID-19 pandemic will affect PE/VC fund managers in multiple ways. While specific impact on individual fund managers will vary depending on a variety of factors, including the stage of the lifespan of the fund, type of fund, the investor base etc., we have put together a list of key considerations for fund managers in the light of COVID-19. One particular issue, which we would like to address in this alert is potential delays or refusals to provide capital for fund’s investments resulting from the economic shock experienced by fund’s investors, triggered by the pandemic.

Capital calls
Fund managers should consider calling funds, or at least providing a more advance notice than normal of capital calls to the investors. This will provide more time to address and mitigate potential defaults by investors and give an opportunity for fund managers to mitigate any adverse impact on transactions or portfolio companies.
 
Defaulting Investor provisions
Fund documents normally include a number of rules and remedy options which may be applied to the defaulting investor. Firstly, the investor is subject to a fine on the amounts in delay (e.g 12% on the amount in delay if investor communicates its default to comply with the draw down notice well in advance, i.e. prior to receiving the draw down notice; or 24% on the amount in delay if investor communicates its default after the receipt of the draw down notice; the fine does not release the investor from its obligation to transfer the committed amounts to the fund). If investor continues its default, the fund manager may apply a range of penalties such as (a) suspending investors right to receive information about the fund activities (b) suspending investors right to participate in the distribution waterfall; (c) applying a forced sale of defaulting investors participation to existing or outside investors at a discount; etc.
 
Withdrawal from the fund provision
Generally, PE/VC fund documents do not provide with the possibility to request redemption of investor’s participation directly by the fund or manager. However, transfer of participation on the secondary market is normally allowed subject to prior approval of the manager. In this regard, Secondary Private Equity fund may be a way of selling unrealised investor commitment.

Side Letters
Side letters are supplements/modifications to the key fund document (e.g. limited partnership agreement) and are often used to grant exclusive rights and privileges to special investors. Side Letters may accommodate the situation by imposing individual conditions to separate investors. Side Letters are normally subject to disclosure to the remaining investors in order to avoid the conflicts of interest and unequal treatment of investors.
 
Bridge Financing / Co-Investment
Also, in case of shortage of sufficient cash flow for a specific deal, alternative short-term or long-term financing providers may also be a solution. Consider securing financing from non-traditional lenders, external co-investors interested in the deal.
 
Force majeure
If investor is justifying its default by force majeure, consider assessment of its legitimacy. Bear in mind that quarantine due to COVID-19 does not automatically trigger force majeure situation and therefore each case should be assessed individually. More information on force majeure and other COVID-19 related recommendation prepared by our experts can be found here (available in Lithuanian only)
 
Recommendation
Analyse your fund documents (LPA, fund rules, articles of association, etc.) and look for the provisions notably related to (a) defaulting investors; and (b) investors possibility to withdraw from the fund; (c) Side Letters; (d) Bridge Financing.
 
How can we help

  • Qualify the situation as per the existing provisions in the fund documents.
  • Propose existing and possible alternative solutions on managing investor’s default.
  • Assess defaulting investor’s force majeure status.