Reputational risk, early secondaries help assuage LP default fears

When a financial crisis hits, talk of defaults rises in all camps as institutions and individuals struggle to meet their commitments. LPs are not immune to the rumours and, when the coronavirus lockdown began to impact markets in March, talk of limited partners being unable to fulfil their commitments was rife.

Capital calls are currently running well in excess of distributions, so private equity programmes are seeing cash outflows on a net basis after years of inflows, further boosting speculation about a spike in LP defaults. But several market players believe that since the modern LP universe mostly comprises well-funded institutional investors, the idea of widespread defaults remains an urban myth for now.

"There has obviously been disruption," says Nicolas Vagner of Axelium Capital, an independent placement agent and GP consultancy, "but much of it has been just logistical, which in some cases has led to LPs being simply a bit late funding capital calls, since the process hasn't been originally designed to be fully dematerialised. Short notices for some of those portfolio cash injections or opportunistic acquisitions have also compounded the problem.

"Funding is much more dependent on pension contributions, insurance premiums and corporate cashflow than distributions," says Mathieu Dréan of fund advisory firm Triago. "As a result, we expect a minimal rise in defaults tied to the Covid-19 crisis."

Answer the call
Limited partners typically have 21-30 days to stump up money when a capital call is made and, if this does not materialise, an LP goes into default. If a €10m commitment was made at closing and the first €8m has already been drawn, failure to pay the outstanding commitment when requested would technically result in the original €8m being forfeited. However, if a fund has only recently closed and there have been no capital calls to date, an LP could walk away without any immediate financial penalty.

"GPs who recently raised are the ones that are most worried, as the funds that haven't drawn down on any commitments could see LPs walk away if liquidity is a concern," says Sunaina Sinha of Cebile Capital.

Reputational risk is very high in all scenarios though, both for the GP and the LP, so all parties will tread with caution. An institutional LP defaulting would close most GP doors in the future and mean it is up against a very significant liquidity squeeze, since its future in deploying and remaining committed to the asset class would be called into question.

Given this, defaulting on a commitment could suggest that there is some bigger issue going on and the Covid-19 crunch is merely a catalyst, especially since limited partners are sophisticated and very well-funded, Vagner argues.

"There was also quite a bit of noise around LP defaults in 2008-2009," says Vagner, "but the cases where LPs refused to fund capital calls were typically not the result of a liquidity issue. There was usually a bigger issue with the GP." He says there were actually very few LP defaults at the time, not least because of the reputational damage associated with it.

Meanwhile, GPs potentially faced with a default situation would also have to think twice about the best way forward. Clauses in fund documentation vary, and although the GP may technically have the right to bring a claim against a defaulting LP for failure to pay and for loss of management fees and running interest, it may not be in its best interest to actually bring a claim.

"Contractually, an LP is committed and will be in breach of the partnership agreement if it doesn't meet a capital call, but do they [the GP] really want to wait and count down the days until it can default an investor?" says Daniel Greenaway, head of funds at Mishcon de Reya. "There is usually the ability to try to sell the interest on the LP's behalf either to other investors or on the secondaries market." If no buyer of the stake can be found, a GP may ultimately be able to forfeit an interest if they so wish, with the investor only retaining a subordinated right to a return of its contributed capital, he adds. 

Secondaries solution
Copious amounts of dry powder have been raised in the secondaries market, so any LP anticipating a default would indeed likely try that avenue first.

Many have looked to the secondaries market in recent years as a liquidity solution and, in 2019 alone, close to $50bn was raised for the strategy, with little sign of capital or appetite dwindling, as Ardian's $19bn raise at the beginning of June has shown.

Regardless of whether an LP is in a liquidity squeeze, they may wish to use the secondaries market to be rid of their undrawn commitments if they see them as a liability. A handful of buyers of so-called "early secondaries" or highly unfunded positions are coming to the fore with many funds-of-funds such as Ardian already involved in such programmes. 

From a buyer's perspective, pricing could even be seen as advantageous when taking a highly unfunded liability away from an LP, as the purchaser could be getting assets that are already in the fund for a cheaper price.

"Until the Covid-19 crisis, the overwhelming majority of secondary market activity revolved around relatively mature assets – including tail-end assets. In a repeat of what happened during the global financial crisis, we are seeing a very strong proportionate increase for deals involving funds that are only 5-20% drawn," says Triago's Dréan.

Early secondaries account for at least a third of the deal volume initiated since mid-March – up from 5% or so of annualised volume in a typical year, according to Triago.

"Because secondary market discounts only apply to invested capital, early secondaries are a fairly painless way for sellers to get out of commitments and for both buyers and sellers to find prices at which deals can clear," says Dréan.

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• Topics
• Fundraising
• Secondaries
• LPs
• GPs
• Secondaries
• Triago