See you in court

A recent lawsuit by a firm against two LPs highlights the new dangers that may await those who fail to find liquidity solutions in today's market.

The notion of a private equity firm suing its limited partners was considered practically unheard of just a short time ago. But with the boom times in the industry over for now and cash-strapped investors having an increasingly hard time meeting capital calls, a recent lawsuit filed in Delaware may be a sign that more sponsors could be taking a harder line against LPs in the future.

The suit is further evidence that parties who fail to successfully deploy liquidity tools in advance of defaults face ugly consequences.

New York private equity firm CapGen in early March took the rare step of suing two of its LPs – Chalice Fund and WK CG Investment – for allegedly failing to honour capital calls to three funds formed in 2007 and 2008. CapGen is seeking payment of the outstanding commitments with interest, as well as a court order requiring the LPs to make all future contributions.

“There are only a handful of cases that deal with a private equity fund sponsor suing its LPs for defaulting on a capital contribution … Maybe they want to take a hard line with their LPs and make it clear that no one is going to get special treatment.”

The case, being tried in Delaware's Chancery Court, has attracted attention in the industry mainly due to its novelty. “This is very unusual,” said Andrew Wright, a partner at Kirkland & Ellis. “There are only a handful of cases that deal with a private equity fund sponsor suing its LPs for defaulting on a capital contribution. Mainly this is because we have historically seen few defaults in the private equity industry, as we have never been through a period like this, and also because there are other alternative remedies available in most private equity fund partnership agreements.”

Such remedies typically include reducing the limited partner's capital account, forfeiting of all or a portion of the defaulting investor's interest in the fund, enforcing a penalty interest on the defaulted capital call at a high default rate of interest, assisting the LP in obtaining a credit line to fund capital calls or – the most preferred fix – finding a buyer for the interest on the secondaries market. But while CapGen had such remedies at its disposal under its funds' partnership agreement, it chose to pursue legal action against Chalice and WK CG instead.

Firms in the past have avoided the courtroom due to potential distractions on a sponsor's time, adverse publicity and potential impacts on fundraising. GPs also often do the math and decide that the cost of trying to chase down an investor and recover a sum in court – especially against an LP located overseas – is not worth the time and money.

Sending a message
The timing of the suit and the size of the LPs being targeted has also raised eyebrows. For one, CapGen – which declined to comment on the issue – filed the lawsuit less than three months after the capital call in question was first issued.

Meanwhile, Chalice and WK CG are two of the smaller investors in the three funds, as their respective commitments of $3.5 million and $1 million – some of which had already been paid in – were well below the average investment of $6 million to $7 million. In fact, a managing partner at Grail Partners, which sponsors Chalice Fund, told the Wall Street Journal that they had not yet been served with legal papers and called the $800,000 missed payment “small beer” compared to the $500 million in combined capital commitments for the three CapGen funds.

A WK CG investment partner also told the paper that his firm only owed $200,000 on the latest capital call and said he wanted to talk with CapGen about making a schedule of payments so he could stay in the fund. It's possible that CapGen may have decided that targeting two small LPs could be the best way to send a message while not alienating their larger investors.

“It puts everyone on notice that the GP is going to take these things seriously and enforce the default provisions,” Wright said. “Maybe they want to take a hard line with their LPs and make it clear that no one is going to get special treatment.” He adds that in light of the current economic environment it is “certainly more likely” that the industry will see more lawsuits like this, although it should normally be a course of last resort.

However, one LP who is not invested with CapGen said the suit could represent a double-edged sword for the firm. “One one hand it is bad for the GP since it makes then out to be very litigious and LP unfriendly – which can't be good for fundraising the next time around,” he said. “On the other hand it can be good for the GP in the short term since it acts like a warning flare to the other LPs who may be considering default options.”

No special treatment
While the threat of lawsuits could alienate some LPs, others may welcome a tougher stance by a GP. “I think LPs want sponsors to enforce default provisions,” Wright said. “From the non-defaulting LP's standpoint, they want to know that no particular investor is getting special treatment. Some are telling GPs, ‘We invested in your fund to take advantage of the market opportunities out there right now, and we expect you to be calling capital, making investments and enforcing the default provisions, and if you don't do that we will consider ourselves to be aggrieved’.”

Another private equity LP said in most cases the default provisions in every agreement are usually so onerous that LPs either find a way to fund or walk away, leaving most or all of the interest to the GP. Due to the uncertainty of going through the courts, he said it's best for the GP to work on a payment plan with LP or seek out a secondary.

“I would guess there is much more to this story with CapGen,” he said. “Given the times, these suits may occur more often, but still should be rare.”

As the spectre of more LP defaults increases as more pension funds, endowments and other investors are asking firms to hold off on new capital calls, sponsors have taken varied roads in addressing the situation while avoiding the courtroom. For instance, Guy Hands' Terra Firma headed off a potential default in February by buying three of its limited partners out of its 2007 fund at a “small premium” to the face value.

Meanwhile, a proposal by European buyout fund Permira to cap commitments to its fourth buyout fund at 60 percent was taken up by 18 of its 180 investors, while TPG offered its LPs the opportunity to reduce their pledges by 10 percent. Private equity advisor Probitas Partners is also approaching large investors about a new liquidity vehicle that would match investors looking to get reduce their allocations with counterparties eager to help fund future capital calls.

It's likely that suits such as CapGen's will remain rare as the actual number of investor defaults that are actually occurring is still quite small on a percentage basis. But if a rise in defaults becomes a reality, firms will be considering all their options.