Happy Friday, Funds Family!

In last week’s article, we learned how to call capital from investors.

But…what happens if the LP just…doesn’t send the money?

🚨Defaulting limited partners

The fund documents for a fund or syndication should have a defaulting limited partner section that addresses the remedies and process if an LP doesn’t fund a capital call.

Basically, the defaulting LP is in really big trouble. 😨 

Here are some remedies available to GPs in a typical fund LPA:

1. Default interest. The GP can charge a high rate of “default” interest on the amounts the LP should have funded.

2. Suspend distributions. The defaulting LP no longer receives distributions until the default is cured.

3. Forced sale. The GP can force the LP to sell their interest to someone else. In some cases, the GP might have the right to buy out the LP at a predetermined price (e.g., 50% of the market value).

4. Lawsuit. The GP can sue the LP for specific performance (making the LP fund their capital call).

5. ☣️ The nuclear option. The GP may have the right to cancel the LP’s interest in the fund for no consideration and kick them out.

🤝 What do GPs typically do in real life?

When a defaulting LP situation actually occurs, GPs are often somewhat merciful.

Examples of nicer responses include:

• Help the LP sell their interest to someone else

• Give the LP an extension

• Excuse them from the capital call

In 2022, when people had liquidity problems, the most common solution was helping the LP transfer their unfunded commitment to someone else.

Being a GP is a long game, and you don’t want to develop a reputation for being an asshat. 🎩 

🙄 What if an LP doesn’t fund its first capital call?

The short answer is you’re out of luck. 😭 

While technically you can yell, complain, and sue, I’ve never seen a GP sue an LP to compel them to fund their capital call.

If they had the money, they probably wouldn’t have defaulted.

💵 Escrowing LP funds

One way to mitigate default risk is to require LPs to pre-fund some or all of their commitment into an escrow account.

Then, the GP calls capital from the escrow account instead of calling from the LPs directly.

However, many LPs (reasonably) don’t like this. The money in the escrow account doesn’t accrue a preferred return or count toward IRR calculations. LPs would often rather have the money in their own high-yield savings account than in a savings account controlled by the GP.

In some cases, this “escrow” requirement might only be for small LPs. In addition to reducing default risk, this strategy incentivizes people to write bigger checks.

Thanks for reading, everyone.

Have a great weekend! 🙌 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.