A DEFAULTING INVESTOR is an investor that fails to transfer cash to a fund within the timeframe stipulated in the DRAWDOWN NOTICE
What happens in the case of a default
Although most DRAWDOWNS proceed without incident, sometimes cash is not received on time. Perhaps a High Net Worth Investor happens to be on holiday or is otherwise uncontactable, and fails to see the notice so does not fund on time.
If a Limited Partner doesn’t fund within the period agreed in the LPA, the LP technically become a “defaulting investor”. This can lead to draconian consequences: a private equity fund may, depending on the Limited Partnership Agreement, strip an investor of its right to profit and possibly its capital and the General Partner or Manager may also have the right to sell the Limited Partner’s commitment to another investor on the secondary market (typically this would be to a different existing LP), meaning that the Limited Partner could lose value created in a previously funded commitment.
And this is not just an issue for smaller investors. An institutional investor will have a large treasury function and will manage its cash float to keep it as small as possible, always seeking to fund any commitment as late as possible. This can mean that funding within a specific timeframe may become a challenge. However, running an efficient and effective drawdown process is vital for a fund as, if cash doesn’t come in, as requested, this may make it impossible to complete a deal.
Of course, the General Partner or Manager may, at its discretion, decide not to enact some or all of the measures available to it and will have a mind to not antagonise its investors. In some cases, when deals are not impending, the Manager can, within reason, show latitude for slow payers. Indeed, the Manager way look to mitigate the chance of slow payers derailing investments, for instance by holding a cash float – although this will impact the IRR hurdle when calculating the WATERFALL and so will impact the level of carried interest. Overdrawing from investors in previous drawdowns is another option, but again has an impact on the IRR.
An alternative may be for a GP or Manager to reach out to a bank or other specialist funder and put in place a bridging facility. These are expensive and ultimately end up being paid for by the Limited Partners. And while some LPs do like bridging facilities as the demand on them to fund ad hoc DRAWDOWN NOTICES is reduced, other LPs don’t like them, as they want their monies to be invested: they, in turn, need to show they have put their cash to work.