Historically, the incidence of “serious” defaults (“serious” meaning contribution failures that persist to a point in time at which consideration of enforcement action is necessary) in institutional venture capital funds is quite low. This article is being written half a year into the 2020 pandemic, during a time at which not surprisingly many managers we work with are concerned to understand their rights in the event of serious defaults. Nevertheless, and while healthy to understand what the agreements provide for, the case remains even in these unusual times, as historically, that serious defaults don’t happen all that often.
The principal reason for the low incidence of serious defaults is that typical venture capital fund agreements impose very onerous default remedies against the defaulting investor, including up to full forfeiture of the capital account value associated with the interest, inclusive of paid-in capital and any gains. Once material capital has been contributed to the fund, there is considerable impetus to make further contributions timely. If I’ve paid in $1 million of my $5 million commitment, am I really willing to walk away from that $1 million and any attendant gains? Even if I’m seriously distressed financially, there’s a high incentive not to simply abandon my capital account value. In short, paying in contributions timely is something that investors are well advised to try to remain on the right side of, and most often, they do.
With that said, occasionally cases of serious default arise, and fund managers are put in the position of acting on the default remedies found in their fund agreements. This article explores typical options available to venture capital fund managers when defaults reach a serious level demanding action.
Do I Have to Act? When?
The preliminary question we usually get is: do I have to act and when? We are often contacted at a point when a contribution is several months past due, the manager may have had some initial conversations with the investor, and the investor isn’t taking, or seeming likely to take, timely remedial action.
From a manager’s perspective, defaults are not ideal. They disrupt budgets for future investments and follow-on activity and potentially cause shortages of cash for quite immediate investment activity, which can then require unplanned additional capital calls from other investors. If you raised a $500 million fund, you want to end up with $500 million to invest, not $450 million. Furthermore, defaults will eventually work their way into audited financials if there are not direct contractual notification provisions in the fund agreement or side letters in the first place. Other investors will eventually learn of the situation, which may raise questions. Managers typically prefer to avoid this for reputational reasons.
With the above in mind, our first advice is to try to work with the investor to rectify the situation. Perhaps the investor is not aware of the possible onerous consequences and/or is trying to manage many different capital demands. A stern letter reminding them of their obligation and the potential outcome can often lead to a reprioritizing of payment to the fund. Take the case of a distressed corporate investor that has money to pay some but not all obligations. On reminder, it is often a result that the payment to the fund is moved to the front of the payment queue after awareness is focused on the impending downside. In our experience, stern letters of explanation may cure something like 25-40% of serious default situations.
Another potential early conversation is to encourage a secondary sale, in which the purchaser will catch-up on missed contributions and take over the interest going forward. In the preceding example, even if the distressed investor ends up with 70-80% of FMV in a secondary (i.e., $700,000 to $800,000), the result is much more favorable than forfeiting the $1 million of value under the fund agreement’s default clauses. Where a seller just simply does not have cash, and there is capital account value, this path almost always makes sense and a distressed investor that is rational will pursue it. They may do that largely on their own once prompted (say by approaching typical secondary buyers), or in some cases the fund manager may wish to get more involved, for example to “steer” the interest to a friendly existing or prospective LP that is or may be a long term investor in the manager’s other funds (i.e., usually not a secondary buyer, unless they have a fulsome primary investment platform).
As to the question of whether a manager is required to do anything, and if so when, fund agreements we work with generally provide that the choice of a manager to enact or not enact default remedies, and the timing thereof, is at the manager’s discretion. Even on this typical drafting, there may be an ultimate fiduciary duty at law to take action in good faith for the benefit of the fund and its partners as a whole. We are not often distressed by this concept because typical contracts make it clear enough that ample time is to be permitted for rectification of the situation, and give the manager a lot of discretion on how to handle each case in particular. Regardless, interest is frequently aligned as the manager has its own capital at stake, has the reputational concern of keeping the books and records free of evidence of serious default and more than anything, has an interest in preserving originally targeted capital to ensure budgeting for follow-ons isn’t disrupted. In practice most managers we work with might give a long standing, credible investor suffering temporary distress some leeway to rectify, but not likely in excess of say 6 months at the outer edge. Less known, newer investors, or those as to which there is specific doubt as to creditworthiness, would typically get less leeway, with formal default provisions enacted sooner.
That Didn’t Solve It – What Do I Do Now?
In a few cases, no matter how sensible it may be on that part of the defaulting investor to cooperate, the above methods won’t yield successful results. So what then?
First, make sure to follow any technical “notice and cure” periods in the fund agreement, if not already done by this time. Usually there is a requirement for a formal notice of default letter, and 10 or 20 days cure time. There may be multiple notices and cure periods in some cases. Given the serious nature of the situation, and notwithstanding notice procedures in the relevant fund agreement, we recommend dispatch by both trackable courier and email. Once this box is checked, the manager is free to pursue remedies under the default provisions of the fund agreement. Typically, the choice of which remedy or remedies to pursue is at the discretion of the fund manager, and not mutually exclusive. Among the typical remedies we would expect to see in a typical fund agreement are the following:
1. Sue for Damages and/or Performance: This is ordinarily provided for, including the right to collect interest on the defaulted contribution(s) at an interest rate significantly in excess of the prime rate (say 12-18%). It is not often, however, relied upon because by the time an investor is in serious default there are likely to be collection issues on any judgment, and proceeding along this route takes time and money. Furthermore, there is reputational risk (fund managers generally don’t want to be seen suing their investors) as well as the potential for the lodging of counterclaims, such as breach of fiduciary duty or other “complaints”. Even where meritless, the simple potential risk of the filing of a counterclaim can deter the initiation of legal proceedings by the fund manager. In any event, the typically found remedies listed below are stronger, faster and easier to implement.
2. Enact a Transfer: Under this approach, the fund manager may designate one or more parties (which usually may be existing limited partners or third parties) to be transferees who will receive the defaulting investor’s interest (or parts of it if there are more than one transferee) in exchange for agreeing to contribute capital toward the outstanding capital calls and make good on future capital calls. This approach usually will not involve payment of any purchase price to the defaulting investor (i.e. the “seller”), other than assumption of these liabilities. So this approach involves a forfeiture by the defaulting investor of 100% of the existing capital account balance. Notice that this approach results in aggregate commitments being unchanged, and therefore this is commonly a preferred method by managers. It is also simpler to deploy (less parties to transact with) and in a sense more “private” (in terms of not “outing” the situation with each and every investor) than #3 below, and thus tends to be more frequently considered.
3. Enact a Sales Waterfall: Under this sort of provision, the non-defaulting investors are offered, essentially in a “ROFR” type offering, their proportionate pieces of the defaulting investor’s capital account balance in exchange for proportionate contribution of then-unfunded and future calls. If not all investors make the election, commonly a second tranche may occur where investors initially electing can get “more”. Ultimately if the whole interest is not spoken for, third parties may be invited to participate. In some sense this is not vastly different from #2 above: the defaulting investor suffers a 100% forfeiture, and the fund manager (assuming a successful process) ends up with an undisturbed amount of aggregate commitments. However, this remedy requires undertaking a significant formal process from a logistical standpoint, and furthermore involves effectively notifying all investors of the situation. So why would a manager choose this? Sometimes, there is a view that the most equitable result since some party stands to get a windfall is to share that windfall proportionately with the entirety of the investor base.
4. Run To Zero Rights: This type of provision calls for declaring that the defaulting investor is no longer a limited partner, has no right to vote on any fund matters, and is held back from income/gain allocations into its capital account (and usually distributions as well, discussed further below); however, expenses including management fee may be debited against the capital account (and in doing so “full scheduled management fees” may be collected at the fund level) until such time as the capital account reaches zero. If that does not occur by liquidation, the remaining balance is often forfeited and allocated proportionately to the other partners. While this provision protects the fee base, it does not maintain the full aggregate commitments, and as such, is seen as an inferior approach to methods #2 and #3 above. However, this type of provision is commonly present in most fund agreements in the venture space and can play a role in certain situations where macroeconomic or other events beyond the specific limited partner limit participation in amelioration efforts by other sources of capital.
5. Pure Forfeiture Provisions: The most punitive commonly available remedy is the provision allowing the enactment of a simple, pure forfeiture, either of the capital account balance, the right to future profit allocations, or both. These will commonly cause the forfeited amounts to be redistributed proportionately amongst the other partners, creating a windfall for them to the extent of any capital account balance being shifted. As is the case with #4 above, this causes aggregate commitments to decrease, and as such, is not usually a preferred method.
6. Distribution Withholding Provisions: Recall that the above remedies are not mutually exclusive. Distribution withholding provisions usually exist and are used in tandem with other default remedies. These are rights to refrain from distributing cash or securities to an investor in default, and apply proceeds to outstanding calls and expenses, including outstanding interest. In the case of securities, a well drafted provision will allow the right to sell the securities to generate cash to satisfy such items, which for tax purposes should expressly provided to be a deemed distribution to the investor, followed by sale by them and a deemed recontribution (with a pre-agreed hold harmless in favor of the fund manager).
Anything Else To Consider?
There are a couple of closing thoughts on the issue of investor defaults to keep in mind. First, a well drafted fund agreement will place the right to act for the defaulting investor squarely in the hands of the fund manager by reference to the power of attorney provisions. For example if a transfer is to be enacted to rectify the situation, there should be no need to chase down the recalcitrant investor for signatures; the fund manager should be able to act on that directly using a pre-agreed power of attorney. Ideally, the drafting is very broad, to the effect of the power of attorney being available for any needs arising under the default provisions.
Next, consideration should be given to making sure parallel funds are properly included in the default provisions. As an example, if a sales waterfall will run to all investors, it will usually (though not always) be appropriate to include parallel fund investors for this purpose. This should be considered and resolved appropriately in the given context. Another item to consider is the potential for cross-default provisions, meaning a default by investor X in fund A may be deemed to be a default in additional fund B automatically and lead to the potential for enactment of remedies in both funds A and B. This is rarely appropriate, but in some cases may be. For example funds that are literally stapled (say a growth fund with a top up fund for home run deals that has no management fee and lower carry, and everyone is subscribed in a 2:1 ratio; in this case access to the preferred terms fund is “part and parcel” of an investment in the growth fund, and it would not be equitable for an investor to default in the growth fund and keep the preferred piece).
Another concept to keep in mind is credit security. In venture funds with typical default provisions along the lines discussed above, credit security comes from drawing down cash in order to put value in the capital accounts. The greatest credit risk exists right after the fund is formed, and until the time capital account balances are sufficient to provide incentive to perform contribution with respect to the remainder of the commitment. This often deserves special consideration, especially when holding a dry closing in turbulent economic times. Some fund managers will call a small amount of capital (~5%) in order to create this credit security at the outset of the fund.
In the case of fund managers that utilize capital call lines or other credit instruments, there will often be borrowing covenants in their loan agreements with respect to defaults by investors in the fund that may require self-reporting or other remedial steps. Fund managers should review their loan agreement to fully understand the implications of a default on the credit arrangement.
Yet another issues centers around questions about the extent to which a fund manager may itself participate in default remedies. For example, could the fund manager assign itself to be the transferee of the interest where there is a material capital account balance, taking all the windfall for itself? There are potentially significant contractual and fiduciary limitations in this area, so consult carefully with counsel before acting in this manner.
Our best closing advice is to get a health check. Have you reviewed your default provisions with fund counsel lately? Default provisions have come a long way in the last few market cycles, and if this area of your fund agreement has remained untouched for several vintages, the default provisions probably do not reflect the “latest and greatest” techniques being deployed. This is an unusual area of the fund agreement inasmuch as investors are generally aligned with the fund manager to provide greater protections and remedies to the fund; unless the investor plans to be the defaulting investor, updating it serves to both help ensure the fund is fully capitalized to make investments, and create stability within the investor group.