China LP defaults: Battle of wills

Having an anchor investor try to pull the plug on a fund 12 months into its 10-year life is among the worst misfortunes that can befall a private equity manager. "I'd probably cry," says one industry participant, when asked what he would do in such a situation. "You could sue the LP, but if they are based in China it could take years to litigate and enforce, assuming you can enforce. I would query if you still have a viable business at that point, even if you do feel better about yourself."

Yet this is what happened to 1955 Capital, a cross-border GP that invests in global technologies relevant to Asia's emerging markets. The alliance between Andrew Chung, 1955's founder, and Wenxue Wang, chairman of Shanghai-listed property developer China Fortune Land Development (CFLD), was supposed to be a meeting of minds. But relations soured and CFLD, having deployed $80 million out of a $200 million commitment to 1955's first close, tried to claim its money back.

They have spent much of the past three years locked in a legal battle. Last month, a US court upheld an earlier confidential arbitration ruling that CFLD could not withdraw from the fund on grounds of a breach of fiduciary duty by Chung. David, the four-year old VC firm, has triumphed over Goliath, the $9 billion corporate behemoth, but this is a battle that could have been avoided. Advisors describe it as an unusual and extreme example of a fund default discussion descending into legal drama.

The timing is prescient as the threat of defaults hangs over the PE industry globally. Economic unrest caused by the coronavirus outbreak has left LPs in a bind: overallocated to private markets due to a collapse in public equities, starved of distributions as exits come to a standstill, and facing capital calls from GPs looking to help troubled portfolio companies. If conditions don't improve, some may struggle to make good on their commitments.

But CFLD versus 1955 is essentially a China story. While the pool of Chinese institutional capital is deepening, some of the cash that has flowed into offshore private equity funds came from less sophisticated investors. When encumbered by regulatory or liquidity obstacles – or maybe just by boredom with the asset class – there is a tendency to turn off the tap, regardless of contractual obligations. It amounts to a stark warning for any GP taking on certain kinds of Chinese money.

"There have been problems with certain Chinese LPs because a lot of the money that went into some funds has been non-institutional. We saw a similar problem elsewhere in the world in the aftermath of the global financial crisis, and it led to a greater emphasis on the quality of the LP base. If you're a first-time fund, beggars can't be choosers, but it becomes more important in GPs' minds," says Wen Tan, CEO of Azimuth Asset Consulting, an advisor to asset owners and asset managers.

Letter of the law

PE firms may offer varying degrees of leniency as to how long a defaulting investor is given to make amends – though daily interest will be charged while the capital call remains unmet. However, limited partnership agreements (LPAs) are almost uniformly punitive in what happens if a default is enforced. The most extreme action is forfeiture of the LP's entire interest in the fund. Even if they aren't completely wiped out, distributions might be withheld until the end of the fund life.

One investor's loss is often another's gain, with the defaulter's fund position offered to other LPs. Positions are sold at cost, or at least at a discount to net asset value, which means these events can turn into windfalls. Say the defaulter committed $100 million and the portfolio has since appreciated in value by 40%. Existing LPs who buy in at cost would get $40 million for free.

"No rational actor is going to default on a typical private equity fund if they have a material amount of money in there," says Gavin Anderson, a partner at Debevoise & Plimpton. If relations are good, GPs are generally helpful in these situations because an actual default isn't in anyone's interests. They normally organize a rescue package like selling the stake on the secondary market or the GP might take it over."

The conversation becomes trickier if the capital already put to work is not material – so the LP has less to lose by defaulting – or there is no ready buyer for the fund position, even at a sharp discount. The latter situation may arise in the event of a default by an anchor LP. Should the manager try to stagger on with a smaller quantum of capital, confidence among the remaining LPs is likely to dissipate quickly. Immediate termination or an even paced winddown would result.

China presents an added layer of complication, given the difficulty of enforcing against investors with assets onshore. Even in the renminbi funds space, calling capital on a deal-by-deal basis is a challenge, unless the caller has political leverage. As such, most GPs demand 40-50% of the commitment upfront and the rest across one or two tranches. One local fund manager describes discussions over capital calls and defaults as "a perpetual negotiation."

"Enforcement is hard in Asia, especially against individuals," says Alice Huang, a partner at Morgan Lewis. "A lot of people have nominee arrangements or family members pool assets if litigation is going on. There is an element of cultural difference. People do business with handshakes and the contract is two pages with only key terms."

Arbitration to litigation

In a statement explaining its side of the dispute, 1955 speculated that CFLD reneged due to liquidity issues arising from government curbs on capital outflows. While this is unverified, numerous other groups faced that predicament in 2016. Over the preceding couple of years, a host of GPs and fund-of-funds that raised money from Chinese investors descended on Silicon Valley in search of technology deals. They pitched themselves to local VCs and start-ups as a new capital source and many deployed at a rapid pace.

Beijing's move to clamped down on renminbi-to-US dollar conversions brought investment to an abrupt halt. Suddenly, LPs in these funds were either unable to meet capital calls or unwilling to do so because they wanted to put their limited supply of foreign currency to work elsewhere. As a result, fund-of-funds had capital call issues of their own, and primary fund managers struggled to participate in follow-on rounds.

"When the Chinese government stopped issuing approvals on outbound flows, many investors were trapped. The first thing I tell clients is figure out an investor's source of capital. There are a lot of individuals, companies, institutions and government entities that have offshore bank accounts in US dollars. If an investor needs permission to convert from renminbi to US dollars for each capital call over the next 10-15 years, that's a big problem," says Jordan Silber, a partner at Cooley.

1955's first close came in early 2016 and CFLD moved to liquidate the fund and have the undeployed capital returned about 12 months later. A source close to the private equity firm suggests the timing was strategic: 1955 had lined up investors for a second close and CFLD essentially truncated the fundraise because no LP would commit to a GP in dispute with its anchor investor.

Unsurprisingly, the CFLD perspective is different. According to a spokesperson for the company, suspicions were raised by the fund's slow pace of investment and that Chung was employing his wife – a high-profile start-up founder in her own right – as a part-time consultant on a significant salary. It is also claimed that Chung acceded to and then reneged on a personal request from Wang that 1955 portfolio companies would become tenants in CFLD's industrial parks in China. "He spat in the face of the chairman," the spokesperson says.

These issues were cited in court documents in support of the argument that Chung had neglected his fiduciary duties. He denied all the allegations. Further, 1955 has accused CFLD of launching "an unprincipled digital smear campaign engineered by an aggressive public relations firm," that "repeats false claims drawn from [CFLD's] baseless lawsuits and involves malicious social media attacks designed to impugn the reputations of 1955, Andrew, and his wife."

Another claim made by CFLD during the arbitration hearing was that 1955 signed off unauthorized changes to the LPA under a power of attorney granted by GIIL (an offshore subsidiary of CFLD). The revisions were made around December 2015, but 11 months passed before CFLD saw them due to what 1955 claims was an unintentional oversight. It is ironic that the changes related to the default remedies now being enforced. 1955 inserted a provision that CFLD would forfeit its entire fund interest if the remaining $120 million failed to come through – not unusual in venture capital but apparently not what the Chinese company expected.

The arbitrators concluded this constituted a technical breach, though CFLD suffered no damages nor did the GPs benefit as a result of it. 1955 had to pay $100 in damages. All other accusations were rejected. CFLD was ordered to pay 1955 around $9.3 million in costs and found to have acted in bad faith. The Chinese company was happy that the breach had been recognized but dissatisfied with the outcome, which led to the ruling being challenged in court.

Chung added the forfeiture provision having appreciated his vulnerabilities. "The question asked was how do you protect yourself when dealing with a partner like [CFLD] and the answer was you have to assume they may end up pulling out and the fund will shut down if it happens in the wrong way," the source close to 1955 explains. Self-protection was also front of mind several months earlier when asking that $80 million be committed upfront to the fund.

Escape routes

Without referring to the CFLD-1955 situation specifically, fund formation lawyers observe that it's unusual but not unknown for LPs to devise "Hail Mary" ploys to back out of fund commitments without defaulting. It is not solely a China issue, but Chinese investors are often perceived as high-risk counterparties. State-owned enterprises and large financial institutions could be boxed in by changes in government policy, while corporates, family offices and high net worth individuals (HNWIs) are more likely to be tripped up by liquidity crunches or a general lack of familiarity with private equity.

"They come up with reasons that aren't within market practice for private equity funds," says Lorna Chen, Asia managing partner at Shearman & Sterling. "I've seen LPs argue that they cannot participate in an investment because doing so would violate their internal policy, yet the policy has never been mentioned to the GP. Disputes over policy validity arise easily. A Chinese LP can just put its company chop on a document without due procedure, especially if the LP doesn't have strict procedures for managing chops."

They might also look for technicalities, for example arguing that the notice period of the investment wasn't long enough or the information on the target was insufficient. Some of these positions are difficult to stand up: a claim that an investment violates excuse provisions in the LPA would normally have to be accompanied by the opinion of a reputable counsel, while pursuing a breach of fiduciary duty with a view to terminating the fund normally requires final determination by a court. Nevertheless, managers should be aware even small violations could leave them open to attack.

"We always say to clients when they are running these judgment calls, ‘You might realize an investment isn't necessarily in line with the investment policy and you want to do it anyway because it's a great deal, but just appreciate you are opening yourself up to many risks.' The risk is not so much that the breach occurs but for some reason or another an LP doesn't want to be in the fund anymore. Managers need to be whiter than white," says Dean Collins, a partner at Dechert.

In addition, private equity firms can take steps to strengthen their hand when working with a highly concentrated LP base, which isn't uncommon for less proven managers. First, while removal of the GP for cause is a feature of LPA agreements, there might be scope for pushback on no-fault removal. Even if it remains in place, the threshold for implementation could rise from the standard two-thirds of the LP base to 85-90%, reducing the ability of one investor to act unilaterally.

Similarly, a GP would normally resist granting LPs the right to terminate the investment period without cause. In theory, a group of investors looking to minimize their exposure but keen to avoid default penalties, could band together and use this to halt further drawdowns.

As for managing Chinese investors, some private equity firms – especially those dealing with HNWI feeder vehicles – have taken money upfront or at least ensured they have a buffer to offset defaults. It is also possible to include an anticipatory right regarding LPs that are deemed to be high risk, which gives the GP more options. These might include demanding the LP make good on their entire uncalled capital commitment in the event of a likely default.

"I've come across a few situations in which GPs that raise money from HNWIs have said in their documentation that for a certain class of LP there is a mechanism to call 50% of the capital upfront on closing. It's not treated as a capital call – the money is put into a bank account with low interest and the interest goes to the LP – so there is no IRR pressure," says Huang of Morgan Lewis. "In Asia, because the cost of enforcement is high, more LPs default, so you create two baskets of LP."

A lot of pain can be avoided by ensuring fund documentation is robust, although GPs enduring a difficult fundraise often give way on terms in order to build up traction. Sometimes clauses such as no-fault termination of the investment period are rolled over from fund to fund, creating a series of potential nightmare scenarios.

"I've seen GPs agree to almost anything the LPs ask for in order to get a quick closing, especially during a market downturn" says Shearman's Chen. "In a normal situation, with no crisis or cash flow problems for LPs, the problems will not be obvious. However, as soon as bad things happen, a small loophole created during fundraising period in the partnership agreement could lead to big problems for the whole fund.

Pick your partner

Advisors identify two other key takeaways that apply to all fund managers, regardless of jurisdiction: pick investors that you believe can be long-term partners; and maintain regular lines of communication across the LP base, so that remedies can be sought for imminent defaults before situations escalate out of control.

"In the global financial crisis, some GPs were proactive with LPs by reaching out and saying, ‘We are experiencing pain and we realize you might be as well,' and offering to think about your activities going forward outside of the strict wording of the documentation. LPs appreciated that and the funds were more stable," says Collins of Dechert.

Thanks to the $80 million it took upfront and the willingness of other investors to participate in transactions on a deal-by-deal basis, 1955 Capital has stayed in business. When relations broke down with CFLD, it had made one investment in energy storage technology developer Gridtential. There have since been about eight more, including alternative protein developer Sustainable Bioproducts and ecofriendly agrochemicals producer Crop Enhancement.

The standout investment is Sustainable Bioproducts, which recently rebranded as Nature's Fynd to mark the start of commercial production of food products cultivated from microbes found in volcanic springs. The company closed an $80 million Series B round to take its overall funding to $113 million. 1955 led the Series A last year and remains the largest shareholder. The likes of Archer Daniels Midland, Danone and Breakthrough Energy Ventures are also represented in the cap table.

Even though the investment was made at a time when it was trying to liquidate the fund, CFLD still has exposure to Nature's Fynd – if the company cures the default and pays the penalties. However, it is unclear when the cycles of accusation and denial will end. CFLD is seeking arbitration over claims that 1955 exceeded its investment remit and also suing Chung and his wife in China for fraud. For its part, 1955 has asserted new arbitration claims, citing continued bad faith conduct by CFLD.

"It really is David and Goliath: you are a small investor up against a multi-billion-dollar company," says the source close to 1955. "1955 took a chance on a Chinese LP and it didn't work out. Unlike some other firms, it was able to protect itself – but not perfectly because it is still dealing with the fallout."

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• Topics
• Greater China
• Fundraising
• GPs
• LPs
• China
• 1955 Capital