A default provision is the section of the limited partnership agreement that defines what happens when an LP fails to fund a capital call. When an LP commits $50M to a fund, that commitment is a binding contractual obligation. The GP relies on the ability to call that capital over the fund’s investment period to execute the investment strategy. If an LP does not fund when called, it creates an immediate shortfall that can disrupt deal closings, damage the GP’s reputation with co-investors and sellers, and trigger cascading problems across the fund structure.
The default provision exists to create deterrence and to provide the GP with remedies when a default occurs. The typical structure involves a notice-and-cure period followed by escalating penalties. When an LP misses a capital call, the GP issues a default notice. The LP then has a cure period, usually 5 to 15 business days, to fund the call plus any interest or fees that have accrued. If the LP funds within the cure period, the matter is resolved. If the LP does not cure, the GP can exercise a menu of remedies.
Those remedies typically include several layers. First, the defaulting LP loses its voting rights and its right to receive distributions. Second, the GP can charge penalty interest on the unfunded amount, often at a rate significantly above market. Third, the GP can force a sale of the defaulting LP’s interest at a steep discount to net asset value, sometimes 50% or more below the current valuation. Fourth, and most severely, the LP may forfeit a percentage of its existing interest in the fund, commonly 25% to 50% of its funded capital account. The forfeited amount is typically reallocated to the non-defaulting LPs. These penalties are intentionally harsh because the credibility of the capital call mechanism depends on LPs believing that default carries real consequences.
The default provision also addresses how the shortfall is managed operationally. Most LPAs allow the GP to make additional capital calls on the non-defaulting LPs to fill the gap, subject to each LP’s remaining unfunded commitment. Some funds maintain a credit facility to bridge the immediate shortfall while the default is resolved. The GP may also have the right to reduce the fund’s commitment to a particular investment or, in extreme cases, to terminate the defaulting LP’s entire interest and admit a replacement investor.
For emerging managers raising capital, the default provision is a section worth getting right during fund formation. The provision should be severe enough to deter defaults while being procedurally fair. The cure period should give LPs a reasonable window to resolve what might be an administrative error, since not every missed capital call is a genuine inability to pay. The GP should also consider the composition of the LP base when assessing default risk. LPs with co-investment obligations across many funds may face liquidity crunches during market dislocations, which is exactly when the default provision matters most.
Frequently Asked Questions
What are the typical penalties for an LP who defaults on a capital call?
Penalties escalate in severity and commonly include interest charges on the unpaid amount (often at a penalty rate of prime plus 3 to 5%), suspension of voting rights and distribution rights, forced sale of the defaulting LP's interest at a discount (typically 50% or more below NAV), and in the most severe cases, forfeiture of a portion of the LP's existing fund interest (commonly 25% to 50%). The specific penalties are defined in the LPA.
How common are LP defaults?
Actual defaults are rare in normal market conditions. They occurred with more frequency during the 2008-2009 financial crisis when certain LPs, particularly those with liquidity constraints, were unable to meet capital calls across their portfolios. The experience led to broader adoption of more detailed default provisions and increased GP focus on LP credit quality during the fundraise.
Can a defaulting LP cure their default?
Most LPAs include a cure period, typically 5 to 15 business days after a default notice, during which the LP can fund the missed capital call plus accrued interest and penalty fees. If the LP cures within this period, the default is typically treated as if it never occurred. Once the cure period expires without payment, the GP can exercise the full range of default remedies specified in the LPA.
