Default in Drawdown

An AIF investor does not hand over the whole commitment on day one. The manager calls it in instalments — drawdowns — as deals need funding. That leaves the manager exposed: the deal is signed, the money is due, and an investor does not pay.

The workbook calls this default in drawdown. It can happen for reasons as ordinary as timing. Investment managers normally protect themselves through a mechanism under which, if a particular investor cannot fund a drawdown, other investors take up the drawdown call. The investors who fail to fulfil their commitment then substantially lose their rights and returns under the investment agreement.

The workbook is direct about the investor's position: defaulting on commitments "constitutes a contractual breach of the subscription agreement".

Remedies under the agreement. The options the workbook lists are to:

1. reduce the capital commitment of the defaulting investor;
2. charge interest for delayed payment; or
3. in extreme cases, terminate the agreement and return the capital invested so far.

What the drawdown terms should tell investors in advance — the purposes for which a drawdown can be made; the schedule (initial, fixed periodic or as-needed); the notice period; class-wise drawdowns and timelines; the mode of issuing notices; return of drawdown subject to recall (optional); and drawdowns after the commitment period and their use.

Bridging a shortfall at the fund. Category I AIFs may not borrow for making investments, except for temporary and day-to-day funding requirements for not more than 30 days, on not more than 4 occasions a year and not more than 10% of investable funds. To provide operational flexibility, Category I AIFs are also allowed to borrow to meet a temporary shortfall in the amount called from investors for investments in investee companies ("drawdown amount"), subject to additional conditions specified by SEBI. A 30-day cooling-off period, counted from repayment, applies between two borrowing periods.

Oversight. The scope of the annual PPM audit includes a review of practices on the consequences of default by investors, including penalty, forfeiture and suspension of rights. The SEBI risk-factor template for PPMs includes the "risk to investment on account of default on capital calls".

Illustrative figures. Brahmaputra Venture Fund, a Category I AIF, has commitments of Rs 300 crore and investable funds of Rs 280 crore. To fund a Rs 45 crore investment, it issues a drawdown notice for 15% of commitments, payable in 15 days.

Mr Bhatia has committed Rs 10 crore, so he owes Rs 1.5 crore. His money is tied up in a property sale, and he does not pay.

Day 15 — closing the deal. The fund borrows Rs 1.5 crore to meet the temporary shortfall. That is well inside 10% of investable funds (Rs 28 crore) and it is the first borrowing of the year. It must be repaid within 30 days, and the next borrowing cannot start until 30 days after repayment.

Day 25 — others take up the call. Under the contribution agreement, the other investors fund Mr Bhatia's Rs 1.5 crore pro rata, and the borrowing is repaid on day 26.

The consequences for Mr Bhatia, as provided in the fund documents:

• his commitment is reduced to the Rs 4 crore he had already paid in (Rs 6 crore undrawn is cancelled);
• he forfeits his share of this deal; and
• the fund charges interest for the period of delay.

The annual PPM audit then reviews whether the fund applied its default provisions as its PPM described.

Chapter 3 (Concepts in Alternative Investment Funds Industry) defines default in drawdown at 3.6 and lists the drawdown disclosures. Chapter 4 (Regulatory Framework — Indian Context) sets out the Category I borrowing limits, including borrowing for a drawdown shortfall, at 4.1.10. Chapter 9 includes default consequences in the PPM audit scope, and Chapter 10 warns investors that defaulting is a contractual breach. Expect questions on the three remedies, the other-investors-take-up mechanism, and the borrowing limits.

• The primary protection is other investors taking up the call — not SEBI stepping in or the fund automatically winding up.
• The three remedies: reduce the commitment, charge interest, or (in extreme cases) terminate and return capital invested so far.
• Default is a breach of the subscription (contribution) agreement, not merely a missed opportunity for the investor.
• Category I borrowing limits: 30 days, 4 occasions a year, 10% of investable funds, 30-day cooling-off from repayment. Numbers are routinely swapped.
• Borrowing to cover a drawdown shortfall is for a temporary shortfall only, subject to additional SEBI conditions — it is not leverage for making investments.
• The PPM audit reviews default practices — penalty, forfeiture and suspension of rights.