Worst Case Scenario: LPs Unable To Cover Capital Calls?

I recently heard a pretty scary hypothetical situation for both LPs and GPs. A financial type who will go unnamed told me:

“A couple of decent sized LPs are concerned about their ability to fund capital calls if things stay ugly.”

No money for capital calls? That sounds unheard of, but it could be possible. And “if things stay ugly” seems to be a very strong possibility.

There’s the denominator effect of shrinking portfolios, thanks nosediving returns across the board. And then there’s the money market funds coming dangerously close to par (Which is, luckily, now guaranteed by the Fed, after Reserve Primary broke the buck in mid-September.) It’s sort of a big deal for an LP’s cash positions. Lastly, not all LPs have set committed capital aside; some have an aggressive structure that relies on the stability of some now-unstable investments.

Even if these factors are not the case for most LPs, the possibility is causing investors to do the “Worst Case Scenario Math,” meaning, if stretched to the max, can we meet these capital calls? This, I believe, is leading to the heaving secondary trading action we’re seeing. If it’s anywhere close, both GPs and LPs are ready to get out of their commitments. I like the preemptive strike approach, I just hope the market doesn’t get too saturated.

But there is a big caveat. Here are two reasons (we hope) this will be unlikely: First of all, deal volume is down, so very simply, there are less capital calls of that nature. Second of all, many firms do set aside their committed capital to avoid exactly what we’re talking about here (and the fees that go along with it), so they’re covered, no matter what they lose elsewhere.