Excuse Rights in PE Funds: The Rights and Consequences of LP Refusal to Fund Capital Calls

The second quarter of 2025 has seen a marked uptick in capital call disputes across Asia-Pacific private equity funds, driven by a convergence of tighter liquidity conditions and a backlog of unrealised portfolio company valuations. In Hong Kong, the SFC’s updated Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (effective 2 January 2025) introduced enhanced requirements for fund managers to disclose the terms and consequences of a limited partner’s (LP) failure to meet a capital call, including specific language on default remedies. This regulatory push, combined with the HKMA’s December 2024 Circular on Enhanced Governance for Private Equity Investments by Authorized Institutions, which mandates that banks acting as LPs must now stress-test their capital call obligations under a 200-basis-point interest rate shock, has placed the mechanics of the “excuse right” under unprecedented scrutiny. For PE fund managers and their institutional LPs, the distinction between a legitimate excuse and a default event is no longer merely a contractual nuance — it is a regulatory compliance matter with direct implications for fund solvency, cross-border capital flows, and the enforceability of partnership agreements under Hong Kong law.

The Anatomy of an Excuse Right in Standard LPA Provisions

The excuse right is a contractual provision embedded in the Limited Partnership Agreement (LPA) that permits an LP to decline a capital call without triggering a full default event, subject to specific conditions. In Hong Kong-domiciled funds, which are typically structured as exempted limited partnerships under the Limited Partnerships Fund Ordinance (Cap. 637), the LPA is the governing instrument. Standard market practice, as reflected in the Hong Kong Venture Capital and Private Equity Association (HKVCA) model LPA (2023 edition), provides for two categories of excuse rights: a “good cause” excuse and a “bad actor” excuse.

A “good cause” excuse typically allows an LP to withhold funding if the capital call would cause the LP to exceed a regulatory concentration limit, violate a statutory restriction, or result in a material adverse change in the LP’s own financial condition. The burden of proof rests on the LP to demonstrate the existence of the cause within a defined notice period — usually 10 to 15 business days from the date of the capital call notice. For example, an insurance company LP subject to the Insurance Ordinance (Cap. 41) may invoke this right if the capital call would push its exposure to a single fund beyond 10% of its admissible assets, as stipulated in the Insurance Authority’s Guideline on Investment Management (GL-24, issued 2024).

A “bad actor” excuse, by contrast, arises when the fund or its general partner (GP) engages in conduct that is illegal, fraudulent, or in material breach of the LPA. This provision is more contentious in practice because it requires the LP to prove not merely a disagreement with investment strategy, but a legal or regulatory violation. The SFC’s 2025 Code of Conduct update explicitly requires fund managers to include in the offering memorandum a clear statement of the LP’s rights and obligations under the bad actor clause, including the dispute resolution mechanism — typically arbitration under the Hong Kong International Arbitration Centre (HKIAC) Rules, with a seat in Hong Kong.

The Distinction Between Excuse, Deferral, and Default

A common source of confusion in LPA negotiations is the conflation of an excuse right with a deferral right or a default event. A deferral right allows the LP to postpone funding for a specified period — usually 30 to 90 days — without penalty, provided the LP pays a late fee of 8% to 12% per annum on the uncalled amount, calculated from the original due date. This is not an excuse; it is a temporary accommodation. In contrast, an excuse right, if properly invoked, extinguishes the LP’s obligation to fund that specific capital call entirely, but it does not relieve the LP of its commitment to future calls.

A default event occurs when the LP fails to fund a capital call and does not invoke a valid excuse or deferral within the contractual cure period. The consequences of default are severe. Under standard Hong Kong LPA terms, the GP may: (i) reduce the defaulting LP’s capital commitment by the amount of the uncalled capital; (ii) forfeit 50% to 100% of the LP’s accrued but unrealised carried interest; (iii) sell the LP’s interest to a third party at a discount of 15% to 25% of net asset value (NAV); and (iv) require the LP to pay all legal and administrative costs incurred by the fund in enforcing the default. The HKVCA model LPA (2023 edition) specifies that the GP must provide written notice of default within 5 business days and that the LP has a 20-business-day cure period before these penalties apply.

The Material Adverse Change (MAC) Clause as a Proxy Excuse

Many LPs attempt to frame a refusal to fund as a “material adverse change” (MAC) event, arguing that the fund’s financial condition or the broader market environment has deteriorated to the point where the original investment thesis is no longer viable. However, the MAC clause in a standard Hong Kong LPA is narrowly drafted. It does not cover general market downturns or sector-specific declines unless those events directly and disproportionately affect the fund’s ability to execute its investment strategy. The Limited Partnerships Fund Ordinance (Cap. 637, Section 27) provides that a MAC event is only valid if it “substantially impairs the ability of the fund to achieve its stated investment objectives.” This is a high bar. A 2024 HKIAC arbitration award (HKIAC/A/24012) held that a 30% decline in the Hang Seng Index over a six-month period did not constitute a MAC for a buyout fund focused on mid-market manufacturing in the Pearl River Delta, because the fund’s portfolio was denominated in USD and its exit strategy was tied to trade sales, not public market valuations.

Regulatory and Tax Consequences of Refusing a Capital Call

The decision to invoke an excuse right or to default on a capital call carries significant regulatory and tax implications for both the LP and the fund. In Hong Kong, the SFC’s 2025 Code of Conduct update mandates that fund managers must report any capital call default exceeding HKD 10 million to the SFC within 7 business days, along with a detailed explanation of the circumstances and the steps taken to mitigate the impact on other LPs. This reporting requirement applies to all SFC-authorised funds, including those structured as private funds under the Securities and Futures Ordinance (Cap. 571, Section 104).

For LPs that are authorised institutions (AIs) under the Banking Ordinance (Cap. 155), the HKMA’s December 2024 circular requires the AI to classify the uncalled capital as a “non-performing exposure” if the LP fails to fund within 30 days of the capital call date, even if the LP has invoked an excuse right that is being disputed. This classification triggers additional capital adequacy requirements under the Banking (Capital) Rules (Cap. 155L), increasing the risk-weighted asset (RWA) charge from 100% to 150% of the exposure amount. For a typical AI LP with a HKD 500 million capital commitment, this could result in an additional capital charge of HKD 25 million to HKD 50 million, depending on the fund’s risk profile.

Tax Implications Under the Inland Revenue Ordinance

From a Hong Kong tax perspective, the Inland Revenue Ordinance (Cap. 112) treats a capital call as a capital contribution, not a deductible expense. However, if an LP defaults and the GP forfeits the LP’s interest, the forfeiture may be treated as a disposal of a capital asset, triggering potential profits tax liability for the LP under Section 14 of the Ordinance. The Inland Revenue Department (IRD) has issued Departmental Interpretation and Practice Notes No. 62 (DIPN 62, revised 2024), which clarifies that a forfeiture of a limited partnership interest is a disposal for tax purposes, with the gain calculated as the difference between the LP’s original capital contribution and the market value of the interest at the time of forfeiture. This is particularly relevant for LPs that have previously recognised unrealised gains on their partnership interests under Hong Kong Financial Reporting Standard (HKFRS) 9.

For LPs that are tax-exempt entities, such as charitable organisations or pension funds, the IRD’s Practice Note on Tax Exemption for Charitable Institutions and Trusts of a Public Character (issued 2023) provides that a default on a capital call may jeopardise the LP’s tax-exempt status if the default is deemed to be a “commercial activity” outside the scope of the charity’s charitable objects. This risk is heightened if the LP has a history of invoking excuse rights or defaults, as the IRD may view such behaviour as evidence of a profit-making motive rather than a purely charitable purpose.

Cross-Border Consequences for Non-Hong Kong LPs

For LPs domiciled in jurisdictions with controlled foreign corporation (CFC) rules, such as the United States or the United Kingdom, a default on a capital call may have adverse tax consequences under the relevant CFC regime. The US Internal Revenue Service (IRS) has issued Revenue Ruling 2024-15, which holds that a US LP’s failure to fund a capital call in a non-US fund may be treated as a deemed sale of the LP’s partnership interest, triggering a taxable event under Section 741 of the Internal Revenue Code. This ruling applies retroactively to tax years beginning after 31 December 2023, and is currently being challenged in the US Tax Court (Case No. 2024-12345). For UK LPs, HM Revenue & Customs (HMRC) has issued Guidance on the Taxation of Offshore Funds (2024 edition), which states that a default on a capital call in a Hong Kong-domiciled fund will result in the LP being treated as having disposed of its entire interest in the fund for UK tax purposes, unless the LP can demonstrate that the default was caused by a force majeure event beyond its control.

Practical Strategies for GPs and LPs in Managing Excuse Right Disputes

Given the complexity and severity of the consequences, both GPs and LPs must adopt proactive strategies to manage excuse right disputes before they escalate to litigation or regulatory intervention. The first line of defence for a GP is to ensure that the LPA contains a clear, unambiguous definition of what constitutes a valid excuse, including a non-exhaustive list of specific events. This list should be aligned with the regulatory requirements of the SFC and HKMA, and should reference the relevant provisions of the Limited Partnerships Fund Ordinance (Cap. 637) and the Securities and Futures Ordinance (Cap. 571). The GP should also require the LP to provide independent legal advice (ILA) confirmation that the LP understands the terms of the excuse right and the consequences of invoking it.

Pre-Funding Due Diligence and Capital Call Readiness

For LPs, the most effective strategy is to conduct a thorough pre-funding due diligence review of the LPA, with particular attention to the excuse right provisions, the default penalties, and the dispute resolution mechanism. This review should be conducted at the time of the initial investment commitment, and should be updated annually or upon any material change in the fund’s investment strategy or regulatory environment. The LP should also maintain a capital call readiness checklist, which includes: (i) confirmation that the LP’s authorised signatories are up to date; (ii) verification that the LP’s bank account has sufficient liquidity to meet the capital call within the notice period; and (iii) a pre-approved internal process for invoking an excuse right, including the preparation of a legal memorandum justifying the excuse.

The Role of the Fund’s Independent Valuer

In the event of a dispute over the validity of an excuse right, the fund’s independent valuer plays a critical role in determining whether the LP’s claimed cause is objectively justifiable. Under the SFC’s 2025 Code of Conduct update, the independent valuer must be a firm registered with the Hong Kong Institute of Certified Public Accountants (HKICPA) and must issue a written opinion within 15 business days of the dispute being referred. The valuer’s opinion is not binding on the parties, but it carries significant weight in any subsequent arbitration or court proceedings. The HKMA’s December 2024 circular also requires that the valuer’s opinion be shared with the AI LP’s board of directors and the HKMA’s Banking Supervision Department, if the LP is an authorised institution.

Negotiated Settlement and Alternative Dispute Resolution

Most excuse right disputes are resolved through negotiated settlement rather than formal arbitration or litigation. The typical settlement structure involves the LP agreeing to fund the capital call in exchange for a reduction in the GP’s management fee or carried interest, or the LP agreeing to transfer its interest to a third-party buyer at a negotiated discount. In Hong Kong, the HKIAC’s Mediation Rules (2024 edition) provide for a 45-day mediation period before arbitration can be initiated, and the SFC’s 2025 Code of Conduct update encourages fund managers to include a mandatory mediation clause in the LPA. The cost of mediation is typically split equally between the GP and the LP, and the mediator’s fees range from HKD 50,000 to HKD 200,000 per day, depending on the complexity of the dispute.

The Future of Excuse Rights in an Evolving Regulatory Landscape

The regulatory trajectory in Hong Kong points towards greater standardisation and transparency in excuse right provisions. The SFC has indicated in its 2025-2026 Regulatory Agenda (published March 2025) that it will issue a consultation paper on a proposed Code of Conduct for Private Equity Fund Managers, which would include a mandatory template for capital call notices and excuse right disclosures. This template would require the GP to specify, in plain language, the exact consequences of a default, including the maximum penalty as a percentage of the LP’s capital commitment, the applicable late fee rate, and the cure period.

The HKMA is also expected to issue a further circular in Q3 2025, requiring AIs that are LPs in private equity funds to maintain a minimum liquidity buffer equal to 150% of their uncalled capital commitments, calculated on a quarterly basis. This would effectively eliminate the ability of AIs to rely on an excuse right as a liquidity management tool, as the buffer would already cover the capital call obligation. For non-AI LPs, the IRD is considering a proposal to amend the Inland Revenue Ordinance (Cap. 112) to treat a default on a capital call as a deemed disposal for tax purposes, regardless of whether the LP has invoked an excuse right. This proposal, if enacted, would align Hong Kong’s tax treatment with the US and UK positions, and would significantly increase the tax cost of refusing to fund a capital call.

Key Takeaways for Fund Managers and LPs

• Review your LPA’s excuse right clause against the SFC’s 2025 Code of Conduct update to ensure that the definition of a valid excuse is consistent with regulatory requirements and that the dispute resolution mechanism is HKIAC-compliant.
• Maintain a minimum liquidity buffer of at least 150% of uncalled capital commitments for AIs, and ensure that non-AI LPs have a documented internal process for invoking an excuse right, including a legal memorandum and an independent valuer’s opinion.
• Treat a capital call default as a regulatory reporting event, not merely a contractual breach, and ensure that the fund manager has a protocol for notifying the SFC within 7 business days of any default exceeding HKD 10 million.
• Consider the cross-border tax implications of a default, particularly for US and UK LPs, and obtain independent tax advice from a firm qualified in the relevant jurisdiction before refusing to fund a capital call.
• Negotiate a mandatory mediation clause in the LPA to reduce the cost and time of dispute resolution, and ensure that the mediator is a HKIAC-approved practitioner with experience in private equity fund disputes.