Most private equity firms openly accept that it will be some time before meaningful levels of deal activity return.
Comments made at the sector’s recent Super Investor conference in Paris were very clear on this. So what, if anything, are private equity firms doing? Well, they are certainly not all on holiday. In fact, far from it. Most are working very closely with their portfolio companies to make improvements and prepare them for more difficult times ahead.
In doing so, they are discovering that things are not always straightforward and that there may be a real need to reposition the portfolio company in some way. Or, more fundamentally, that certain businesses may need immediate assistance in a distressed situation.
The type of legal advice necessary to assist clients making business decisions in a challenging environment can be quite different from ;that required in ;the normal course of deal-focused business. That said, this is not the moment for private equity transaction lawyers to run for cover and hand over the work entirely to their banking, restructuring and insolvency colleagues.
Instead, this is a time to step up and to continue supporting clients by providing the clear, commercially focused advice they have come to expect – drawing on quality banking and restructuring advice as appropriate. In essence, private equity clients need assistance with significant judgment calls from the advisers who know the private equity sponsor’s business and structures.
What to do?
In addition to specific guidance in relation to the immediate portfolio company issues – which to date have largely centred on the rights and obligations under the banking documentation – private equity clients also expect their legal advisers to be proactive in terms of alerting them to things that can be done now to either avert or prepare for challenges at a later stage. For example, some of the things that can be done for clients in tandem with banking and restructuring teams are:
#Encouraging private equity sponsors to conduct a general health check on their portfolio companies – particularly those in sectors that may face challenges. This might cover, for example, identifying pinch points (covenant test and principal and interest repayment dates, the ongoing availability of credit insurance, cross default risk, etc), examining opportunities for disposing of non-core or underperforming businesses, reviewing portfolio company transactions to assess vulnerability, investigating the financial health of key customers and suppliers, and assessing the adequacy of insurance.
• Considering equity structures and management alignment. One impact of a downturn in economic performance and significant levels of debt (or equity injections to de-lever businesses) is that the management equity may be underwater – thereby ceasing to be useful in retaining, motivating or aligning key management. Therefore, it is worth considering the options that might be available to reposition management to ensure they are refocused and reinvigorated. There are a number of potential solutions to this issue that can be economically neutral to the sponsor and there are good reasons to deal with this now. In addition to management equity, consideration should be given to the overall economic structuring of portfolio companies and to whether structural modifications could be made to take advantage of, or guard against, fiscal changes anticipated in prospective tax legislation.
• Providing guidance on ringfencing and/or mitigating potential liability.
This would cover issues for the private equity investor as an organisation – for example, dealing with the consequences of shadow directorship and implementing procedures to avoid shadow directorship concerns going forward. It would also cover an assessment of the risks for investor-directors, focusing on items such as the proper approval of conflicts of interest under the Companies Act 2006, financial assistance whitewashes (or other solvency declarations given in the past 12 months) and evidence of compliance with fiduciary duties, etc.
This type of preparatory guidance will not of itself be enough to prevent certain portfolio companies from requiring more substantive restructuring or avoiding insolvency where quality specialist advice will be required. However, it will provide an early warning to private equity sponsors and give them more time to consider and take advice on the most appropriate course of action, giving them the best chance of preserving value and avoiding liability.
The months ahead will present many challenges for the private equity industry and on a number of levels. However, a proactive approach from lawyers who understand the deal structures and potential legal pitfalls for private equity sponsors, when properly integrated with restructuring expertise will be of real value.
Jonathan Wood is a partner at Weil Gotshal & Manges
For more on private equity, see the other two features in our private equity special report.