Equity Sponsors: How to Deal
With a Portfolio Company in Financial Distress
What should you do when a
portfolio company goes bad (yes, it happens to all equity sponsors
from time to time) ? How can you manage expectations of the company's
various constituencies-and avoid liability to creditors? Should
you keep the company out of Chapter 11 at all costs? Could a
debt restructuring-whether out-of-court or under Chapter 11-actually
represent an opportunity for the equity sponsor?
Private equity funds face unique
challenges when a portfolio company enters a period of financial
distress. Typically, whatever else a troubled company might need,
it has an immediate and paramount need for cash. The equity sponsor
will need to make an investment decision: How much incremental
investment, if any, should be made? As always in the insolvency
context, an intelligent decision cannot be made without understanding
the legal landscape. The danger is not simply potential loss
of the investment, new money as well as old. Rather, a course
of action adopted without considering legal issues could subject
the equity sponsor to litigation risk in the event of failure
that might dwarf the potential benefits of success. But there
is another side of this coin. Crisis can create opportunity.
By restructuring the portfolio company's obligations, it may
be possible to reduce the equity sponsor's financial risk and
increase its rate of return.
At the beginning of the crisis,
the equity sponsor will typically face an immediate challenge.
Management will identify a need for "temporary" or
"interim" or "bridge" financing. Typically
it will appear that the equity sponsor is the only realistic
source of funds. If the amount seems tolerable, most sponsors
will advance the funds, because it seems like the responsible
thing to do (with the practical benefit of avoiding potential
damage to the sponsor's reputation if the company were to suddenly
shut down) and the only way to buy the time necessary to develop
a comprehensive plan. Sometimes there truly is no choice, but
before making that critical first advance, the sponsor should
consider:
1. Making that advance
will likely create expectations among the other parties - most
importantly, the portfolio company's lenders - that the equity
sponsor will continue its unilateral support of the company.
It may prove very difficult to get the banks to believe a future
statement that the sponsor will not advance more funds without
reciprocal concessions from the banks.
2. The legal documentation
of that first advance, if not carefully considered, could have
consequences beyond the sponsor's ability to recover that particular
advance.
3. Early in a financial
crisis, it is rare for a company to have done everything possible
to maximize internal generation of cash. An outside turnaround
consultant can often identify and help implement a program
to reduce or defer the need for outside investment.
Whether or not the equity sponsor
injects additional funds, it is crucial to adopt a disciplined
approach to the financial crisis. This will involve three elements:
Separate the Sponsor from
the Company
Even if the problem appears to
be transitory or fixable, the sponsor should adopt the conservative
assumption that for legal purposes the company has entered the
"zone of insolvency." This means that the directors
and officers will most likely owe a fiduciary duty to the company's
creditors, as well as, its owners. (For a more detailed discussion
of this issue, click here.) In order to protect the company,
its directors and officers, and the sponsor itself, the company
should immediately engage independent counsel - a law firm different
from the one representing the equity sponsor, and that ideally
does not represent the equity sponsor on other deals. Furthermore,
the sponsor, in consultation with its own advisors, should analyze
the sponsor's own interests as distinct from those of the company.
This approach does not dictate that the company and sponsor become
adversaries; in fact, there will often be a confluence of
interest between a troubled company and an equity sponsor
willing to consider further investment. But proceeding as though
there were an identity of interest between the sponsor
and the company could endanger both.
Assemble a Team
Many equity sponsors will shift
oversight of the troubled investment to someone in the organization
with distressed-company experience or to a group that includes
such persons. Correspondingly, the sponsor's law firm will either
involve its own insolvency experts or recommend an outside firm
with this type of expertise. In their capacity as directors of
the portfolio company, the sponsor's personnel will also be involved
in selecting legal and financial advisors for the company. For
more on this topic, click here.
Develop a Restructuring Plan
There are several distinct tasks.
First, the company must prepare a reliable near-term cash flow
projection. A rolling 13-week forecast is standard. Second, the
company must develop a new business plan or revise its existing
one to consider all available options, even those (such as cutbacks
in staffing, sale of divisions, etc.) that might not be management's
first choice absent a crisis. Third, the company must develop
a restructuring proposal specifying the terms on which obligations
will be honored, deferred, reduced, converted to equity, or otherwise
addressed. The business plan and the restructuring plan are intertwined.
For example, shutting down a business segment may be essential
to the company's survival yet give rise to near-term liabilities
(such as damages for breaching leases or other contracts) that
must be addressed as part of the restructuring plan. Finally,
the company must analyze liquidation scenarios, not because it
intends to liquidate but because the liquidation analysis serves
as a point of reference for all constituencies in evaluating
their alternatives. It would not be realistic to expect concessions
from creditors unless they would do even worse in a liquidation.
Consider Legal Alternatives
The company and the equity sponsor
will need to understand the various ways to accomplish a financial
restructuring. Consideration should always be given to an out-of-court
restructuring, as a way to minimize expense and disruption. But
there are limitations, including difficulty of dealing with "hold-outs,"
inability to ward off legal actions such as attachments and injunctions,
and the reluctance of many creditors to make major concessions
outside of Chapter 11. At the other end of the spectrum, Chapter
11 can be a powerful tool to accomplish a restructuring. Disadvantages
include the expense which - although in most cases a small fraction
of the liabilities that will be eliminated - must be funded from
cash flow or from some other source of liquidity. In addition,
even after management gets over its initial gut reaction (usually
erroneous) that Chapter 11 will kill the business, the likely
effects of a Chapter 11 on business operations do need
to be carefully assessed. In some instances, a pre-packaged or
pre-negotiated Chapter 11 plan can serve to minimize risk and
expense while gaining the benefits of Chapter 11, such as eliminating
hold-outs, rejecting unfavorable contracts and leases, preserving
favorable ones, inducing creditors to accept substantial write-offs,
and providing a safe vehicle for the equity sponsor to inject
new funds if it chooses to do so.
Conclusion
For the equity sponsor, the most
important attribute is discipline. Debt restructuring always
involves a degree of confrontation seldom present in an initial
investment. This is an inevitable consequence of disappointing
the expectations of other parties with a stake in the portfolio
company. Investing additional funds in the portfolio company
on a non-economic basis may sometimes seem like a solution. However,
it is unlikely to work and is in any event not a realistic option
for most equity sponsors. Rather, the equity sponsor should adhere
to the principle that its contribution will consist of (a) making
a clear-headed determination whether the business is worth saving,
and (b) if it is, then proposing a realistic restructuring plan
that offers other constituencies with a superior outcome to liquidation
(or whatever other transaction is available in the marketplace)
while providing satisfactory levels of risk and potential reward
to the sponsor. As with an initial investment, the equity sponsor
must be prepared to walk away if a deal cannot be achieved on
a satisfactory legal and economic basis. Back
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This article provides general
information concerning its topic. It is not intended to provide
legal advice or to create an attorney-client relationship.