Foley’s Financial Crisis Response Team offers the following recommendations for anticipating and minimizing the impact of the current credit crisis on private equity funds and their portfolio companies.
Credit Facility Expiration
The most obvious impact of the credit crisis is the lack of liquidity in the credit markets. Private equity funds should undertake a comprehensive review of the outstanding credit facilities of each portfolio company in order to determine the maturity date of each facility. Funds also should establish contingency plans to address the possibility that, once expired, those facilities will not be renewed or can only be renewed either at significantly higher costs or at significantly lower credit limits.
Credit Facility Defaults
During prior credit crunches, lenders scoured existing credit arrangements in an attempt to accelerate maturities and thus generate cash. Accordingly, the audit of the portfolio companies’ credit lines should include a review of covenants and default provisions that might enable the lender to accelerate the maturity date. In the present circumstances, customary assumptions about non-enforcement of minor “technical” defaults are not applicable. Similarly, assumptions regarding lenders’ incentives to retain, renegotiate, or extend performing loans with potential minor covenant defaults may no longer hold true.
Material Adverse Change (MAC) and Material Adverse Effect (MAE) Clauses
Not only are MAC and MAE clauses the subject of controversy in aborted deals, they also have the potential to create controversy in credit agreements, where such clauses are the basis of an event of default. Fund managers should review their portfolio companies’ credit agreements for this provision and take appropriate steps to minimize this risk.
An Aggressive New Federal Agency
The proposed federal bailout is likely to involve the purchase of lenders’ troubled loan portfolios by a new federal agency. While the media is currently focusing on residential mortgage loans, it is quite likely that this buyout will encompass commercial, non-real estate facilities. Both lenders and the federal agency will have various incentives to interpret the mandate of the new legislation broadly. Witness the expansive reading of the Federal Reserve in defining “financial institution stock” for purposes of the anti-shorting rules. Furthermore, if the activities of the Resolution Trust Corporation (RTC) during the last real estate crisis are any indication, the new federal agency will take aggressive steps to liquidate the loans it acquires. The RTC, for example, declared defaults where the loan-to-value ratio was not maintained (the result of declining real estate values), even when the loan was not otherwise in default. Therefore, funds and portfolio companies should track whether their loans are sold to the new federal agency. If so, as in the case of all government interactions, maintain prudence and discretion when dealing with the new federal agency.
Limited Partnership (LP) Issues
Many private equity funds have call provisions that allow the funds to draw down the investment commitments of their limited partners. Given the institutional nature of these limited partners, fund managers have assumed capital calls will automatically produce the requested funds on a timely basis. The financial crisis may have affected the liquidity of many institutional LPs adversely. Significant positions in various types of bonds and short-term securities that previously provided guaranteed liquidity to these institutions may no longer be available to meet capital calls. Moreover, fund managers may be distracted by various portfolio issues and may not react with their usual alacrity. This fact should be taken into account by fund managers when planning future capital deployments.
Portfolio Company Capital
Venture funds will typically invest in portfolio companies through a single tranche. As a result, after the close of a venture round, portfolio companies have a substantial amount of funds in hand, which they invest in appropriate short- and medium-term securities. Most portfolio companies do not have a highly developed treasury function to monitor these investments, some of which could be at risk, given the current markets. Fund managers must assist their portfolio companies in making appropriate risk assessments and investment adjustments with respect to their equity capital. Failure to do so might give rise to claims against fund managers by their limited partners.
Private equity firms holding funds for future investment must minimize the credit risk of this uninvested capital.
The disappearance of Lehman Brothers, Inc. and other key intermediaries impacts long-term relationships between such intermediaries and private equity firms on the one hand, and institutional buyers and sellers on the other. Fund principals must develop strategies for cultivating alternative channels to maintain and enhance their deal flow.
The current credit market impacts the competitive landscape between financial and strategic buyers. Owners of private businesses are especially sensitive to the impact that leverage has on private equity firms’ investment strategies. They may perceive that the credit crisis will adversely impact buyout firms’ ability to close deals and, accordingly, sellers may gravitate toward strategic buyers.
Proposals for additional regulation of various financial institutions such as hedge funds are likely to encompass, intentionally or not, many if not all private equity funds. Foley’s Government & Public Affairs professionals are closely following these developments.
Involve Legal Counsel
Many of the above concerns can be mitigated through advance planning, which should involve legal counsel. In many circumstances, independent counsel can take a fresh look at the risks of existing documentation and assist in developing appropriate strategies for responding to the credit crisis.
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.
If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individual: