As the coronavirus (COVID-19) outbreak continues to impact business, markets, and society at large, our attorneys who work with private equity (PE) clients in the U.S. have been having conversations with those clients about unique issues that are arising in the course of managing investors, completing transactions, and steering existing portfolio companies through this period of disruption. In a previous article, we discussed COVID-19’s impact on PE investors and their portfolio companies in Asia (see here).
The insights collected in this article, on the other hand, represent some of the most impactful issues, trends, and opportunities that our attorneys are seeing right now in their work with PE clients in the U.S. and that we anticipate being relevant in the near term. The article is divided into two parts:
- Part I – Fund Management and Transactional Insights – Considerations for raising funds, managing investors, supporting portfolio company liquidity, and completing new transactions.
- Part II – Portfolio Company Considerations – Important issues that portfolio company boards are dealing with right now, along with some special issues and opportunities for portfolio companies in the healthcare, technology, and government spaces.
PART I – FUND MANAGEMENT AND TRANSACTIONAL INSIGHTS
Fund Management and Limited Partner (LP) Relations – Todd Boudreau and Mike Maroni
Many general partners (GPs) we’ve heard from feel that the transition of their organizations to working from home has been relatively seamless without material technology, accounting, or other service issues. There have been robust communications within organizations, capital calls going out, and payments being made.
GPs are considering what happens if LPs are unable to fund capital calls due to the COVID-19 outbreak and related disruption. Should the failure to fund be treated as a default under the limited partnership agreement (LPA), or does the GP have the ability to forgive the funding requirement or defer it until a later date. The answer to these questions are fact specific and subject to the terms of the LPAs. To date, we have seen few, if any, institutional investor defaults, but some GPs have seen a few individual capital call defaults.
Overall, GPs felt that the first two weeks of lockdown were focused on LP calls and questions, while focus seems to have shifted more recently to thinking about new deals; as in the middle innings of a crisis, people have partially figured out how to do business in the new normal. In terms of expectations for the next few quarters:
- There is an expectation that the second quarter is not likely to be very active for dealmaking, but that the third and fourth quarters should be more active, and that it will be easier to find deals in public markets rather than private markets, given due diligence and other concerns.
- Lending attorneys feel that people are looking to raise distressed debt/credit funds (this was echoed by others, as well, including some fund managers). Lenders remain active, especially for special situation and distressed debt funds, and report that fundraising seems to be proceeding quickly. Real estate funds are more adversely affected than other sectors, according to one attorney. Asset class reallocation may happen sooner rather than later (which could mean more secondary transactions (though see below as to the current state of the secondary market)).
- Borrowings may be slightly higher, but close to normal levels. There is concern about asset valuations at the end of the quarter; this may cause concern for many LPs. We expect some high net-worth individual capital call defaults, but within normal levels. We expect a lot of extensions and amendments will occur, including the request for recycling of capital and/or allocation to distressed assets, if not otherwise permitted.
- The secondary market (sales of both LP interests and portfolio company interests) have been slow, and we expect it to be slow through the third quarter. GPs without borrowing bases could have issues, especially if they need to support distressed portfolio companies, unless they have sufficient dry powder to call capital. Some debt funds are having trouble, including with their warehouse and other real estate financing.
- Sponsors are seeing special situations funds closing very quickly with a lot of fundraising and project that there will be net asset value (NAV) defaults due to the markdown of asset values.
- Lenders in the lower middle market might see a bigger drop-off in fundraising compared to other lenders.
We saw an acceleration of fund closings in March by longtime, successful fund managers in an effort to get ahead of the turmoil caused by the COVID-19 outbreak. New and emerging fund managers saw most of their fund raising activities come to a halt, especially those relying on certain “anchor” investors who may now have liquidity concerns. We have seen several university endowments cut back on their tentative allocations to fund managers due to endowment liquidity needs and pressures on public securities/private securities ratios following the drop in the equity markets.
Tax – Jay Blaivas and Katherine Elaine Erbeznik
Much of the focus in our tax practice over recent weeks has been on how clients can take advantage of the CARES Act. In the PE space, we think most of the available benefits will be to portfolio companies, rather than the management companies – but certain CARES Act provisions may help portfolio companies improve their liquidity at a challenging time.
- PE-backed portfolio companies have told us that they are looking at the payroll tax provisions and plan to take advantage of the net operating loss (NOL) carryback. The CARES Act provides that NOLs can be used to offset 100% of a corporation’s taxable income for taxable years beginning before January 1, 2021, and allows corporate taxpayers to carry back NOLs arising before January 1, 2021 to the five prior tax years. To the extent that portfolio companies have post-January 1, 2018 NOLs that were limited under the Tax Cuts and Jobs Act of 2017 (TCJA), or had net taxable income in prior years but generate a loss in 2020, these companies can obtain refunds for prior years’ taxes.
- Leveraged portfolio companies may also benefit from the changes to Section 163(j) in the CARES Act. Under the TCJA, business interest deductions were limited to 30% of the company’s “adjusted taxable income” (similar to EBITDA), and unused interest deductions were carried forward to future years. The CARES Act increases the limitation to 50% of adjusted taxable income for 2019 and 2020. To the extent that portfolio companies had interest deduction carryforwards from 2019, the portfolio company can claim a refund for the additional taxes paid, and such companies will be entitled to a larger tax deduction in 2020.
Finally, in the current environment, there may be opportunities for PE funds to purchase the debt of their portfolio companies at a discount without a corresponding recognition of cancellation of indebtedness income by the portfolio companies (as would otherwise generally result from such a related party acquisition of debt). This can be done by forming a corporate entity that benefits from a tax treaty with the United States, such as an Irish 110 special purpose vehicle, to acquire the debt, provided the transaction is structured properly, and all of the requirements (both U.S. and non-U.S.) necessary to qualify for this treatment are satisfied.
Bankruptcy and Insolvency – Jennifer L. Marines
In the current economic environment, private equity firms – through appropriate corporate governance and oversight – should ensure their portfolio companies maintain prudent levels of leverage; companies with oversized debt may not be able to survive in this environment. In certain circumstances, lenders may be willing to forbear or consider other loan modifications or accommodations. But with constrained capital markets, it is also important for portfolio companies to confirm the availability of, and draw down on, credit lines where necessary to increase liquidity. Importantly, companies should understand their ongoing liquidity needs under various scenarios and continue to update their 13-week cash flows based on various conservative and aggressive business scenarios.
Private equity appointed directors serving on the board of a portfolio company need to be particularly aware of their fiduciary duties as we progress through this crisis.
- If there is a question of a portfolio company’s solvency, board members must exercise caution and perform their duties with an eye towards increasing value for an expanded set of stakeholders. There can be liability or claw-back actions for distributions when a company is unable to pay its debts as they come due. In some circumstances directors can also face personal liability for nonpayment of certain items like wages and withholding taxes.
- Given the increased risks for directors, it is important that all board decisions be well informed and properly documented. Consider increasing the number of board meetings and management presentations to the board, and always consult counsel.
From the perspective of our bankruptcy practice, the current environment will create opportunities for PE investors – there will be deep discounts in several industries (airlines, hotels, entertainment, sports, and energy, among others). If a firm has capital, then depressed valuations, low interest rates, and the availability of financing from private credit sources could make this a good environment to find new investments.
Finance – Alexander G. Rheaume
The Federal Reserve has announced the establishment of the Main Street Lending Program for small- to mid-sized businesses. The Fed anticipates making up to $600 billion available for businesses impacted by the COVID-19 outbreak, including businesses that have already received funds through the Small Business Administration (SBA) Paycheck Protection Program (PPP).
While the final requirements for the Main Street Lending Program have not yet been released following a public comment period on proposed requirements, we anticipate that the program will be available to significantly more U.S. companies than the PPP.
- For the PPP, if a company is majority-owned by a PE fund, applicable SBA affiliation rules will aggregate the employees of that company with all companies controlled by the same PE fund for purposes of a requirement that the company have fewer than 500 employees (with certain exceptions). The Treasury Department and the SBA issued guidance on April 24 specifically confirming that these affiliation rules applied to PE-owned companies, and pointedly reiterated that prospective PPP borrowers “should carefully review” the required certification that “[c]urrent economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” This guidance also stated that “private equity firms” themselves are ineligible to receive PPP loans.
- By contrast, the analogous employee threshold for Main Street Lending Program eligibility is up to 10,000 employees or $2.5 billion in 2019 annual revenues. It does not appear that any “affiliation” rules will require aggregation of a PE-backed company’s employees with those of other portfolio companies.
- Companies receiving Main Street Lending Program funds will be subject to certain compensation, stock repurchase, distribution, and dividend restrictions.
Please see our related client alerts, House Passes a $484 Billion Relief Package; Treasury and the SBA Release New Guidelines for PPP Loans and The Federal Reserve Lends Support to CARES Act Through Main Street Lending Program.
Deal Negotiation and Execution – Todd Boudreau and Leo Martin
Unsurprisingly, given disruption caused by the COVID-19 outbreak, we have seen some clients choose to delay launching M&A processes that had been planned for Q2.
Transactions that were already in process when the disruption began have generally been able to proceed, albeit with delays in some cases, especially where regulatory review is involved. Due to government agencies dealing with remote workers and strained resources, many review processes are taking longer than normal. Of particular note, “early termination” of the initial 30-day waiting period under the Hart-Scott-Rodino (HSR) Act is only now being granted on a limited basis, meaning that almost all transactions subject to the HSR process will take a minimum of 30 days to receive clearance, and the relevant agencies have also indicated that transactions subject to Second Requests may take longer than normal to resolve.
Additionally, we are starting to see the impact of the COVID-19 outbreak on negotiations of acquisition agreements. Over the next few quarters, we expect a continued focus on certain risk allocation terms in M&A agreements, including:
- Increased use of downside protection mechanisms such as earn-outs. Use of earn-outs in U.S. M&A has remained relatively steady over the last 10 years, with the last bump in popularity coming after the economic downturn in 2007-2008. We expect increased use this year due to continued business and market uncertainty.
- Sellers pushing for pandemic-related carve-outs to “material adverse effect” definitions. These are to make clear that buyers cannot back out if the outbreak, or related disruption, causes significant damage to the business or its prospects between signing and closing.
- Enhanced due diligence, and negotiation of representations and warranties, to identify risks the outbreak may pose to the business. For example, scrutiny of customer, supplier, and other key commercial agreements to establish the presence of force majeure clauses that might excuse performance and evaluate the practical risks of interrupted compliance by either party. Depending on the nature of the target’s business, new representations specifically addressing COVID-19 related risks may be negotiated.
- More rigorous negotiation of operational covenants applicable to targets between signing and closing. This is to give or restrict (depending on your perspective) a target business’ flexibility to take non-ordinary course actions that might be prudent or necessary under the present circumstances (for example, ceasing to pay rent obligations, significant changes to business practices to comply with social distancing guidelines, etc.).
- Continued widespread use of representation and warranty insurance by PE. However, representation and warranty insurers are developing underwriting protocols to address outbreak-related risks, and some have already begun to propose to exclude coverage on COVID-19 related matters; as a result, parties may need to address those risks with “old-fashioned” approaches like special indemnities and escrows.
- More flexible termination provisions providing for longer “outside dates” for closing transactions, and/or automatic extensions if necessary regulatory approvals or satisfaction of other closing conditions is delayed by outbreak-related disruption.
Please see our related client alert, Negotiating Deals Through the Coronavirus (COVID-19) Crisis and our recent webinar, M&A Series: M&A Through the Coronavirus Pandemic.