MoFo PE Briefing Room
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:
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:
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.
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.
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.
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.
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.
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.
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.
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:
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.