Global menu

Our global pages

Close

Coronavirus - Private equity and the pandemic: Restructuring considerations - Global

  • Global
  • Coronavirus
  • Corporate

08-09-2020

It is with some trepidation that I note that this article brings our bitesize series to a close. I would hate to lay claim to a grand finale before the critics have piled in, but confess I am delighted to be tackling a topic that I feel is apt in many ways to conclude with. The experience of restructuring can no doubt be a grand, if somewhat morbid, spectacle itself in circumstances where a business has struggled on, only to go down in flames, falling through the figurative stage trap door to the embers below, never to rise again. However, the more interesting question for me as a corporate lawyer dealing with restructurings, is whether the crowd can expect any encore: is the beleaguered business capable of rising from the ashes?

Before we become embroiled in theatrics however, let’s take things back to the basics of restructurings. Last week saw us entertained by a somewhat high stakes game of snakes and ladders, negotiating moves around management incentive plans and tax planning. This week we are confronted with what has recently seemed to be a less refined, even perverse, game of inverted whack-a-mole, with many a business being beaten down below the parapet to shark-infested waters below. Since the on-set of Covid-19 the press has been littered with household names that have fallen victim to one form of restructuring process or another. Let’s take a closer look at the rule book to understand what exactly this ‘restructuring’ entails and what that might mean for sponsors.

‘Restructuring’ is a broad umbrella term for a range of different activities which, as with everything, can be considered from different perspectives. In terms of activities, restructuring can cover the full range of transaction types from an internal re-organisation of debt and equity arrangements, to a full scale and formal process of one kind or another (administration, pre-pack sale, company voluntary arrangement or liquidation, for example). In the context of the financial sponsor world, one might consider restructurings from a portfolio perspective and/or an acquisition perspective. The possibilities are endless! Being mindful of maximum stage time and with a view to keeping things focused however, we will start by looking at internal re-organisations from a portfolio perspective, which are increasingly commonplace, before moving to look at acquisition opportunities that may arise from more formal restructuring processes.

Portfolio Perspective

As the devastating impacts of the Covid-19 pandemic are well and truly setting in and businesses that perhaps weren’t initially dramatically hit at the start of the crisis now feeling the effects, many sponsor-owned businesses are looking to restructure their existing debt burdens and rebase their equity structures with a view to emerging from this period financially sound and looking to the future.

The key considerations in this context are (a) the ability to write off accrued interest and/or principal debt loaned by sponsors and external debt loaned by third party finance providers, (b) further cash injections and (c) reformulating existing management incentive plans to ensure they are fit for purpose.

As far as debt is concerned, sponsors will need to speculate to accumulate and engage some tax advisers to ensure that reducing debt (at either a shareholder or third party lender level) does not trigger any tax liability within the portfolio group. Consideration should be given as to the best approach to implement a right-sizing of debt and whether e.g. capitalising debt or undertaking a straight write off is best to achieve the underlying commercial goals. The terms of existing debt documents should be considered so as to ensure that prescribed processes are followed and consents obtained or notices served.

Likewise in relation to further funding, sponsors should consider the most economically efficient instruments for investing additional funds – loan notes, preference shares, ordinary equity etc. and the implications of each choice. For example, for existing investments there will already be in place a full suite of equity documents which should contain terms governing additional investments and which may place restrictions on the form of such investment and the manner in which it is undertaken. In particular, there may be pre-emption rights in favour of existing shareholders on any issuance of new shares or a catch up process post-issuance that will have to be adhered to. Alternatively, a well-prepared set of equity documents ought to contain specific exceptions or derogations to the rights of other (usually management) shareholders in situations where ‘emergency’ funding is required and/or the financial situation at the portfolio company is such that a default is on-going under external financing documents. Sponsors and their portfolio boards should review the specific wording of equity documents to ensure that any proposed restructuring steps are permitted pursuant to their terms, or that the appropriate processes are followed and consents obtained where required and in good time so as not to hold up any much-needed relief or funding.

Management incentive plans will usually be the sore spot in the context of any restructuring of a portfolio company. Where the business is struggling and its value has been impacted such that the equity is under water, the private equity model loses its raison d’etre from the perspective of a manager participant, particularly where that individual holds institutional strip as well as sweet equity and has therefore got real personal funds at risk. Although it would be usual to expect existing equity documents to contain provisions allowing sponsors to restructure in specific situations, engagement from management will nevertheless be required to ensure that the leadership team cooperates with the implementation of a restructuring and agrees a revised model and achievable set of hurdles to remain incentivised to stay and work to turn the business around. In particular, management will likely be concerned about how revised terms will impact vesting schedules applicable to their existing equity and whether this will carry over to new equity and the benefit in kind costs that may arise in connection with a new issuance of shares depending on the issue price.

As an aside, one other key area that sponsors in particular need to be aware of in situations of portfolio company difficulty, is the thorny issue of directors’ duties. As discussed in a previous article in this series, the duties of directors shift from being owed to shareholders to being owed to creditors in certain distressed restructuring scenarios. Sponsors who have appointed investor directors as representatives on their portfolio company boards should be mindful of potential conflicts and the changing nature of directors’ duties as restructuring situations evolve.

But getting back to the script, the key considerations outlined above are not necessarily new to sponsors, just perhaps a faded memory from the post-financial crisis years. Provided that sponsors and their portfolio companies refresh their memories and remain mindful of the above, internal restructurings can prove a helpful tool in rebalancing the books of distressed portfolio companies.

Acquisitions and Administrations

Turning up the drama dial now to look at what may be described as more typical ‘restructuring’ scenarios involving formal administration and other insolvency processes and the key considerations for sponsors and their portfolio companies looking to take advantage of these situations to acquire distressed targets.

For sponsors with dry powder to put to work and portfolio companies with available cash resources, there are significant opportunities across a range of sectors resulting largely from the impact of the pandemic. For those willing to take the plunge and pursue these opportunities however, there are several factors to bear in mind, as M&A processes involving distressed targets that are subject to formal restructuring processes are quite different in many respects from solvent M&A processes. We will focus here on (a) matters relating to process, (b) transaction documents including liabilities and indemnities, and (c) employment matters.

In terms of process, distressed targets and their creditors understandably have little time to waste in getting a transaction concluded and returning as much value as possible to creditors. Acquisitive sponsors will therefore usually find that processes involving targets in administration or other insolvency processes will therefore run on an accelerated basis, and timeframes to conclude diligence and transaction documents will be much shorter. There are several implications of this: diligence items ought to be identified and prioritised quickly – a full scale diligence exercise is unlikely to be practicable and the focus should be on red flag items e.g. outstanding security, customer and supplier contracts and employment matters. This is reinforced by the fact that where insolvency practitioners are running the sale process, they are unlikely to have comprehensive access to all the background information needed to fully address diligence queries as they have not historically been involved with running the business. In addition, the sorts of bidders competing for distressed assets may be different and more varied than sponsors are used to. Distressed processes may attract keen competition from opportunistic investors or competitor trade buyers, all of which have different motivations and therefore potentially different tactics to achieve a successful bid. Sponsors should be mindful of this when putting together a pricing structure for bids and ensure that they use their market expertise/understanding of a particular sector and their innovation to formulate e.g. a proposal relating to stock valuation, that delivers value to the target’s creditors.

Transaction documents may not be at the forefront of sponsors’ minds in a solvent process where lawyers are often relied upon to ensure commercial terms are fully reflected, but in a distressed situation, there are several key issues relating to transaction documents that sponsors ought to focus on. In particular, sales out of a formal restructuring process will often take the form of an asset sale as opposed to a share sale (unless the shares of a solvent subsidiary are being transferred as part of the ‘assets’). It is therefore of paramount importance that the investment teams at a sponsor level work closely with their lawyers to ensure that the documentation accurately captures all of the different assets and elements of the business that are intended to be acquired, and likewise that unwanted liabilities are left behind. Plant and machinery, intellectual property, stock and real estate should all be accurately inventoried or broadly defined as relating to the business to ensure that everything that is needed to run the business post-completion does in fact transfer.

Pricing considerations in a distressed situation may also be different from what sponsors are used to. Locked box concepts are not relevant in the context of asset sales and completion accounts mechanisms fall away - instead it is more usual to see a fixed price with limited, if any, adjustments to be made to that price in the transaction documentation. Tax advisers should be consulted to assist with determination of the allocation of the purchase price across the various assets acquired.

The other key difference sponsors will see in transaction documents relating to distressed assets is the lack of any representations and warranties relating to the assets being transferred. The reason for this is that it is the administrators or other insolvency practitioners that will be party to the transaction documents acting on behalf of the relevant seller. Insolvency practitioners cannot give reps and warranties in respect of matters they have limited knowledge of (having only recently been appointed to manage a sale) and, as officers of the court who are in place for a finite period only, will not expose themselves to personal liability. This approach, combined with more limited scope to complete comprehensive diligence exercises is bound to be a cause for concern for investors, but is expected to be reflected in the pricing of assets and so these matters should be weighed in the balance.

Not only will sponsors miss out on the comfort of representations and warranties when acquiring businesses from insolvency practitioners, but at the opposite extreme when dealing with administrators, will be expected to give extensive indemnities in favour of administrators. Preliminary drafts of transaction documents will usually contain very broad sets of indemnities in respect of all areas of the business and relating to periods prior to and following completion. This will be very unfamiliar and no doubt uncomfortable territory for sponsors, but there are means of limiting the scope of requested indemnities. In particular, well-advised sponsors should limit the scope of indemnities to matters that constitute costs and expenses of the administration or personal liability of the administrators. Restructuring experts should be consulted to advise on the nature of potential claims and the scope of liabilities that would be usual to pass to a purchaser.

Finally, given the fact that distressed sales usually take the form of asset sales, it is crucial to understand the position in relation to the transfer of employees and employee liabilities to the buyer and the implications of TUPE (the Transfer of Undertaking (Protection of Employment) Regulations 2006. The TUPE Regulations will usually have the effect of transferring employment contracts across to the buyer automatically on the sale of a business. Liabilities associated with those transferring contracts will also usually carry across and employees will receive protection from any dismissal that is associated with the transfer of the business. Information and consultation obligations may also arise depending on the number of employees. Failure to comply with obligations under the TUPE Regulations could result in significant compensatory awards being made in favour of employees, so sponsors should be fully informed regarding the position of employees and their entitlements before acquiring the relevant business.

Provided that sponsors are alive to the issues that arise during restructuring processes and the differences in approach compared with solvent transactions, they may be in a prime position to take advantage of opportunities presented by the increase in distressed M&A and ensure that appropriate target businesses get a second chance – that they do not have to call time on their performance as it were.

Sadly we do now have to call time on our bitesize series. And so there you have it. Our last hurrah…for now. We hope you have enjoyed the show as much as we have enjoyed entertaining you!

If you have questions about Restructuring matters or this article, please contact the Eversheds Sutherland lawyer with whom you usually work, or any member of our UK Private Equity team.