Restructuring at the time of the global financial crisis
The response of the banks to financial distress in private equity backed companies during the global financial crisis was of course company specific. It is, however, probably fair to say that a common outcome of a portfolio company being unable to meet its debt repayments was either for the private equity investor to ‘hand back the keys’ or for the banks to enforce their security with a view to recovering their investment on a sale of the underlying asset. Equity recapitalizations by the private equity investor (sometimes in conjunction with the purchase of portfolio company debt in the market), debt for equity swaps, or other consensual restructuring transactions did occur, but the odds back then were stacked against these type of transactions. Private equity investors had little forward visibility of demand for the products and services of their portfolio companies and were not inclined to throw good money after bad. Banks in general did not have a culture of taking and holding equity stakes and preferred the clean outcome of a third party sale, often through a pre-pack insolvency process.
Restructuring today
It is probably still too early to judge the full impact of the steep rise in interest rates, beginning at the end of 2021, on private equity backed companies and the attitude of lenders to the financial distress arising. We are, however, beginning to feel it is a bit different this time.
Some things haven’t changed. Private equity investors are not keen to recapitalize struggling portfolio companies with new money unless it is clear that doing so will ultimately allow them to recover value. Although interest rates may have peaked, there is no clear visibility on how long they will remain at levels that don’t work for highly leveraged private equity backed companies.
Where we believe we are seeing a difference to the response of lenders to distressed private equity backed companies during the global financial crisis is in the attitude of private debt funds to restructuring their credit. The private debt funds have made significant incursions into the leveraged debt market in recent years, particularly in the mid-market. These lenders seem more open to considering debt for equity swaps, or other negotiated debt restructurings, where the alternative is enforcement and taking control. Private debt funds are potentially more culturally attuned than lending banks to holding equity stakes, and the fact that the same team who originates deals (and therefore has the relationships with the private equity sponsors) will generally continue to manage the credit in a distress scenario, lends itself to the parties being incentivized to agree a consensual deal, with the aim of stabilizing the underlying business and creating the potential for ultimately delivering upside for all stakeholders. Many private debt funds already co-invest alongside private equity investors in the equity of the companies to which they provide credit.
Process and deal points on a debt for equity swap
Process
The amount of work required to execute a debt for equity swap should not be underestimated by any lender considering such a transaction.
The lender may want to consider undertaking its own diligence on the target to proceed with an equity investment rather than relying primarily on the diligence of a private equity investor as it would in a co-investment. In practice, however, the lender may often largely rely on its own knowledge of the target.
Negotiations will be required not only with the portfolio company borrower and its private equity majority owner but also with other stakeholders, such as management, regulators, and other financial and operational creditors.
Documentation of the debt for equity swap will be complex with the need to document the equity relationship with the private equity investor and management as well as the terms of the swap itself and the amended terms of the agreement covering the debt left outstanding after the debt for equity swap. In the event that negotiations with other financial creditors are required but have not resulted in a consensual deal, the parties may need to pivot to a document heavy non-consensual process with an extended timeline (such as a scheme of arrangement or restructuring plan).
A detailed tax analysis will be required. A release of indebtedness will potentially result in a tax charge on the debt forgiven, although in practice an exemption is likely to be available. Where the lender is a private debt fund, the possible tax consequences for investors in the private debt fund will also need to be reviewed.
There is likely to be urgency in completing the transaction in light of the default, particularly where, in some cases, lenders have not been able to take early action to address financial distress in borrowing companies due to the level of covenant headroom agreed in recent times.
Economics/Size of equity stake
The size of equity stake a lender will require is primarily driven by the amount of the lender’s outstanding indebtedness. The indebtedness must be reduced to a level which is consistent with the portfolio company being able to meet its ongoing debt servicing requirements and other liabilities following the restructuring. The restructuring will also need to ensure that the portfolio company after the debt for equity swap offers the potential of financial returns for the private equity investor, the lender, and the management team going forward.
The size of the equity stake will also have an impact on the controls and protections which are potentially available to the lender and the lender will have to consider the accounting implications of the size of equity stake acquired.
Terms of residual debt?
The parties will need to ensure that the debt burden on the borrowing group is at an appropriate and sustainable level and agree the terms of the residual debt left outstanding after the debt for equity swap.
Type of securities and issuer
For tax reasons, the securities issued to the lender in a debt for equity swap in a UK company should generally be ordinary shares, rather than shares which are debt-like in nature. As a general rule, a release of indebtedness of a UK company (including on a debt for equity swap) results in a taxable profit arising in the books of the borrower company. There are, however, certain exemptions, including where the release is in consideration of an issue of “ordinary shares”.
The lender will generally expect a priority right to income and capital, including on a sale or liquidation in relation to the securities issued to it in exchange for its release of debt. Such priority rights are acceptable from a UK tax perspective provided the shares issued are still “ordinary shares”.
In a typical private equity portfolio company group the borrower will not be the top company in the group. Steps will therefore be required to ensure that the lender is ultimately left with shares in Topco alongside the private equity investor and management in consideration of the debt written off.
Share rights and protections
As mentioned above, the key protection the lender is likely to require is a priority return for its equity capital investment made through the debt for equity swap. Any shareholder debt in the existing capital structure of the portfolio company will be written off, exchanged for equity or subordinated to the lender’s priority right of return.
Otherwise, assuming a sizeable minority equity shareholding, a lender is likely to seek rights including:
- Typical consent rights, including class rights designed to protect the priority entitlement of its shareholding
- Pre-emption rights on new issues
- Tag rights on the exercise of any Drag right and restrictions on share transfers by other shareholders, other than on the exercise of the Drag right (which right may be subject to meeting agreed criteria for returns on investment)
- Appointment of a director or observer
- Information rights
Management Incentive Plans
It will be necessary to review the effect of the dilution resulting from the debt for equity swap on the management’s equity and consider whether a new returns based management incentive plan is required to incentivize management.
What happens next?
It remains to be seen whether interest rates will fall far and quickly enough to come to the rescue of those private equity backed companies struggling to meet their interest payments. What seems the case, however, is that in the meantime private equity and private debt fund investors will continue to be aligned in seeing debt for equity swaps as a sensible way of addressing what they hope will be temporary problem for their portfolio companies.
Authored by John Livesey, Paul Mullen, Tom Astle, Alex Snell, and Graham Nicholson.
