The coronavirus disease 2019 (COVID-19) pandemic and the actions taken by federal, state and local authorities to reduce the spread of the virus present significant challenges for private equity (PE) firms and their portfolio companies. This alert provides an overview of certain financing considerations for portfolio companies of PE firms to address the challenges in the current market created by the COVID-19 crisis.
- Impact on portfolio companies. As liquidity shortfalls become an increasing reality among portfolio companies during the current market stress caused by COVID-19, concerns have arisen about PE portfolio companies navigating the following issues:
- Cash and liquidity. Faced with sharply declining revenues, portfolio companies across industries are facing a short-term cash crunch.
- Many portfolio companies that have revolving credit facilities in place are drawing down on these revolvers as much as possible to ease current liquidity needs, reserve cash on the balance sheet for potential future shortfalls and avoid a possible lock-down on future draws if market conditions further deteriorate. Currently, lenders generally seem to be permitting such revolver draws across all industries; however, as lenders continue to assess the effect of the pandemic on borrowers and the debt markets, borrowers may encounter additional restrictions and/or be unable to meet conditions for future revolver draws.
Prior to making any draws, portfolio companies are encouraged to carefully consider with counsel (i) any conditions to borrowings that may be affected by the coronavirus and resulting market compression, including (a) the bringdown of representations and warranties, particularly those relating to the absence of a material adverse effect, solvency of loan parties and material contracts, and (b) certification of no default or event of default; (ii) selection of interest periods, as selecting longer interest periods (to the extent such option is available) will enable borrowers to maintain outstanding loans at LIBOR without having to bring down representations and warranties or certify no defaults on a monthly or more frequent basis if shorter interest periods are selected; and (iii) whether any springing financial covenants may be triggered by drawing down on the revolver above a certain availability threshold. Lenders are also reviewing material adverse effect/change provisions in existing debt agreements as well as other provisions that may be impacted by the COVID-19 pandemic, which lenders may rely on to restrict the ability of borrowers to make additional draws or to otherwise exercise default remedies.
- Liquidity issues are also raising concerns as to the ability of portfolio companies to make upcoming interest and principal amortization payments under existing credit facilities. In order to preserve cash, PE sponsors and portfolio companies may consider whether lenders will provide any relief as to upcoming payments, whether pursuant to a deferral, waiver or other alternative.
- Financial covenant breaches. At quarter-end, portfolio companies are required to deliver certificates certifying compliance with the financial maintenance covenants in their debt instruments as of the end of the quarter. Although the negative effects of the COVID-19 pandemic on EBITDA may not cause a breach of financial covenants for the first quarter of 2020, continuing market deterioration may present challenges for compliance with such covenants for future periods. To address any potential non-compliance with financial maintenance covenants, PE sponsors and portfolio companies may consider engaging with lenders to obtain waivers, covenant resets, covenant holidays or other options for covenant relief for impacted periods. PE sponsors are also encouraged to carefully consider the use of any available equity cure provisions, particularly whether any such equity cure proceeds will be required to prepay outstanding loans. Sponsors and portfolio companies may wish to seek guidance from counsel in assessing existing adjustments to EBITDA and evaluating the correct approach to obtain such covenant relief. Quarterly compliance certificates will also require certifications of the accuracy of representations and warranties and no default, and sponsors and portfolio companies may consider whether any waivers or amendments are required to address the continuing impact of COVID-19 and the resulting market decline on such certifications. In order to assess the effect of COVID-19 on borrowers’ financial condition, lenders are also reviewing their existing audit and inspection rights under credit facilities to more closely monitor borrowers.
- Audit opinions. Given the market impact to date and uncertainty surrounding the ultimate economic consequences of the pandemic, some portfolio companies may be at risk of receiving a “going concern” opinion rather than an unqualified audit in connection with their audited financial statements. This, in turn, could affect companies’ compliance under credit agreements and sponsors’ disclosure obligations to shareholders and creditors. Additionally, as companies, including accounting firms, continue to impose travel restrictions in response to government mandated policies, this may delay the delivery of audited financial statements and could result in breaches of reporting deadlines. Moreover, because PE firms may use the same accounting firm across their portfolios, these delays may create broader issues across multiple portfolio companies. Therefore, sponsors may consider discussing delivery deadlines with both accountants and lenders to address any potential delays.
- Company-level responses. The COVID-19 situation is fluid, but options that PE sponsors are considering to manage financing concerns at the portfolio company level include the following:
- Capital infusion. To ease short-term liquidity shortfalls, sponsors may consider providing additional equity capital to distressed portfolio companies in order to maximize the value of the firm’s investments. Certain portfolio company debt instruments may include equity cure provisions that require, among other things, mandatory prepayment of loans triggered by an equity infusion. To meet any such capital infusion needs, many PE funds are drawing down on their fund-level revolving facilities to ensure that the fund has liquidity available without making capital calls. However, PE funds should consider reviewing their fund-level credit facilities with counsel to make sure they can meet the requisite borrowing conditions as well as any other provisions that may be affected by the current COVID-19 pandemic.
- Debt buybacks. Although not as prevalent in middle market transactions, to the extent not otherwise restricted under the debt documents, sponsors may consider taking advantage of declining trade prices for bank loans by repurchasing debt at portfolio companies. Depending on the entity purchasing the debt in a debt buyback, the debt may be cancelled or may remain outstanding subject to certain restrictions on voting rights. Prior to exercising any debt buyback options, PE sponsors and portfolio companies are encouraged to consult with counsel to understand the restrictions under the relevant credit facilities as well as to analyze the corporate, tax and securities implications of any buyback, including certain fund-level considerations.
- Reset covenants. A company at risk of breaching its financial covenants would be well served to work with counsel and consider approaching its lender to seek amendments to its debt agreements to reset covenant levels or build in additional EBITDA adjustments to address the effect of COVID-19 in order to avoid a possible near-term default or increase borrowing capacity. In setting new covenant levels, additional cushion to address the ongoing uncertainty of the impact that COVID-19 will ultimately have on portfolio companies may prove beneficial.
- Waiver or forbearance. A portfolio company that defaults under its debt agreements will need to work with its lenders and counsel to determine whether a waiver or forbearance agreement is appropriate under the circumstances. Grace or cure periods may be available for potential breaches that influence the implications of defaults on access to revolvers and use of covenant baskets. Deposit accounts may be subject to control or setoff rights in favor of lenders that could be triggered during the continuance of any defaults.
- Bankruptcy. Companies that are simply unable to meet financial obligations or successfully renegotiate terms with lenders out of court ultimately may need to seek bankruptcy protection.
- External financing options. Portfolio companies may also seek financing relief through the following channels:
- Reach out to existing lenders. Proactive outreach and engagement with lenders can be facilitated with a financing plan and base case and downside models. Especially in the current market, lenders have been receptive to sponsor-backed companies with a thoughtful business plan.
- Consider alternative lending options. Sponsors may also want to consider contacting nonbank lending sources to ease liquidity concerns, as there are still many alternative lenders standing by with ample capital to deploy. However, if portfolio companies already have credit facilities in place, sponsors will need to understand the debt capacity and restrictions under such existing facilities that may limit the access to alternative funds.
- Explore federal stimulus programs. Portfolio companies may be eligible for expanded Small Business Administration (SBA) funds and loans in connection with the recently enacted Families First Coronavirus Response Act and Coronavirus Aid, Relief, and Economic Security Act, although aggregation rules may make it difficult for most sponsor-backed portfolio companies to qualify. In considering such programs, portfolio companies are encouraged to consult with counsel to understand whether any amendments are required under existing credit facilities to, among other things, permit the incurrence of such loans and address any impact on financial maintenance covenants. For additional information on SBA programs, see DLA Piper’s recent alert, SBA to provide disaster assistance loans for small businesses impacted by coronavirus.
- Be aware of local stimulus packages and emergency orders. Many jurisdictions have launched programs to support local businesses through a combination of loans, grants and payment relief. Moreover, certain jurisdictions, including New York State, have issued orders requiring that lenders grant businesses an opportunity for a temporary forbearance of payments in certain circumstances.
If you have questions regarding these issues, please contact your DLA Piper relationship attorney or any member of DLA Piper’s Private Equity group.
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This information does not, and is not intended to, constitute legal advice. All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.