Recent turmoil in the debt markets may cause investment funds to re-evaluate their methods for gaining favorable returns on their investments. Oversupply and lack of demand for some debt securities have driven down their prices to a discount level that funds may view as an attractive alternative or supplement to their investment strategies. Some private equity funds have even established separate funds for taking advantage of such opportunities.
Purchasing the existing publicly traded debt of a portfolio company in the secondary market may serve as a particularly attractive specific debt investment opportunity for a fund for several reasons. First, the fund may consider such an investment as a sound basis for supporting its equity investment and for hedging against possible future losses. Also, compared with an investment in the debt of an unrelated company, a fund may be in a position to more easily evaluate whether the price discount of its portfolio company’s debt securities is a worthwhile investment given the fund’s familiarity with the portfolio company’s fundamentals. In addition to an economic benefit, a fund’s investment in a controlling portion of a portfolio company’s debt securities would enable the fund to forebear from exercising remedies that may have otherwise been exercised by unaffiliated debt holders under conditions constituting an event of default under the terms of such debt.
In the context of any such investment, however, the relationship between a fund and its portfolio company gives rise to certain securities laws, contractual and practical considerations, among other issues (e.g., applicable exchange rules for issuers with exchange-traded securities). For example, the fund must be mindful of prohibitions on insider trading. Additionally, even though the fund may seek to purchase its portfolio company’s debt securities in the secondary market, depending upon the circumstances (and, in particular, if the fund seeks to purchase a substantial portion of the outstanding debt), tender offer rules could be implicated. Moreover, prior to any such purchase, a fund should consider any existing contractual arrangements to which the fund or the portfolio company is subject, both with respect to the fund’s purchase and subsequent sale of such debt securities. Finally, a fund should take into account the practical considerations of its decision to do so.
Insider Trading Concerns
In connection with the relationship between a fund and its portfolio company, the fund may have access to material, non-public information relating to the portfolio company. Specifically, with respect to any sale and purchase of securities, Section 10(b) of the Securities Exchange Act of 1934 and the rules promulgated thereunder prohibits a fund from purchasing or selling securities on the basis of material non-public information. Courts addressing Section 10(b) violations have held that information is “material” if a substantial likelihood exists that a reasonable investor would find the information significant in deciding whether, and on what terms, to buy or sell the securities, taking into account both the probability that the event will occur and the anticipated magnitude of the event in light of the totality of the issuer’s activity.
A fund may have access to material non-public information through director or officer positions held in a portfolio company or because the portfolio company regularly discloses important information to the fund pursuant to contractual requirements or otherwise. If such information has not been publicly disclosed, then the fund must refrain from effecting the purchase or sale until such information is publicly disclosed. As an example, at the time that a fund is proposing to purchase or sell debt securities of its portfolio company, its representatives may be aware of an important, undisclosed contract into which the portfolio company is likely to enter or the undisclosed, likely termination of an important contract. Other areas of material information of a portfolio company that must be considered in the context of insider trading prohibitions include personnel issues, financial results or projections, and issues affecting an industry generally that may have a disproportionate effect on the portfolio company. To mitigate the risk of implicating insider trading rules, the fund should consider making the offer for a purchase shortly after the portfolio company has made its most recent securities filing.
Tender Offer Issues
Even though a fund may purchase the public debt of its portfolio company in the secondary market, under certain circumstances, a series of purchases may trigger tender offer rules under the Exchange Act. The term “tender offer” is not defined in the Exchange Act, but many courts have employed the eight-factor test in Wellman v. Dickinson to determine whether a tender offer for the purchase of securities has been commenced, i.e., whether the purchase: (1) involves an active and widespread solicitation of security holders; (2) involves the solicitation of a substantial percentage of the issuer’s securities; (3) offers a premium over the market price of the securities; (4) contains terms that are fixed rather than flexible; (5) is conditioned upon the tender of a fixed number of securities; (6) is open for a limited period of time; (7) pressures security holders to sell; and (8) would result in the bidder acquiring a substantial amount of securities. Other courts have analyzed transactions in a more holistic manner. Although a determination must be made on a case-by-case basis, as a general matter, a discrete purchase of securities in a private transaction, or a purchase through the open market or through a market maker at market price, is less likely to trigger tender offer rules than a series of purchases for a significant portion of an outstanding class of securities at a premium above the market price. Additionally, to reduce the likelihood of triggering tender offer rules, the fund should consider effecting open market purchases through the securities firm that managed the initial underwriting; the salespersons at such firm are likely in the best position to know the identity of the current debt holders and the magnitude of their holdings.
If a purchase (or series of purchases) does constitute a tender offer, it will be subject to federal tender offer rules (and, as a result, increased transaction costs). If the tender offer involves debt securities registered under Section 12 of the Exchange Act that are convertible into equity securities or that carry a warrant or right to subscribe for equity securities, Regulation 14D of the Exchange Act would require, among other things, that the tender offer be kept open for at least 20 business days, that the fund file a Schedule TO disclosing the terms of the deal, and that the consideration paid to security holders be equal. Although tender offers for debt securities without an equity feature are not specifically subject to all of the same tender offer rules required under Regulation 14D, given that they are subject to tender offer anti-fraud provisions to which all tender offers are subject, such tender offers may sometimes have to comply with Regulation 14D’s procedural and substantive requirements to help safeguard against liability.
While not a source of liability under federal securities laws, contractual arrangements to which a fund or its portfolio company is a party can also present issues in connection with the fund’s purchase of the portfolio company’s public debt securities. The following are examples of such provisions:
• Even though a purchase may not be subject to tender offer rules, the instrument governing the debt securities may require that the purchase be made on the same terms to all holders to which an offer to purchase has been made.
• The documentation pursuant to which the fund acquired its initial equity investment in the portfolio company or its own fund documentation may place a limitation on the size of the fund’s interest in that particular company or other portfolio companies in a similar line of business.
• The purchase of securities generally may be the subject of a shareholder agreement to which the fund is a party. Depending upon the types of securities to which the agreement applies (e.g., securities that are convertible into equity securities) and whether the agreement extends to securities acquired after it is executed, a shareholder agreement may restrict the fund’s subsequent transfer of any debt securities it acquires or provide, for example, that the other parties to the agreement have a right to “tag along” in any subsequent sale.
Apart from compliance with laws and contractual provisions, there are practical concerns that a fund should consider when determining whether the purchase of its portfolio company’s debt is in fact a prudent decision. For example, such an investment would increase the fund’s concentration of risk compared with an investment in an unaffiliated entity. The fund will need to consider in advance how it will justify the additional investment to its limited partners, particularly if the investment in the portfolio company as a whole ultimately yields lower than expected returns. Additionally, even though debt would ordinarily be structurally senior to the portfolio company’s equity, in a bankruptcy scenario, in several cases claimholders have alleged that the debt held by the fund should be equitably subordinated, to be treated the same as equity, in light of some alleged inequitable conduct. Of course, if a fund is mainly concerned about its equity investment, it may nonetheless elect to proceed to purchase the debt despite any concerns of equitable subordination.
The current climate in debt markets offers investment funds opportunities to purchase debt at a discount, and a fund may in fact find it economically or strategically beneficial to purchase public debt securities of its own portfolio companies. Prior to any such transaction, however, such a fund must carefully analyze the potential ramifications of the purchase and subsequent sale of such securities in the context of compliance with both securities laws and applicable contractual provisions, as well as with regard to practical concerns.
Mark G. Pedretti is partner and head of the Private Equity Group at Reed Smith LLP; Marvin A. Artis is a partner in the Private Equity Group, while Vincent R. Martorana, Chad M. Dickerson, and David H. Hung are associates.