Managing portfolio companies which have run into difficulties is a real test of a skill of a private equity professional. Taking the difficult decisions about management, focussing strategy and improving the operating cash flow are all much harder to do in an environment where banking covenants are being broken and the banking relationship is becoming fraught. A cool head and calm hand on the tiller is even more difficult when it becomes apparent that a significant proportion, if not all, of the equity money invested is in danger of being lost.
Clearly, one of the first areas of concern for an investment professional in these circumstances has to be to look at his duties and liabilities as a director of the portfolio company. Directors may be personally liable to make a contribution to an insolvent company where they knew or ought to have concluded that there was no reasonable prospect of the company avoiding insolvency, and they failed to take steps to minimise the loss to creditors at the appropriate time. As soon as a director becomes aware that an insolvency event is a real possibility, he should raise the issue with the board, and the board should then take immediate independent financial advice. Ensuring that you and the board are protected by showing that you took appropriate advice at the time is important given that these matters are inevitably judged with the benefit of hindsight.
Before a company gets itself to this point, there are other options which can be pursued to preserve some value for the equity whilst still complying with the obligations imposed by law. One of these is to take advantage of the increasing interest of specialist investors in seeking distressed opportunities.
Rather than simply handing the keys to the bank or to an insolvency practitioner and relinquishing control, if the nettle is grasped early enough in the process a different structure can be created. A rescue refinancing package can be put together with “loan to own” specialists which will take out both the debt and the equity of the underperforming target. Although the equity provider will not receive any immediate payment in relation to the shareholder money which has been invested in the target (and will therefore suffer a write-off), it is possible to structure a mechanism whereby some future upside can be preserved.
We have recently started to see a number of structures proposed using a management agreement, under which the private equity house will continue to manage the business through its difficulties, using its expertise and knowledge. The business itself is freed from the previous burden of covenant breaches and is hopefully able trade to its way out of trouble. The return under the management contract is performance related and set at an appropriate level to incentivise the ongoing involvement of the private equity house and offers them the opportunity to recover some portion of the money which would have otherwise been lost in a melt down scenario.
The secret to putting in place such a structure is for the situation to be identified sufficiently early on. The point at which an event of default can be enforced by the finance syndicate is too late as the shareholders will lose control of the company and have no seat at the table to negotiate.
Therefore, if your portfolio company starts showing signs that it is moving into a distressed situation, you need to identify the point at which this will impact on your personal position as a director, and start working out ways in which some part of the equity value can be preserved. Considering this earlier rather than later is the way to salvage something.