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Getting ready for the crunch

Minimising the impact of financial crisis on private equity funds and venture capital funds. By Gabor Garai, Foley & Lardner

Gabor Garai is chair of law firm Foley & Lardner's private equity and venture capital practice. He can be reached at ggarai@foley.com

As recently as a year ago, the pundits were divided on the severity of the subprime mortgage crisis and its ability to impact the economy at large. Some categorised it as a worrying economic ailment which could be contained and cured; others argued that it was a far more serious disease, which would only become more pervasive with time and go on to shake the western economic system. Now that we are in the throes of the crisis, there are fewer debates about its far reaching implications. The sense of immediacy has made discussion more focused, as the universal concern now is how best to protect oneself.

The credit squeeze
While the ‘casualty list’ of those hit by this crisis is growing daily, enterprises like private equity funds, whose businesses are tied to the availability of credit, are at a disproportionate risk in the present environment.

“If history is to offer any guidance on the issue, the behavior of the Resolution Trust Corporation during the last real estate crisis could raise concerns”

The most significant impact of the current crisis has been a sharp contraction of the debt markets with a dramatic reduction in liquidity. From the perspective of a borrower, this is a double-edged sword. Not only is the availability of new credit in the market reduced, but existing credit facilities are also placed at greater peril, due to the lender's interest in increasing their own liquidity by, among other things, accelerating the maturity of their existing credit arrangements. There is no good reason to assume that lenders will act any differently now than in the past, when, during credit crunches, they scoured existing credit arrangements in an attempt to generate cash by accelerating maturities.

Furthermore, the current exigency has elicited a strong response from the federal government, a salient part of which is the federal bailout package. This proposed package is meant to increase the availability of credit in the market by injecting cash into financial institutions. It is also likely that the federal government will be involved in setting up a new agency to purchase troubled loan portfolios from lenders. While the media is currently focusing on residential mortgage loans, this buyout will probably also encompass commercial, non-real estate credit facilities. Both the lenders and the federal agency will have various incentives to broadly interpret the mandate of the new legislation, thereby increasing their own liquidity. One only has to look at the expansive reading of the Federal Reserve in defining “financial institution stock” for purposes of the anti-shorting rules to observe the tendency for broad interpretations. This may add a new aggressive federal agency to the list of lenders of a private equity fund or to one the fund's portfolio companies, when the agency purchases the relevant loans. If history is to offer any guidance on the issue, the behavior of the Resolution Trust Corporation during the last real estate crisis could raise concerns. The Resolution Trust Corporation declared defaults where the loan-to-value ratio was not maintained (the result of declining real estate values), even when the loan was not otherwise in default. One fears that the new federal agency may act in similar fashion.

One risk of the unavailability of otherwise expected credit that is peculiar to private equity funds, has to do with the drawdown commitments of the funds' limited partners. Many private equity funds have call provisions that allow the fund to draw down the investment commitments of its limited partners. Since these limited partners are mostly institutions, fund managers typically assume that capital calls will automatically produce the requested funds on a timely basis. The current financial crisis may well have adversely impacted the liquidity of many institutional LPs. Significant positions in various types of bonds and short term securities, which in the past were synonymous with guaranteed liquidity, may no longer be available to meet capital calls. Moreover, fund managers, being distracted by various portfolio issues, may not react with their usual alacrity.

Other challenges
Besides the credit squeeze discussed above, private equity and venture capital funds also face additional challenges in the current financial and credit climate. One of the important roles of investment banks has been the facilitating of transactions, and mediating between funds and institutional buyers, sellers and issuers. Since, as a consequence of the subprime mortgage crisis, Lehman Brothers and other major investment banks have suddenly disappeared, funds that counted on such banks for the facilitation and germination of their deals and relationships have been left out in the cold, with little time to look for and develop alternative channels of deal flow.

Private equity funds now find themselves at a disadvantage in the competitive landscape between financial and strategic buyers. Owners of private businesses are especially sensitive to the impact that leverage has on private equity firms' investment strategies. Sellers may gravitate to strategic buyers, due to a perception that the credit crisis will adversely impact buyout firms' ability to close deals.

Financial instruments and securities, that were until recently regarded as safe sources of short and medium term liquidity, are now seen as risky. Since venture funds typically invest in companies through a single tranche, portfolio companies have substantial funds in hand at the close of a venture round, which they invest in appropriate short and medium term securities. Most portfolio companies do not have a sufficiently developed treasury function to monitor these investments, some of which could be at risk in the current conditions.

Steps to minimise impact
Fund managers need to proactively address the aforementioned risks and minimise the impact of the current crisis on their funds and portfolio companies. Given the immediacy of the risks, funds and their managers should:

   Undertake a comprehensive review of the outstanding credit facilities of each portfolio company in order to determine the maturity date of each facility. Contingency plans should be established to address the possibility that, once expired, those facilities will not be renewed, or might only be renewed at either significantly higher costs or lower credit limits.

  • Carry out an audit of the portfolio companies' credit lines which should include a review of covenants and default provisions which might enable the lender to accelerate the maturity date. In the present circumstances, customary assumptions about non-enforcement of minor “technical” defaults are not applicable. Similarly, assumptions regarding lenders' incentives to retain, renegotiate or extend performing loans with potential minor covenant defaults may no longer hold true.
  • Review their portfolio companies' credit agreements for “Material Adverse Change” and “Material Adverse Effect” (MAC and MAE) clauses which are becoming subject to controversy not only in the context of aborted deals, but also potentially in credit agreements where these clauses are the basis of an event of default. After the review is carried out, appropriate steps should be taken to minimise risks of running afoul of such provisions.
  • Track whether their loans, or the loans of their portfolio companies, are sold to the new federal agency. If so, as in the case of all government interactions, prudence and discretion should be maintained when dealing with the agency.
  • Take into account the fact that capital calls on limited partners may not automatically produce the requested funds on a timely basis, when planning future capital deployment.
  • Assist their portfolio companies in making appropriate risk assessments and investment adjustments with respect to their equity capital. Failure to do so might give rise to claims against fund managers by their limited partners.
  • Develop strategies for swiftly cultivating channels, alternative to Lehman Brothers and other extinct or jeopardised investment banks, to maintain and enhance their deal flow.
  • Brace for a competitively disadvantaged position in relation to strategic buyers and plan to counter the disadvantage.
  • Monitor legislative and rulemaking developments closely, as the proposals for additional regulation of various financial institutions (such as hedge funds) are likely to encompass, whether intentionally or not, most – if not all – private equity funds.