Lawsuits were filed against at least two private equity firms in relation to their portfolio companies in December alone. In both cases, company stakeholders sued in relation to losses incurred through action, or inaction, taken by the private equity owner.
Legal experts agree the likelihood of a private equity firm facing court proceedings is increasing, and expected to continue doing so, meaning private equity firms need to pay more attention to insuring against it.
“For a long time, litigation has been an afterthought for private equity firms, but they now need to take a more corporate approach to thinking about legal matters as risk increases,” Timothy Mungovan, partner, private investment funds and commercial litigation at Proskauer Rose tells pfm.
Private equity firms tend to take a controlling or significant minority stake in target assets, which gives them more responsibility; as the industry grows, more and more private equity capital is in circulation, thus increasing the risk.
“Risk tends to arise in two main situations; the first is when there is a sale. Perhaps the buyer doesn’t obtain what they thought they were buying, or there is a disagreement over the value of the asset,” Mungovan says.
This was the case in PAH Litigation Trust v Water Street Healthcare. In an adversary action in Delaware bankruptcy court, the PAH Litigation Trust claimed former Physiotherapy Holdings controlling shareholders Water Street Healthcare Partners LP and Wind Point Partners LP, along with several affiliates, orchestrated a scheme to make it appear the physical therapy chain was worth roughly twice its actual value, designing a leveraged buyout at the inflated price, but transferring $248.6 million in borrowed capital to themselves and exiting “before the reality could catch up with them.”
According to the complaint, the deal made Physiotherapy instantly insolvent, leading to a Chapter 11 filing in 2013, and leaving creditors holding the bag and the new buyer’s equity investment gutted.
The second risk relates to “catastrophic loss,” which in the case of a private equity firm would be something such as a data breach, or in the case of real assets, a terror attack.
Real assets
For managers in real estate and infrastructure, litigation over portfolio assets is not new, but increases in dry powder and investment potential carry risk of an increase in action.
“There are typically more participants in a real estate deal; many are joint ventures between a property owner and a fund, which can create problems,” Chip Parsons, partner, private investment funds, private equity, at Proskauer says. “And funds often own the leasehold rather than the property itself, meaning there is a third party involved – the property owner. This can also create more friction.”
Real estate funds can be sheltered from action by their commitments to some properties. “If a fund owns a hotel building, for example, and that hotel is under a big name brand, the plaintiff will often launch legal action against the big name, rather than the lesser-known fund,” Parsons says.
The issues are similar in infrastructure, where the government and regulatory nexus is often a source of dispute.
“Infrastructure fund managers can also face challenges in relation to concessions, licensing, and labor disputes,” Monica Arora, partner, private investment funds, private equity real estate, at Proskauer says.
The typical lifespan of an infrastructure investment and a real estate holding also increases the fund manager’s risk of litigation.
“Infrastructure and real estate assets are held for longer, so there is more downside. This creates more opportunities for lawsuits,” Arora says.
In general, the sources agreed the first step to mitigating litigation risk is to be prepared, and be sure to be aware of where the risk can arise.
“At a portfolio company level, there should be someone from the private fund firm on the board that is attuned to the risk of litigation arising from the firm’s involvement in the company,” Mungovan says.
The general counsel or chief compliance officer should also be paying attention to where legal contention can arise. The firm also recommends fund managers re-examine their professional liability insurance in light of the scope of indemnification rights at a fund and portfolio company level.
“It is clear that the litigation climate for private fund sponsors is rapidly changing. But those who take early and proactive steps to manage their risk will be well positioned to weather the storm,” the firm said in its 2016 annual outlook for private funds.
The jury’s out
Cases were brought against two private equity firms in December, relating to portfolio company holdings
Apollo Asset Management is being sued by lenders to its now-defunct portfolio company Core Media for allegedly stripping its assets, and avoiding liability for the debt the media company incurred. The lawsuit, filed in mid-December, is led by pre-bankruptcy financers including Tennenbaum Capital Partners, Bayside Capital and Hudson Bay Capital.
It said Apollo “orchestrated a complex series of moves that resulted in Core’s lenders not being paid in full, or even having their loan liabilities assumed.”
The chairman of a portfolio company owned by Actis plans to sue the firm for its alleged failure to prevent the company losing value.
Rakesh Malhotra has issued a writ of summons against a group which includes Actis Consumer Grooming Products, Actis LLP, and four Actis executives in relation to Super-Max Mauritius, a razor blade manufacturer which the private equity firm acquired in 2011.
Since Actis acquired the group, its value has fallen sharply, despite the markets in which the company operates growing rapidly, a spokesman for Malhotra said.
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