How much do you trust your lawyer?

Private equity sponsors are now designating lawyers for lenders, weakening protections for debt funds.

Lawyers offer vital protection to debt funds, ensuring their documentation provides funds, and ultimately investors, with covenants and terms they can rely on. But could the practice of equity sponsors designating lender counsel be leaving creditors in the lurch?

Legal advice is at the heart of private debt deal-making and having a solid team of lawyers can be the difference between a successful investment or a crippling loss. But as debt markets increasingly favor borrowers, a new and worrying development could mean your legal counsel is not as reliable as you had hoped.

Lawyers and general partners have been in touch with us to raise their concerns about the growing use of “designated lender counsel” in private equity-backed deals, which they believe is leading to conflicts of interest and causing debt funds to get a raw deal.

So what is designated lender counsel? It’s where private equity sponsors appoint lawyers for private debt managers on their deals, often well before they have selected which lenders they will work with. Once the creditor has been chosen, the sponsor assigns its lawyer to represent the debt fund on the transaction. The rationale is, in a fast-moving auction process, managers need to be able to act quickly and assigning a lawyer already familiar with the details of the transaction can speed things up significantly, ensuring the private equity sponsor can secure the deal.

The practice has existed for years but traditionally only appeared in very large transactions.

“This comes from very large-cap deals with €1 billion or more of debt which are usually underwritten by investment banks. The sponsors designate the lender counsel because bank lenders won’t pay the legal bills but still need some representation,” one lawyer tells sister title Private Debt Investor.

“In these deals the lender is often mandated very late in the process, sometimes not until the day before signing.”

However, industry insiders are seeing it extend into the mid-market where credit funds operate. They argue it is less justified in this space as creditors are usually chosen much earlier in the transaction.

While there is nothing inherently wrong with the practice, which could be viewed as similar to a mortgage borrower’s legal representative also working for their lender, recent developments have led to concerns within the industry.

“We’re in a very competitive market for private debt and the last three or four years have exposed problems with this model,” says one fund manager, who wanted to remain anonymous. “This started with being given a list of three or four lawyers we could use but these days the sponsors will give us one choice and if we aren’t happy with it, we lose the deal.”

This has resulted in private debt funds using lawyers they have not previously worked with and don’t know very well. Credit funds are concerned that the lawyers they are being offered are heavily reliant on the private equity sponsors for business and therefore likely to put the needs of the borrowers first.

“We’re also seeing this manifest as a squeeze on legal fees, which isn’t good for the lawyers involved either,” one GP says. “This results in a lower quality of service as these firms are operating on very small margins and they’re under pressure to keep the sponsor happy so they can get deals in the future.”

The bigger risk for debt funds in these situations is that their lawyer goes soft on terms and fails to fully explain how soft they are. However, this may not be apparent until it is too late, a covenant has been breached and the private debt manager finds it doesn’t have the rights it thought it should. In a world where terms and covenants have been weakening for several years, an already bad situation for lenders could be made even worse.

A similar problem many credit funds now face is that of the commercial termsheet.

“This is essentially a termsheet that’s printed off, often from a previous transaction, with fixed pages that feature all the key elements of a credit agreement. There’s no lender counsel and you can either take the deal or leave it,” according to one GP.

These sorts of tactics are predominantly being used by larger US and UK-based equity sponsors, and are far less common when dealing with continental European private equity funds.

SRA principles

Legal counsel must: 

Uphold the rule of law and the proper administration of justice

Act with integrity

Not allow their independence to be compromised

Act in the best interests of each client

Provide a proper standard of service to their clients

Behave in a way that maintains the trust the public places in them and in the provision of legal services

Comply with their legal and regulatory obligations and deal with their regulators and ombudsmen in an open, timely and co-operative manner

Run their business or carry out their role in the business effectively and in accordance with proper governance and sound financial and risk-management principles

Run their businessorcarry out their role in the business in a way that encourages equality of opportunity and respect for diversity

Protect client money and assets

Pay attention

So what can private debt managers do to protect themselves from this at a time when the balance of power sits firmly with the borrower?

Unfortunately, in many cases the answer is simply that GPs will have to pay a lot more attention to their documentation and provide much of the scrutiny themselves to ensure they know what they’re signing up to.

In some cases, larger debt fund managers have in-house legal teams able to analyze documents independently and advise deal teams on the full extent of their rights.

One manager of credit funds operating in the upper mid-market says: “We have a team with legal backgrounds in-house who know how to read these documents and can provide additional advice on the transaction. But a lot of smaller managers don’t have this function and so have very little protection in the current market.”

The other option available to firms is to pursue action via regulators. One lawyer we spoke with says “a lot of fund managers are furious about the way they are being treated and are considering making a formal complaint to the Solicitors Regulation Authority.”

The SRA is the legal regulator in the UK and has powers to reprimand or even close down legal practices that break its code of conduct.

The SRA handbook states that solicitors “should always act in good faith and do your best for each of your clients. Most importantly, you should observe a) your duty of confidentiality to the client; and b) your obligations with regard to conflicts of interests.”

It is possible that designated lender counsel could lead to breaches of both these principles, which would be sufficient for the SRA to take action.

However, a spokesman confirmed that, at the time of going to press, no formal complaint has been made.

It is also worth noting that designated lender counsel does not necessarily do debt funds a disservice. Most legal advisors will take their obligations to fairly represent their clients seriously and act responsibly. Debt funds too know that there needs to be a degree of compromise between both legal teams to get deals done.

The reluctance of firms to speak publicly about their concerns demonstrates the sensitivity of this issue. In these market conditions, equity sponsors can wield a lot of power over their debt providers and many will be afraid to rock the boat or speak out for fear of losing out on deals.

But managers should remember that the market will not be benign forever and their ultimate role is to deliver returns to LPs, not please equity sponsors. One or two significant losses caused by bad legal advice could wipe out all the good work in a portfolio and leave reputations in tatters.