Sponsor Debt Purchases as Affiliate Lenders | King and Spalding
In response to changes in the market, borrowers may resort to debt buybacks as a means of mitigating their overall net indebtedness level (either to address financial defaults resulting from the pandemic, or to strengthen their balance sheet and corporate profile) . [Company Debt Buybacks.] Another possible tool that private equity funds can deploy on behalf of their portfolio companies is to purchase their portfolio companies’ debt from the existing group of lenders (and in doing so, become an affiliated lender). This client alert analyzes why financial sponsors may choose to buy debt from their portfolio companies, then turns to existing lenders’ considerations for affiliated lenders.
Why Sponsors Buy Their Portfolio Company Debt
Although trading debt at a steep discount to par often indicates that a company is in trouble, for some investors it represents an opportunity. In particular, private equity sponsors could choose to purchase the debt of their portfolio companies and become an affiliated lender under a credit agreement. A sponsor’s decision to buy holding company debt at a discount offers several potential opportunities:
- sponsors can realize a return on the purchased debt if the holding company recovers and the debt trades above the purchase price,
- if the portfolio company moves toward an out-of-court settlement, the sponsors could have a seat at the lenders’ table to help influence certain decisions aimed at helping the portfolio company avoid a restructuring in court, such as amending documents to extend the maturity date or relaxation or waiver of financial covenants, and
- if thoughtfully conveyed to existing lenders, a sponsor’s decision to further invest in a company’s balance sheet via a debt acquisition can have a positive and even soothing effect on a struggling company’s lenders or distressed – this may demonstrate that a sponsor believes in the future of the business and wishes to increase its advantage in connection with the eventual turnaround.
Regardless of the underlying strategy, existing market forces – including record amounts of dry powder available to the private equity sponsor – could induce sponsors to buy portfolio company debt at discounted prices in the coming months.
Important Considerations When Authorizing Affiliate Lenders
At threshold, sponsors and lenders must confirm whether the applicable credit agreement allows sponsors to redeem debt. To the extent that the credit agreement allows a fund unrelated to sponsor debt to purchase debt from existing lenders, non-selling lenders should consider the following:
- What is the ceiling for these purchases? Generally, the credit agreement should limit the amount of loans that a sponsor and its affiliates can hold (usually between 20% and 30%) to avoid disproportionate influence by the sponsor.
- How does the presence of Affiliate Lenders affect voting rights? Credit agreements often restrict affiliated lenders from voting other than certain “sacred rights” or only permit sponsors to vote the same as unaffiliated lenders for all required lender votes. Again, these are important mechanisms to avoid excessive shareholder influence.
- What information rights does the sponsor have? Affiliated lenders generally receive only the information that the borrower is entitled to receive.
- What happens if the business goes bankrupt? Are the appropriate protections for existing lenders in place? Consider the following:
- if the Borrower or any Guarantor becomes subject to insolvency proceedings, the Affiliated Lenders generally grant the Agent a power of attorney giving the Agent the right to vote the claims of the bankrupt Affiliated Lenders on all matters submitted to the other Lenders for a vote, and such Claims shall in any event be voted in the same proportion, for and against, as the votes were cast on each matter by the Lenders who are not Affiliated Lenders
- by law, promoters cannot, on their own, implement a cram-down plan under the bankruptcy code given their status as an “insider” for plan voting purposes
- pre-petition voting proxies and other transfers of plan voting rights between lenders may not be enforceable in bankruptcy and, at a minimum, will be subject to scrutiny by the bankruptcy court with respect to relating to any potential defects in the grant or assignment of power of attorney (whether contractual deficiencies or non-compliance with applicable non-bankruptcy law)
- How can sponsors circumvent some of these restrictions? To the extent that a borrower’s supplemental facility is not closed and additional lending capacity remains, a sponsor could provide a supplemental facility that includes only minimal protections for the remaining pool of lenders. In addition, a sponsor may be able to motivate (either through a disproportionate saving or a reduction in lending priorities) a majority of lenders to waive or modify the limitations imposed on affiliated lenders (in particular, the amount that such affiliated lenders may hold).
As the market evolves post-downturn, sponsors will look to their existing portfolio as well as new opportunities in an effort to maximize returns and ease strain on their existing investments. As they take steps to do so, we’re here to help you find the best path forward.