The following provides guidance on managing private equity-owned portfolio companies in distress:

1. Unfortunately, some businesses simply won’t recover from the economic blows delivered by the COVID-19 shutdowns. If your portfolio company took on additional debt in the recent past (especially within the last 12 months) in order to pay dividends and that portfolio company fails as a result of COVID-19, litigation might be on the horizon. That is, a bankruptcy trustee or creditors’ committee might argue that the dividend recapitalization transaction should be viewed as a voidable transaction or fraudulent transfer.

   The key issue will be whether the portfolio company was left with an “unreasonably small capital” after the recap even if the COVID-19 pandemic itself was not reasonably foreseeable. In most states, there is a four-year statute of limitations for these types of claims. As demonstrated in the Chicago Tribune bankruptcy in 2009 and 10 years of subsequent litigation, the fact that the company defaults and fails within about one year of the leveraged transaction makes it very likely the entire deal will be reviewed.

2. If your portfolio company simply cannot make it, then you should understand there is a right way and wrong way to terminate the investment. If a sale as a going concern cannot be accomplished, then we usually recommend an out-of-court wind-down or self-liquidation. We have a detailed checklist we can provide to ensure you identify all the potential pitfalls.
3. If a private equity sponsor is not in fund-raising mode right now, odds are it will be soon. Many sponsors are determined that their occasional failed acquisition avoid bankruptcy so as to obviate the concerns of potential future investors. While occasionally a bankruptcy filing is needed, there are many other options: surrender to the secured creditor, simple auction of assets, etc.
4. Regardless of the chosen approach, sponsors, directors, and senior management teams need to be aware of their own risks and take steps to mitigate those risks. Utilizing skilled counsel and other professionals can help them discharge their duty of care. And making sure to include the cost of extended reporting periods, or “tail” coverage, for the existing D&O policy within a wind-down budget is critical.
5. The current environment will present many buying opportunities for add-on acquisitions for portfolio companies. However, a fund’s governing documents may prohibit it from investing in a distressed business. Sponsors need to check the offering materials that were provided to the limited partners when they invested, as well as the existing governance documents. Then, consider whether it is possible or desirable to amend them to take advantage of new opportunities.