Private Equity in Distress and the Incentives of Collateralised Loan Obligations

In my recent article, ‘Private Equity in Distress and the Incentives of Collateralised Loan Obligations’, in the Current Legal Problems series, I argue that both modern private equity (PE) firms and senior lenders to PE portfolio companies have incentives to avoid a formal restructuring of PE portfolio companies in financial distress.  I argue that this is a change from the past: historically, while shareholders have had the incentive to avoid a formal restructuring procedure, senior lenders have had the incentive to drive a restructuring transaction when financially distressed companies were diverting cash to service junior debt. And I argue it is a problem for the non-financial stakeholders in the firm because companies may restructure late, when the problem is too severe, and may load up with prior ranking debt in the meantime. I also suggest it is a problem for society if assets are allocated to companies that do not have a sustainable capital structure.

In the article, I spend some time on the heightened incentives of PE firms to avoid a restructuring transaction, and the ways in which PE firms can align the incentives of portfolio company directors with their own. I set the incentives of the CLO against this backdrop, investigating the implications of over-collateralisation tests and the challenges that CLOs face in participating in a restructuring transaction. Having staked my claim that both PE firms and CLOs are incentivised to avoid the corporate restructuring transaction, I look at what they might do instead.  I focus on a simple do-nothing strategy in which cash is diverted to debt service; amend and extend transactions; and more aggressive US strategies such as up-tier and drop-down transactions. I am concerned that these alternative strategies do not deleverage the capital structure, or do not deleverage it sufficiently, or even increase leverage.

Before I turn to consider what can be done about the problem, I answer some objections.  I focus on the benefits of avoiding a costly restructuring transaction; Frederick Tung’s (borrowing from Mitchell Berlin, Greg Nini and Edison Yu) analysis of so-called ‘split control rights’; and changing CLO terms.  I conclude that none of these completely solves the problem with which I am concerned.  This leads, of course, to what can be done about it.  I do not place much hope in other creditors to drive the restructuring. I am similarly pessimistic about the role that directors’ duties can play.  I see some potential for tackling lender incentives, particularly noting the difficulties of bringing US tactics to the UK and the demotivating role that costly and protracted litigation may have.  I also see promising signs of incentivising priority debt raising within a formal restructuring procedure.  Ultimately, however, and perhaps counter-intuitively, I see most promise in incentivising the PE firm to drive the restructuring.  I consider that this is possible in the UK because we have not imported the US absolute priority rule (APR) into our principal restructuring procedure, Part 26A of the Companies Act 2006.  The APR provides that no junior creditor can recover until a senior creditor has recovered in full, and no senior creditor can recover more than they are owed.  The result of applying the APR in a distressed situation is that existing equity is almost always wiped out.  The decision not to include it in Part 26A leaves open the possibility that the PE firm may be simultaneously able to deleverage the capital structure and retain some or all of its investment in the firm.

I suggest, however, that extreme caution is needed, lest this become a charter for PE firms to line up with favoured creditors to drive through a transaction that unfairly transfers value away from others outside the inner circle of cooperation.  I make some suggestions about how a balance can be struck between the interests of the PE firm and the interests of its wider stakeholder group.  I acknowledge that some of my suggestions implicate complex valuation questions that we know the UK Government hoped to avoid when Part 26A came into effect.  I suggest, however, that these complex questions are inevitable if the aim is both for PE firms to be able to keep their equity and for other creditors to be confident in the legitimacy of the procedure.

Sarah Paterson is Professor of Law at the London School of Economics and Political Science.

The full article can be read here.