Coronavirus - Private equity and the pandemic: Sponsor-led funding considerations in challenging times – Global

 

It goes without saying that private equity sponsors and their portfolio companies have not been immune to the effects of the COVID-19 pandemic. That is stating the obvious. The current situation remains a threat to portfolio companies, particularly those in industries that have been hard hit by lockdown and restrictions on movement — airlines, retail, hotels, cinemas, theatres and the sports industry are just some of the high profile sectors suffering. Businesses in such sectors are seeing an almost universal need for additional funding to stay afloat.

It has been clear for some time that, in the short term at least, uncertainty is the new normal. This uncertainty initially took the form of remote working, restricted travel and other realities caused by the pandemic (hands up if you had even used Zoom before March?!), and is now evolving into strategies for coming out of lockdown - re-opening shops and restaurants, getting supply chains back up and running, tentative steps towards returning to the office and documenting those hastily agreed changes to contractual terms.

We have already seen high profile casualties, and no doubt many more will follow. Private equity firms however play a vital role in times of financial uncertainty by providing capital and liquidity to portfolio companies where others cannot or will not (i.e. where government or bank funding is not available, is insufficient or is just not appropriate).

As a private equity investor, a key consideration is how to structure your capital injection into an existing portfolio company with a view to managing downside risk and staying ahead of true equity interests in the capital structure while supporting businesses that face short-term liquidity issues due to the COVID-19 pandemic. Drawing on our wealth of experience in the private equity industry, we have put together a bite-size list of the main instruments that a private equity investor should at least consider when seeking to establish a strong position in the capital structure as part of their rescue funding.

 

• Ordinary equity: to mitigate downside risk, private equity investors traditionally avoid using ordinary equity in a rescue scenario and instead rely on other, higher ranking legal instruments. Consideration will need to be given at the outset to the existing investment documents, which may provide for rescue funding to take a particular form which may include ordinary equity, and management shareholders will often have the benefit of a “catch up” right to subscribe for or acquire a pro rata allocation of shares within a certain period. In addition, it is important to determine whether issuing any new equity will have any impact on any tax groups or tax incentives (such as Entrepreneur’s Relief or relief under the Enterprise Investment Scheme) which rely on the existence of there being certain minimum percentage shareholdings of ordinary share capital. 
• Preferred equity: preferred equity is typically senior to ordinary equity but junior to all debt instruments. Generally, preferred shares rank ahead of ordinary shares either as to dividends or capital (or both), but which carry limited voting rights. Many varieties of preferred equity exist, ranging from “participating preferred” (for which, upon an exit event, the holder is entitled to a preference amount plus the amount that the holder would have received as an ordinary shareholder), to “non-participating preferred” (for which the holder is entitled to the higher of its preference amount and the amount it would have received as an ordinary shareholder), to “redeemable preferred” (where the issuing company has the right – or usually obligation - to redeem the shares at a future date). The exact nature of preference shares and the rights attaching to them will be set out in the company’s articles of association. 
• Unsecured loan notes: loan notes are a common form of investment on a standard UK private equity investment, supplementing the subscription for ordinary equity (which is normally a very small proportion of the money that the sponsor invests). There are three main reasons for this approach: (i) loan notes rank ahead of the ordinary shares on exit, (ii) loan notes accrue interest payable throughout the life of the loan notes (albeit this is often rolled up and compounded and also payable on exit) and (iii) if the transaction is structured correctly, loan notes may enable the target group to obtain a tax deduction against profits for any interest payable on the loan notes. Loan notes as a form of “rescue funding” in the current climate will likely attract a higher coupon (to reflect the risk), should be structured that they sit ahead of existing loan notes and may have a short term repayment profile. They will still typically sit behind bank debt, and may require lender consent. 
• Secured loan notes: an extension on the above, secured loan notes would rank ahead of unsecured loan notes (but typically still behind secured lenders).
• Convertible loan notes: in the context of venture capital financing, convertible loan notes are typically issued by a company as a short-term bridge facility ahead of a future round of venture capital investment. In the current climate, where valuations are in flux, convertible loans could be effective in allowing companies to access the liquidity they badly need while deferring valuation discussions. More so than ever, the conversion price is likely to be a focus issue, with investors seeking discounts to the price used in the Qualified Financing Round”, that triggers the conversion into equity. As convertible loan notes represent a right to subscribe for, or convert the loan notes into, shares in the issuing company, they will generally be unsecured.
• Listed Eurobonds: listing loan notes can help make the use of loan notes more attractive to private equity investors by removing certain tax costs and increasing their transferability. Private equity investors will ultimately want to ensure that if they have injected debt into a portfolio company using loan notes (whether unsecured or secured), they receive the interest due under such notes free of any unnecessary UK withholding tax and at the rate they were expecting. UK withholding tax can either be a cashflow issue for those investors who can reclaim or obtain a credit for any tax withheld or an absolute cost if they cannot. Listing loan notes on a recognised, easy-to-deal with stock exchange (like The International Stock Exchange in the Channel Islands) offers private equity investors a swift and complete UK withholding tax exemption. This exemption, known as the Quoted Eurobond exemption, applies to future transferees of the notes, thereby making the notes potentially more attractive and transferable to other potential investors. The Quoted Eurobond exemption also means that the relevant portfolio company avoids having to deal with the administrative hassle of withholding tax related returns and tax deduction certificates and having increased funding costs if the loan note instrument has a ‘gross-up’ provision. Private equity investors and their portfolio companies should ensure that they factor in the listing process and timeframes to ensure that the loan notes are listed before the first interest payment date to avoid any unnecessary UK withholding tax.

 

This is a short, simplified and non-exhaustive list. In practice, the legal instruments that private equity investors use are driven by a range of factors, including the company’s pre-existing capital structure, banking and shareholder arrangements, the relevant jurisdiction and tax considerations.

If you have questions about how to structure a capital investment or you have questions about this article, please contact Chris Archer, the Eversheds Sutherland lawyer with whom you usually work, or any member of our UK Private Equity team.

Next week our Tax colleague, Colin Askew, will be considering tax cash flow management and tax issues arising from the COVID-19 pandemic.