Navigating the private equity and lender relationship when portfolio companies experience liquidity issues

In the world of private equity, successful investments often hinge on the careful management of portfolio companies. While these companies are chosen for their growth potential, unforeseen challenges can arise, including liquidity issues that jeopardise their ability to service loans. The relationship between lenders and private equity firms becomes increasingly crucial when such situations occur.

This article delves into this intricate relationship, exploring the challenges posed by liquidity issues and outlining some strategies to mitigate them, including debt-for-equity swaps and debt sales.

The Lender-Private Equity Dynamic

Private equity firms often rely on loans to finance acquisitions, provide working capital, or facilitate growth initiatives in their portfolio companies. These loans come from various sources, including commercial banks, institutional lenders, and private credit funds. These financial arrangements create an interdependence that requires a delicate balance to maintain when a portfolio company faces liquidity issues.

Challenges Posed by Liquidity Issues

When a portfolio company encounters liquidity issues, it can strain the relationship between private equity investors and lenders. These challenges may include:

• Default Risk: Liquidity issues increase the risk of loan defaults, leading to strained relationships and legal disputes between the private equity firm and its lenders. In our experience, early identification and communication of potential default risk is paramount to a collaborative and successful workout.
• Loss of control (enforcement scenario): In many cases, lenders may impose covenants and restrictions on a portfolio company to protect their interests. As the company's financial health deteriorates, lenders may exert more control, which can be perceived as intrusive by private equity investors. Lenders will generally only undertake enforcement action where the estimated return through a receivership scenario (sale of business and/or assets) is higher than the perceived value of continuing to support the private equity fund if the business continues to trade.
• Devaluation of equity: Liquidity issues can result in a declining valuation for the portfolio company, potentially eroding the equity invested by private equity firms. Successful funds can often avoid this situation by adapting to market conditions quickly, making quality strategic decisions, and taking corrective actions to minimise potential downside risk. In most cases, lenders will often reject additional funding requests when the company is private equity backed, preferring to push PE to fund the gap given they know PE has access to capital (has further potential to erode PE ROI’s).
• Difficulty raising additional capital: When liquidity problems become evident, attracting new investors or securing additional financing can be challenging. While Australia’s alternative capital sources have grown exponentially with the emergence of private credit and distressed debt funds, attracting new capital without a viable pathway from insolvency is impossible.

Mitigating the Relationship: Strategies for Liquidity Issues

To navigate the complexities of a portfolio company's liquidity issues and maintain a constructive relationship between lenders and private equity firms, several strategies can be employed:

• Debt-for-Equity Swap: This strategy involves converting a portion of the outstanding debt into equity ownership in the portfolio company. This is becoming more prevalent in the market as lenders find themselves in situations where they have no choice but to align themselves with the borrower and private equity fund. This can help alleviate the immediate debt burden while allowing lenders to potentially benefit from future upside if the company recovers.
• Asset Sales: Selling non-core assets or divisions of the portfolio company can generate cash that can be used to service debt and improve liquidity. This strategy can be employed with full transparency, as lenders will generally take comfort in the strategy if it is supported by visibility over an indicative timeframe and the prospective realisation value in a sale process.
• Equity Infusion: Private equity firms may inject additional capital into the company to shore up its financial position and meet debt obligations. This strategy makes sense for private equity funds to avoid a one-off default event (covenant breach or interest payment) in a scenario where the portfolio company may face a short-term liquidity gap and have strong confidence and visibility over the business’ future viability.
• Debt Sales: Private equity firms may also explore selling the debt to another investor at a discount. From the existing lender perspective, this will ordinarily provide an exit realisation value higher than that of an enforcement scenario. In our experience, this can assist in bringing a different view on the transaction from the incoming lender, allowing for a more flexible outlook (in most cases).
• Debt Restructuring: A proactive approach involves renegotiating the loan terms to better align with the company's current financial situation. This could include extending the loan's maturity, lowering interest rates, or revising covenants to provide the company with more breathing room. In some cases, lenders and private equity firms may engage in collaborative workouts, where they work together to restructure the company's debt and operations for the mutual benefit of all parties involved.

How can we help?

The relationship between lenders and private equity firms is complex and interdependent, especially when a portfolio company faces liquidity issues. No matter the strategy employed to address these issues, open and transparent communication is the cornerstone of any successful turnaround or capital restructure. We are increasingly starting to see scenarios play out where lenders align with private equity as a strategic partner to navigate times of change or stress.

Our BDO Debt and Special Situations Advisory team regularly advises private equity funds and lenders in providing independent support through times of change or uncertainty. Navigating liquidity issues requires a collaborative approach that aligns all stakeholders’ interests and places the portfolio company’s long-term success at the forefront. Contact our team today.