By John A. Thomson Jr.
The way that middle market companies are capitalized has changed, likely forever. Middle market companies have traditionally been owned and operated by an entrepreneur or team of businesspeople who built the business, actively managed it and had a significant, if not controlling, stake in the financial success of the business. Now private firms and family offices are increasingly acquiring these companies.
How does this affect regional and community banks that have relationships with the acquired companies? The biggest change is the ownership dynamic. The prior owners may stay with the company in some capacity, but the financial decisions that were once made by a customer with whom the lender had a close personal relationship are now being made by a party that may be in a different region and certainly has no prior relationship with the bank.
Worse, whether the business is acquired by a private equity fund or a family office, the new owner may have little or no emotional attachment to the continued operation of the business. If the business is performing and generating net operating income, the new owner is content. If not, he/she/they may make a sterile, mathematical decision to shut the business down, without any continued effort to “make it work.”
Banks can draft their commercial loan documents to protect themselves before a customer is acquired by a private equity owner and once a customer has been acquired. While these steps are not foolproof, diligence can help protect a bank’s exposure in these situations.
1. Covenants Regarding Change of Ownership
While today’s lending environment often dictates “covenant light” loans, all loan agreements for middle market credits should have a covenant that makes a sale of a controlling interest in the company an event of default. Such a covenant will ensure that either the existing credit facility is paid off at the closing of the acquisition, or the lender will have the leverage at the time of the closing to declare a default, assess the new owner and determine if it is willing to stay involved in the credit.
2. Obtaining Contractual Assurances of Repayment
Private equity owners may have little or no emotional attachment to — or pride of entrepreneurial ownership in — the acquired business and no financial interest other than its initial investment in the company. When a customer is acquired by a private equity firm, the lender should immediately move to obtain contractual guaranties or other financial accommodations that will keep the new owner appropriately focused on maximizing the recovery if the acquired customer falls into distress.
3. Assessing the Liquidation Value of the Collateral
While it is tempting to underwrite credit facilities based on the customer’s continued strong operating income, banks that are dealing with a new private equity owner should carefully assess the realistic liquidation value of the collateral assets. If an honest assessment indicates that the liquidation value of the collateral will not cover the outstanding balance on the credit facility, the bank should move quickly to obtain additional collateral or other financial accommodations from the new private equity owner in order to reduce its risk.
When a customer that is owned by private equity becomes distressed, and the credit facility is downgraded to a credit risk, banks must move quickly to protect their interests. Unfortunately, there is no roadmap to assure success.
4. Aggressively Monitoring the Company’s Financial Situation
When an acquired customer falls into distress, the bank’s response should be swift and pointed. The bank should aggressively push to secure updated financial information, particularly with regard to accounts receivable, inventory and trailing month-on-month operating income. Meetings with the private equity owners should focus on what the firm is going to do in the short and intermediate term to stabilize the acquired company, rather than an analysis of what might happen with work and some projected change in the situation. This conversation should be accompanied by a demand that the private equity owner infuses sufficient resources into the customer to shore up its collateral position and operations.
This is, however, a delicate dance. If the customer is not performing, and the bank is making difficult and costly demands on the private equity owners, this could accelerate the new owner’s decision to abandon its investment and let the company die.
5. Requiring the Private Equity Owner to Seek a Going Concern Sale
If the new owner has a contractual obligation to ensure maximum recovery, the lender may suggest that the private equity owner continue to operate the company for a given period of time and immediately market the company to other potential strategic buyers. Assuming that the customer has some history of positive EBITDA, and a product or market niche that will generate projected EBITDA going forward, it is often better to market the company through a competent investment banker, particularly one that specializes in distress situations, to determine if the company can be sold as a going concern.
6. Liquidating the Company’s Assets
A liquidation of the company’s principal collateral assets, coupled with aggressive collection of the company’s existing accounts receivable, may yield a satisfactory result. Such a liquidation is often more productive early in the distress process before the company has cannibalized itself by liquidating assets to sustain unprofitable operations. This is no time for lenders to be penny wise and pound foolish. Spending resources on a competent auctioneer or another liquidating agent can pay big dividends over a haphazard effort to sell the collateral assets without adequate exposure to the marketplace.
7. Selling the Company in Bankruptcy
It may make sense to sell a company as a going concern through a bankruptcy filing. Section 363 of the U.S. Bankruptcy Code allows the sale of a company on a going concern basis “free and clear” of liens — a “363 Sale.” Care must be taken prior to filing, however, to ensure that the company will have the resources to operate under the restrictions placed on a company in bankruptcy until it can be marketed and sold in a 363 Sale. Further, the lender should carefully analyze whether the upside from a bankruptcy sale will outweigh the substantial costs now associated with an operating Chapter 11 bankruptcy.
While private equity firms and family offices purchase middle market companies with the intent to grow the business and increase its revenue, some of the acquired companies are going to inevitably fall into distress. How a lender acts during the process by which a private equity firm acquires a customer, and how it reacts when the acquired customer falls into distress, will dramatically impact a bank’s ultimate exposure on that credit.
John A. Thomson Jr. is an attorney with Adams and Reese and a member of the banking and financial services practice team. He can be reached at firstname.lastname@example.org.