Covid-19 advice for the U.S. private equity firms

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Written by VentureXchange

April 14, 2020

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The Covid-19 crisis continues to impact the global economy in unprecedented ways. Shelter-in-place orders and non-essential business closures around the world have disrupted operations across all sectors. All of that has caused a major dislocation with the private equity firms and private equity industry. This pandemic and the ensuing economic fallout raises a mix of pressing concerns and complex legal issues for private equity sponsors and their portfolio company management teams. In addition, the Covid-19 epidemic may also present private equity sponsors with unique and urgent opportunities to deploy capital. We will provide you with a short overview of the US private equity market in this article.

For most private equity sponsors and their portfolio companies, the effects of the Covid-19 shockwave became the new normal. Moreover, while many are still sorting through the everyday challenges, new strategies are emerging to help portfolio companies. During the Great Depression, the highest rate of unemployment in the United States was 24.9%. In the past few weeks, Federal Reserve Bank of St. Louis President James Bullard warned that Covid-19 could cause the US unemployment rate during the second quarter to hit 30% because of workplace shutdowns. That said, they also forecasted a 50% drop in GDP over that same period.

Some policymakers expect the pandemic to impact the US economy deep into the second quarter. Implying what the United States might expect over this period, during the first two months of 2020, China saw home sales shrink by 33%, construction drop by 25%, retail sales fall by almost 20% and factory output drop by double digits. The US economy was at the tail end of one of the longest economic expansions in its history.

The new area for Private Equity firms

In the weeks just before the coronavirus outbreak in the United States, economist Joel Naroff stated, “Going into any potential coronavirus slowdown, the economy is in good shape.” However, there is still a reason to believe that the impact in the United States of Covid-19 could be severe.

While many portfolio companies are undoubtedly at risk as the economy slows, the government had a quick response. That said, private equity firms should move ahead quickly.

Federal Relief

The federal government and many states have announced changes in tax filing and payment dates in response to the Covid-19 pandemic. That includes the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The government announced in the US Senate on March 27, 2020. Tax relief is of interest to private equity funds and their portfolio companies. A $2.2 trillion stimulus package that, among other things, expands relief options available to certain US small businesses through the Small Business Administration (the SBA).

The CARES Act also provides for a loan and loan guarantee program intended to help distressed businesses that do not qualify for small business relief. That includes a program specifically designed for mid-sized businesses with between 500 and 10,000 employees.

Eligible “small businesses” include the self-employed and any business that meets the applicable small business size standard for its industry. It also includes any other business with 500 employees or fewer, based on the company’s NAICS Code.

Bear in mind, however, that all of these funding programs remain subject to further guidance. For more information visit the SBA website.

Economic Stabilization Program

In addition to the PPP Loan and the expansion of the EID Loan Program, the CARES Act also provides for $454 billion in financing to banks and other lenders that make direct loans or guarantees to certain eligible business impacted by Covid-19. However, the CARES Act does not fully establish, the precise mechanics of applying for relief under the CESA.

Moreover, an eligible business can participate in the CESA program if it is created and organized in the US. The business should also have significant operations and a majority of its employees located in the US. Nevertheless, this program should show proven losses as a result of Covid-19.

As mentioned before, the program of the CARES Act is designed for mid-sized companies with 500-10,000 employees. However, the CARES Act requires that any such loans to mid-sized borrowers would feature annualized interest rates no higher than 2% per annum. It also requires that for the first 6 months of financing under the program, no principal or interest is due.

US employment law considerations

Any private equity sponsor or portfolio company considering layoffs or across-the-board wage reductions in response to Covid-19 should first consult with counsel. That is to understand all of its contractual and statutory obligations with respect to any such action. Those businesses retaining their workforce should consider the expansion of paid sick leave. They should also consider the FMLA under the Families First Coronavirus Response Act.

The legislation will enable employers to keep their employees on their payrolls, while at the same time ensuring that employees are not forced to choose between their paychecks and the public health measures needed to combat the virus. Generally speaking, where a company has more than 50 but less than 500 employees, it is a “covered employer” for the purposes of the FFCRA.

Employees may use their 2-week emergency paid sick leave before paid FMLA leave begins. FFCRA also prohibits covered employers from changing their paid leave policies to avoid compliance.

Private equity firms material contracts

In addition to actively managing portfolio companies cash to maximize liquidity, portfolio management teams should undertake the review. Besides, where possible, drawing on available lines of credit to build a cash position for a sustained period of disruption to normal operations. That said, it is crucial to review the complex’s material contracts. That is to better understand their current insurance coverage and potential legal exposure. Also, it is important to identify efficient breach opportunities to back out of (or delay payments under) contractual commitments to preserve their liquidity.

In assessing their material contracts, companies should take particular note of force majeure provisions. That should also trigger other affirmative defences to non-performance such as impossibility and frustration of purpose.

Summary

Beyond the immediate challenges, the crisis poses to business and the economy. The crisis will inevitably present opportunities for private equity firms to help advance economic recovery. Unless there is a prolonged pause on economic activity, the outlook for the private equity industry remains positive. Based on industry data, private equity funds continue to sit on record levels of committed capital (estimated at $2 trillion, with over $700 billion of that in buyout funds).

Although it is too soon to predict what deal terms will look like in a post-Covid-19 world, there are early indications.  In a very short time, Covid-19-related issues have moved quickly into M&A agreements. References to pandemic-related impacts have already appeared in MAE definitions, representations and warranties.  Representations and warranties insurance providers have also moved quickly to exclude coverage for Covid-19-related matters. We can keep monitoring and analysing the latest data available to better understand future indications.

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