Lending Law Report : Corporate Finance Lawyer & Attorney : Reed Smith Law Firm : Lending Transactions, Secured Investments

Like the New York Giants, equity cures have made a comeback here in the fourth quarter -- even without the help of Eli Manning. 

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An equity cure right is a provision that's included in the loan agreement for a sponsor finance deal, giving the private equity sponsor that owns the borrower the right to put in additional cash to cure a default under a financial covenant.  So, for example, if the company breaches its leverage ratio for the quarter (either because it has too much debt or too little EBITDA), the sponsor can make a cash contribution to the company after the quarter-end, and that cash will be added to the company's EBITDA number for that quarter (as if it represented actual earnings), to put the company back into compliance with the covenant.  Once the cash is contributed, the financial covenant default is considered cured.

Back in the day (remember 2006, anyone?) an equity cure right might have contained relatively few limitations on the sponsor's ability to exercise it.  It was not unusual for there to be a very large cap (or sometimes none at all) on the amount that could be contributed, with relatively long periods of time in which to put in the money.  Though there were often restrictions on the number of cures that could be made (both in the aggregate and the number per year), these were often negotiated to permit very frequent cures.  We also sometimes saw permission to put the cash in as subordinated debt rather than equity, and other bells and whistles, depending on the size and type of the sponsor.  All of this was heavily negotiated.

When the credit markets tightened up, we didn't see equity cure provisions in new deals very often.  Now we're seeing them again all over the place -- but with somewhat more restraint in what's permitted.  Though there are a few outliers, it's often the case that the cash must be contributed as equity, within a few days of the quarter-end financials being produced.   There is almost always a cap on the number of cures permitted -- often one per fiscal year and/or three over the life of the deal.   There may sometimes even be a requirement that the cash be used to pay down the amounts outstanding under the loan, rather than just treating the cash as additional EBITDA and keeping it on the books.  Though there's definitely willingness to allow equity cures again, lenders seem to be a bit less eager to permit very broad rights.

I'd be interested to know if any of you are seeing even more flexibility in equity cure provisions these days, and whether you think we'll end up with similar terms to what we saw in 2005-2006.  Email me or post  a comment here with your thoughts. 

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My law partners Sandra Poe (of Reed Smith's New York office) and Alicia Powell (from Pittsburgh), along with other colleagues, wrote the following summary of the Private Fund Investment Advisers Registration Act of 2010.  As part of the larger Dodd-Frank financial reform legislation, this Act significantly changes the rules for funds.  If you manage a hedge fund or private equity fund, or work with (or make loans to) these funds, you'll want to know about these new rules.  Of course, this is just one of many important changes affecting the financial industry -- we'll have a lot more to say about other aspects of Dodd-Frank in future posts. 

In the Private Fund Investment Advisers Registration Act of 2010, Congress adopted changes to the Investment Advisers Act of 1940 that greatly increase the chances that managers of hedge funds or private equity funds will now have to register as investment advisers.  Advisers who are required to register will have about a year to do so -- until July 21, 2011.  Widely covered in the news as “hedge fund registration” requirements, these amendments actually primarily affect the status of the fund managers, rather than the funds themselves.

What Will Change

Currently, advisers that have fewer than 15 clients generally are exempt from
registration.  Advisers that manage private funds can count each fund as a single client.  Most private equity and hedge fund managers have been entitled to rely on this exemption.  The law change eliminates this so-called “private adviser exemption” in its entirety, and provides that the SEC will replace it with a much narrower exemption for advisers with assets under management of less than $150 million, and who exclusively advise private funds (as defined in the Act).   As a result, private fund advisers with $150 million or more in assets under management will be required to register with the SEC.  Private fund advisers falling beneath the $150 million threshold must determine whether they are required to register with the securities regulators in one or more states (we note that all states other than Wyoming have some sort of registration requirements).

The New Rules

• Registration on Form ADV — To register, advisers must complete Form ADV, which requires substantial disclosures to the SEC and to the adviser’s clients. Form ADV must be updated at least annually and, with respect to certain key information, at the time of certain changes in the reported information.
• Disclosures to Adviser’s Clients — “Part II” of Form ADV, or the “brochure,” calls for substantial narrative description of the adviser’s business, products, management, material adverse financial or disciplinary matters, conflicts of interest and policies designed to address conflicts of interest.  Advisers are required to deliver their brochure to advisory clients annually. The brochure is often used as a means of conveying other required disclosures such as privacy policies.
• Adoption of a Comprehensive Compliance Program — Registered advisers must adopt written policies and procedures designed to prevent violation of the Act and its rules. Such written policies must be reviewed at least annually for adequacy and effective implementation, and a chief compliance officer must be appointed to oversee their administration.
• Adoption of an Anti-Insider Trading Policy — A policy must be designed to ensure that material, non-public information is not misused in violation of the Act or the U.S. Securities Exchange Act of 1934 (the “1934 Act”), and may entail (i) circulating a written policy to all employees, (ii) employee training programs, (iii) creating physical and organizational information barriers, (iv) maintaining restricted lists, watch lists, and rumor lists, and (v) maintaining a procedure for monitoring client and personal trades.
• Adoption of Code of Ethics and Personal Trading Policy for Access Persons — Access persons must report their personal securities holdings and transactions.  Some access persons must also obtain pre-clearance before participating in, and may be barred from investing in, initial public offerings and limited offerings.
• Subject to SEC Examination Authority — The SEC conducts periodic examinations of registered advisers.  You'll want to stay abreast of “hot topics” and periodic SEC staff
  statements about the focus of the SEC’s examination program.
• Substantial Recordkeeping Obligations — The Act imposes requirements with respect to
  adviser records substantiating the basis of performance claims and other records reflecting
  the relationship between the adviser and its clients.  New legislation would add to these
  records for each private fund under management.  These records include AUM, the use of
  leverage, counterparty credit risk exposure, trading and investment positions, valuation policies, side arrangements or side letters, trading practices, and any other subjects that the SEC, in consultation with the Financial Stability Oversight Council, deems necessary for the public interest, investor protection or the assessment of systemic risk.
• Compliance with Anti-Fraud Laws — The Act generally prohibits an investment adviser from
  employing a “device, scheme or artifice” to defraud clients or engaging in a “transaction, practice or course of business” that operates as a “fraud or deceit” on clients. The Act’s anti-fraud provisions also prohibit certain securities transactions absent disclosure to clients, as well as any “act, practice or course of business which is fraudulent, deceptive or manipulative.” Rules under the Act extend these protections to investors in the adviser’s private funds. In addition to the antifraud provisions of the Act, you may also be subject to the anti-fraud and manipulation provisions of the other federal securities laws, such as section 17(a) of the U.S. Securities Act of 1933, as amended, and Rule 10b-5 under the Securities Exchange Act of 1934, as amended.
• Custody Rules — The Act imposes specific measures registered advisers must take to safeguard client assets over which the adviser has, or is deemed to have, custody. These steps include maintenance of client assets with a “qualified custodian” and submission to an annual surprise examination by an independent public accounting firm (or the issuance of annual audited financial statements by private funds advised by the adviser). 

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This post was written by my partner Ben Brimeyer, a member of the Financial Industry Group in Reed Smith's Chicago office.

In today's challenging economic climate, private equity sponsors are trying to figure out how to fill funding gaps in acquisition financings -- and how to provide additional capital to their troubled portfolio companies.  In lieu of providing additional equity, some sponsors are requesting the ability to participate as a lender in the senior debt facilities of the portfolio company.  Also, on occasion, it's the lenders who need to find someone to take a piece of a new loan, and the equity sponsor is the only one standing by ready to do so.

If the lenders decide to allow the sponsor to become a lender in their debt facilities, what steps should they take to best protect themselves, given the different hats this new lender will be wearing?

Voting rights. Given the sponsor's ability to control the borrower, the sponsor should not have the same set of voting rights available to the other lenders.  The sponsor should have the ability to protect its investment, but should generally be a silent participant, without the ability to interfere with actions the lenders may need to take.  The sponsor’s commitment should be removed from the calculation of required lenders, and the voting terms should provide that the vote of the sponsor won’t be required other than for a very specific set of items (typically 100% vote issues):

• Increase the commitment of the sponsor-lender
• Reduce the interest rate on the sponsor-lender's loans
• Reduce the principal amount owing to the sponsor-lender
• Change the pro rata treatment of the loans
• Subordinate the loans

Information/Meetings. It is important to ensure that the sponsor, as both the equity owner and a lender, does not have the same access to information, rights to attend bank group meetings and ability to require action by the agent as the other lenders have.  In this regard, the sponsor-lender should not be allowed to:

• Require the agent or any lender to take any action or exercise any remedy
• Attend any meeting between the agent and the lenders to which the borrower is not invited
• Receive any information or communication from the agent or any lender that is not sent to or by the borrower (i.e., shared among the lenders only) 
• Provide information obtained in its capacity as a lender to any member of management of the borrower

Bankruptcy. In a bankruptcy, the sponsor-lender’s interests differ significantly from the rest of the lenders, since the sponsor as equity owner receives a different set of rights. To protect the lenders from actions which may be taken by the sponsor-lender in a bankruptcy, the sponsor should agree not to impede any actions being taken by the agent, so long as the sponsor-lender is being treated equally with the other lenders.  The sponsor-lender should also agree that its vote in bankruptcy shall be cast in the same proportion as that by the other lenders, which results in the sponsor essentially being dragged along proportionally to the votes of the other lenders. This is particularly important if the sponsor-lender will hold more than one third of the debt, providing a potential blocking position on issues requiring a lender vote in a bankruptcy.

Allowing the sponsor to participate in the senior loans may be essential to completing a transaction or providing a portfolio company with additional liquidity.  It can be done, but with careful consideration of the challenges it presents to the rest of the lender group.
 

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