By Anastasia Kaup and Robert Horwath

Law360 (September 14, 2020, 5:40 PM EDT) --

Anastasia Kaup

Robert Horwath

In recent months, some portfolio companies[1] have seen operations shrivel or shut down entirely and had revenues slashed.

Increasingly, lenders, particularly private credit funds, are looking up the organizational structure chart to deep-pocketed private equity sponsors,[2] in order to shore up credit support for the portfolio companies' debt obligations, in the form of sponsor guarantees.

Sponsors will be interested to know how sponsor guarantees can enable struggling portfolio companies to access additional liquidity without an immediate cash equity infusion or capital call upon investors in the sponsor's funds, and where there's market precedent to push back on lender requests that they may view as overreaching.

Lenders will want to be prepared for common touch points in negotiations of sponsor guarantees, and to arm themselves with some potential options to reach an agreement.

Sponsor Guarantees in COVID-19 Times

Every day, there are new headlines about portfolio companies that have either succumbed to the economic crisis precipitated by the COVID-19 pandemic, and the related lockdowns and restrictions on business, or that are struggling to continue operating due to resulting ongoing concerns.

Even if sponsors have sufficient cash on hand, they may not want to make a cash infusion into a particular struggling portfolio company now, for a variety of reasons. A sponsor may also be reluctant to call capital from its funds' partners at this time for strategic, relationship or other reasons.

Moreover, in the case of funds that are a few years old, available capital commitments may be limited if the fund has previously drawn down and used capital contributions to fund investments in its portfolio companies.

As many brick-and-mortar banks have pulled back on lending, at least to portfolio companies in certain particularly hard-hit sectors, many private credit funds and specialty lenders have stepped up to fill that gap.

However, some sources have reported those private lenders exacting interest rates as high as 10% to 15% from portfolio companies with few to no other options. This combination of factors would seem to leave sponsors with few — or at least fewer than usual — options to bolster liquidity for struggling portfolio companies at a reasonable cost.

Historically, sponsor guarantees have been requested by lenders, and sponsors have been on the defensive end of those requests. However, in light of the foregoing facts and current market conditions, lenders and sponsors should reconsider practices around, and the use of, sponsor guarantees.

Sponsor guarantees can entice lenders to continue to extend, or to extend additional, credit to a struggling portfolio company where they would not be comfortable doing so under current circumstances.

If a portfolio company is able to use that credit to maintain its operations long enough to turn its financial performance around, the sponsor may reap the benefits attendant with a sponsor guarantee while potentially never having to pay out under the guarantee, contribute additional capital to the portfolio company or call capital from its funds' partners.

Meanwhile, a lender can obtain additional comfort that the sponsor and/or its funds are standing behind the portfolio company, via contractual privity — i.e., the guarantee — with the sponsor or funds, and access to an additional source of repayment for the credit facility obligations, to which the lender would not otherwise have direct access.

Below, we provide an overview of sponsor guarantees, including some standard terms. We also discuss a few selected issues that often arise with sponsor guarantees, together with some potential solutions.

Overview

Operating companies utilize debt financing, such as term loan and/or revolving credit facilities, to manage working capital needs and for other purposes. That debt financing is often secured by a security interest in substantially all of the portfolio company's assets, in favor of one or more lenders.

When a lender determines that a security interest in the portfolio company's assets alone is insufficient support for its credit facility obligations, based on the leverage profile, or, more often, financial results or conditions of the portfolio company that may have deteriorated over the life of the loan, a lender may require its sponsor to guarantee those obligations as additional credit support.

Some lenders we have spoken to liken a sponsor guarantee to a mandatory equity cure.

A sponsor's obligations to pay pursuant to the guarantee are triggered by the occurrence of certain agreed events or circumstances stated in the guarantee.

Typically, this occurs upon nonpayment, financial covenant defaults or other events of default under and as defined in the portfolio company's credit facility agreement with the lender. A triggering financial covenant default may be a one-time event or, more often, a financial covenant default that persist for more than a single quarter.

Sponsors will often push to limit the scope of agreed triggering events, for example, to material defaults such as nonpayment or bankruptcy, as opposed to any default that might include a so-called foot-fault default.

Terms

Sponsor guarantees are typically highly negotiated, and are frequently capped at an agreed dollar amount, which may be less than the aggregate amount of the portfolio company's credit facility.

Additionally, sponsor guarantees are typically unsecured — i.e., the lender's primary recourse in the event of a failure to pay or other default by the sponsor is to sue for damages based on breach of contract or other claims.

Sponsor guarantees usually remain outstanding for the term of the credit facility unless circumstances warrant a shorter period — e.g., only from execution until a portfolio company achieves a target earnings before interest, taxes, depreciation and amortization figure, or a certain leverage ratio for a certain period.

Some of the provisions customarily included in sponsor guarantees are:

• An unconditional and irrevocable promise to pay and perform the guaranteed obligations when due and payable until termination of the credit facility and satisfaction of all outstanding obligations thereunder;
  
  
• Waivers of defenses, notices, consents and rights of the sponsor as permitted by applicable law;
  
  
• Representations and warranties, including as to customary corporate matters such as enforceability of the guarantee, and as to the sponsor's solvency and financial ability to satisfy the guaranteed obligations when due and payable;
  
  
• Subordination of (A) the obligations of the portfolio company to the sponsor and the rights of the sponsor against the portfolio company to (B) the obligations of the portfolio company to the lender and the rights of the lender against the portfolio company; and
  
  
• Remedies of the lender and provisions for payment of the lender's fees and expenses in connection with enforcement and collection on the guarantee.

Additionally, some sponsor guarantees will include ongoing covenants including requirements that the sponsor periodically provide financial information and/or satisfy financial covenants such as maintaining a minimum liquidity coverage ratio.

There is usually an inverse correlation between the extent to which the foregoing and other provisions are included in a sponsor guarantee and the breadth of such provisions, and the size and negotiating power of the sponsor.

Large, established sponsors are often able to successfully resist asks for sponsor guarantees at the outset, or at least resist the inclusion of some of these provisions, or limit their scope — e.g., limiting subordination to only times when there is an event of default continuing under the portfolio company's credit facility.

However, lenders may have more success both in requiring sponsor guarantees at the outset of loan, and including broader, lender-friendly provisions with independent sponsors and those sponsors with a less established track record (whether with the particular lender or in the marketplace in general).

Selected Issues and Potential Solutions

Numerous issues can arise with the negotiation, documentation and enforcement of sponsor guarantees. Two of the most heavily negotiated touchpoints center on the structure and timing for payment, and financial covenants and reporting.

Guarantee Structure and Timing for Payment

Lenders often request that the top-level entity in the organizational structure and/or the principals personally provide sponsor guarantees. In contrast, sponsors frequently push to have one or more investment fund(s) sitting above the portfolio company borrower provide the guarantee.

In the latter instance, these guarantor funds may apportion the guaranteed amount according to the percentage interest they own, directly or indirectly, in the portfolio company, or some other theory of responsibility.

A fund's limited partnership agreement often limits the fund's ability to guarantee portfolio company obligations — e.g., providing that the amount guaranteed cannot exceed a certain dollar amount or percentage of the total capital commitments of the limited partners of the fund.

Sponsor guarantees at the fund level can potentially frustrate a lender looking for deep pockets to shore up the credit profile of a portfolio company and seeking prompt payment of the guaranteed obligations upon an agreed triggering event.

The fund may not have cash on hand at the relevant time and may need to call capital from its partners to satisfy the guaranteed obligations. This can leave the lender at the mercy of the fund's general partner — typically a sponsor-owned/managed entity — to call capital from the fund's partners to repay the guarantee, as well as the fund's partners to fund their capital contributions.

Even assuming the fund's partners contribute capital as and when called without objection or delay, it can take a few business days for the capital call to go out, 10 business days or more for the partners to fund and additional time for the funds to get transferred from the guarantor to the lender.

This can potentially reduce the utility of some sponsor guarantees, as time is of the essence, particularly in distressed situations when a payment obligation under a sponsor guarantee is likely to be triggered.

One way to potentially address these vitally important issues is for the lender to require delivery of an executed capital call notice in escrow. This enables the lender to deliver the notice more quickly upon an agreed triggering event, and to call capital to one of its accounts — assuming the limited partnership agreement and other fund documents permit capital calls by the lender and capital contributions to the lender's account.

Funds would then be directly available, and available more quickly, to the lender to satisfy the guaranteed obligations and the lender would not be dependent upon the other side to call and receive capital before forwarding the funds to the lender.

If this is not an available option, lenders should consider the anticipated timing and process to receive payment, and sponsors should ensure that there will be adequate cash on hand or sufficient time under the guarantee to call, receive, and forward on capital to the lender.

Financial Covenants and Reporting

Lenders may request that sponsors agree to satisfy certain financial covenants — e.g., as to minimum liquidity — during the term of the guarantee, and provide financial statements or other financial information at the time the guarantee is executed and/or on a periodic basis, to demonstrate covenant compliance of the sponsor and financial wherewithal to satisfy the guaranteed obligations.

It is fairly common for sponsors to extend multiple — typically unsecured — guarantees at various levels of the organizational structure to support management company, fund-level, portfolio company, and/or asset-level debt obligations.

Knowing this, lenders naturally want to see evidence that the sponsor has not overextended itself and, for example, guaranteed $5 billion worth of debt obligations when there are only $4 billion worth of assets available to satisfy those guarantees.

Sponsors often push back on requested financial covenants and object to a lender's request that the sponsor provide financial statements or information for confidentiality, reputational and principle reasons — essentially saying, "take our word for it, we are 'X' sponsor, we have the money".

This can make it difficult for a lender to ascertain the true financial ability of the sponsor to independently satisfy the guaranteed obligations from cash on hand or, where guarantors are at the fund level, to gain visibility into remaining uncalled capital commitments available to satisfy such guaranteed obligations or the creditworthiness of the fund's partners.

Lenders should anticipate these objections, and prudently consider the larger relationship and/or accessing information available within the bank/credit fund, across credit facilities and platforms, to gain comfort here — assuming there's no contractual or legal restriction that prohibits doing so.

That said, unless credit approval for the credit facility requires such financial information, sponsors oftentimes win this battle, as the sponsors control access to the information, and lenders are often reluctant to act in a way that may be viewed as insulting the sponsor's creditworthiness or that would strain the long-term relationship.

Conclusion

Sponsor guarantee agreements are often complex and heavily negotiated, implicating numerous issues.

Sponsor guarantees can both provide additional credit support for credit facility obligations of portfolio company borrowers and give lenders more assurance in lending to a portfolio company when they might not otherwise be comfortable doing so.

In the current market, sponsor guarantees are also a tool sponsors can employ to shore up liquidity for a portfolio company that may be currently struggling but still shows promise, while maximizing a sponsor's flexibility to keep cash on hand and avoid calling capital from its funds' partners.

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Anastasia N. Kaup and Robert E. Horwath Jr. are partners at Duane Morris LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] As the term is used herein, "portfolio companies" are entities — typically companies with operations and employees — in which a private equity-investment fund sponsor directly or indirectly invests. Such companies are referred to as portfolio companies because all such companies collectively comprise the investment portfolio of the applicable sponsor.

[2] As the term is used herein, a "sponsor" is an investment firm that financially sponsors or supports an investment  in portfolio companies. An entity is sponsored when it has such a firm directly or indirectly (e.g., through holding companies and investment fund entities) backing its finances and managing its operations. Sponsors that invest in the equity of privately held operating companies — private equity sponsors — seek to grow and/or improve the operations of such companies, typically over a multiple-year term, with a plan to eventually divest such investment at a profit.

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