COVID-19 has already rocked the world of alternative investment. The two biggest private equity markets in the world – New York City and London – are now epicenters of the most recent wave of the outbreak and remain under “stay at home” orders. Travel has been curtailed or outright banned in most of North America and Europe, creating substantial impediments to analyzing potential portfolio investments through conventional means. A recession likely has begun.

While there are many precautions that all employers and commercial firms currently should take we believe that private equity managers should take a number of unique steps, in response to the immediate crisis as well as to prepare for the post-outbreak environment.

Look at your partnership agreements and side letters

• Managers always are well served to analyze the terms of each fund’s partnership agreement and side letters whenever there is a major shift in the market.

• For example, it is advisable to assess the operating expenses provisions to understand how the costs of proposed methods of responding to the shift, such as accelerating investments in technology to facilitate virtual work environments during the current crisis, are to be allocated. “Key person” provisions should be assessed to determine if they might be triggered in case of a quarantine or an extended period of limited mobility.

• Fund-level leverage provisions should also be reviewed to determine current compliance and the ability of the fund to obtain additional leverage to support portfolio companies or alleviate the need for capital calls during the anticipated downturn.

• Determine what you can and can’t do with LP Advisory Committees (LPACs), particularly with respect to eliminating in-person meetings.

• Consider whether interim claw-back provisions might be triggered due to an anomalous event.

• If an amendment to a fund’s partnership agreement may be necessary or desirable – such as to permit the fund to take additional actions due to extraordinary events, extend the final closing date or extend the investment period, among other things – it is often helpful to socialize possible amendment proposals with investors sooner rather than later.

• Take care to manage funds strictly in accordance with governing agreements and offering documents.  In challenging economic times, defaults make occur that should not be waived unless permitted in these documents. Moreover, refrain from entering into any transactions with affiliated parties and portfolio companies that could create a conflict of interest unless previously disclosed in the offering documents or otherwise preapproved by investors or an independent committee.

Revise or supplement marketing materials

• Managers who are out on the road should look at marketing materials to re-evaluate whether the statements therein are still true and whether risks are adequately disclosed. Managers have an obligation to provide investors in their managed funds with full and fair disclosure that is not misleading.

• In addition to including a COVID-19 risk factor specific to the fund’s asset class, risk factors and conflicts of interest should be re-evaluated from top to bottom and updated and supplemented as necessary, to anticipate the effects and after-effects of the current crisis and the changes in social behavior resulting therefrom.

• Performance information should be revisited, particularly where unrealized portions of the portfolio are included. In addition, performance projections, if any, also should be revisited.

• Consider whether disclosures regarding business interruption and business continuity plans should be elaborated upon.

• In some instances there may even need to be a slight pivot in the business thesis or value proposition of the fund, or a change in emphasis on aspects of your business model that you believe are countercyclical.

Keep an eye on standard provisions

• Outside of certain industries, this appears to be the strongest buyer’s market in more than a decade. In addition, the world is experiencing something unprecedented since the advent of private equity. Merger agreements, purchase agreements, loan agreements and other definitive agreements have been changing to account for the new world we are living in, both now and after the pandemic has passed.

• Regulatory approvals will certainly take longer than usual and the backlog may extend well into when operations normalize. This has put additional pressure on provisions governing how regulatory approvals are obtained, as well as how the business will be operated between signing and closing, what constitutes a force majeure and what will toll the drop dead date or outside date.

• Representations, warranties and closing conditions regarding customers, suppliers and material adverse change have all materially shifted from where they were only months ago. Some of these changes likely are only going to remain relevant through the coronavirus crisis and until the valuation gap closes, but others are here to stay. In particular, don’t be surprised if processes of regulatory bodies and others change if it turns out that the same tasks can be accomplished in a more cost-efficient manner.

Consider valuations

• ·Valuations of portfolio investments likely will be under a microscope. Carefully review policies and procedures that affect valuations.

• If existing investments will be marked down, consider how that could affect disclosure and reporting obligations and, if the fund is still in its marketing period, how this might affect limited partners’ required contributions at closing and the limited partners’ economic interest in existing investments, particularly if this might result in reopening side letter negotiations.

• Consider how valuations could be affected in a worst-case scenario, or if there is a recurrence of present events. In addition, prepare for LPs potentially to perform additional diligence in respect the valuation and performance of existing portfolio companies.

Adjust legal and business diligence

• What was important when evaluating a business a month ago may not be as important now, and vice versa. Diligence that had already been completed may need to be reinstituted, even in areas where the effects of the virus and its economic effect are not obvious.

• Providers of rep and warranty insurance have honed in on matters relating to COVID-19 and, in many cases, are not willing to bear the risk of matters pertaining to the outbreak and its consequences.

• Financial models may also need to be adjusted not only for the direct effect of COVID-19, but also for potential societal changes such as increased telecommuting, increased utilization of SaaS and lifestyle technologies, changes in governmental funding priorities and adjustments in interest rates and leverage ratios.

Make new friends

• If there is a prolonged downturn or valuation gap, many managers may need to turn to others to meet investor demands, adequately compensate employees, generate deal flow and keep portfolio companies afloat.

• Many investors are likely to want liquidity; building up relationships of those in the secondaries space can provide a means of giving a particular investor a liquidity opportunity or giving an entire fund a liquidity opportunity via GP-led restructuring. Far more secondary alternatives are available than there were in 2008 with there being significantly more dry powder and much more sophisticated transaction structures that can provide liquidity relief at any point in a fund’s or portfolio company’s life cycle.

• Without the ability for people to travel freely, intermediaries and investment bankers could become instrumental in generating deal flow.

• Alternative debt providers now provide funding to more asset classes than ever, including venture debt and lending to GPs themselves, and refinancings might be key in being able to make distributions to investors and, when acceptable, boosting IRR.

• Private debt will become more important if commercial banks take a more conservative approach to lending in the post-crisis environment. As commercial banks take a step back, credit funds may reprise their role as “lender of last resort” as they did during the Global Financial Crisis of 2008. Many of the larger players in the private debt market have waited years for a correction in the market, although few would have anticipated one this severe and none would have hoped that the cause would be a global pandemic.  Across the market, expect greater protections in loan documentation and fewer “cov-lite” loans.

Think about how you may want to reposition portfolio companies

• Many portfolio companies will need to pivot their operations, exit strategies and possibly even business plans in response to the coronavirus crisis and any resulting change in the market environment. A number of steps that can be taken at the portfolio company level are described in another Polsinelli alert, Tips for Companies Facing Distress as a Result of COVID-19.

• That said, you need to be careful that businesses don’t stray so far from their original business that they’re no longer within the fund’s investment mandate. Consider whether any of these changes might require LPAC approval.

Evaluate the nature of your investors

• Funds with different investor bases will have different needs and different things that will keep them happy.  

  • Managers of “plan assets” could have far more restrictions as a fiduciary than those who are not, depending on a number of factors.

  • State investors might be subject to changes in law or changes in internal policy that are binding as a matter of chain-of-command but not necessarily transparent to the outside world.

  • Family offices may have a longer liquidity horizon and might better be able to withstand a years-long recession, should that happen.

• While many managers have a lot of experience with their investors, they haven’t necessarily dealt with those investors in a time of financial instability. Knowing the needs of those investors can help a manager better anticipate their needs and to which changes they might provide more or less resistance.

Consider whether new financing alternatives might be available

• The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) expands existing eligibility requirements and provides greater funding opportunities for businesses under two Small Business Administration Loan programs.

  • Under the SBA 7(a) program, eligible portfolio companies may borrow up to $10 million with significant loan forgiveness if the funds are used for payroll, lease payments and other general expenses.

  • Under the disaster assistance program, your portfolio companies may be eligible to borrow up to $2 million.

  • This chart compares the salient aspects of both the SBA 7(a) loan program and the disaster assistance program.

• Eligibility has been extended or expanded under a number of other federal programs, including the qualified opportunity zone fund program.

Review cybersecurity and infrastructure security

• The Department of Homeland Security’s Cybersecurity and Infrastructure Security Agency (CISA) held a stakeholder security briefing that led to an alert (CISA Alert) issued on March 13, 2020, which we have described in greater detail here.  The CISA Alert encourages all businesses to implement a heightened state of cybersecurity in the course of establishing remote work options (i.e., telework).  The CISA Alert applies to all industries, described in greater detail elsewhere in the Polsinelli COVID-19 blog, but raises unique issues for fund managers arising from COVID-19. 

• The CISA Alert recommends attention to disaster recovery and business continuity plans (BCPs) because cybersecurity risks may be heightened during this period of telework.  CISA suggests adjustments to existing cybersecurity plans if needed to avoid and address cyber incidents arising by COVID-19. 

• Fund managers should deliver notices to personnel and investors who could be affected by a data breach including relevant government agencies under applicable notification laws related to data breaches, as generally required. 

• Broker-dealers and investment managers utilizing telework arrangements should consider applicable compliance rules from FINRA and the SEC.

Don’t panic

Remember the lessons we learned from 2008. While this downturn has come much faster, the circumstances are also very different. There are more sources of unregulated debt financing. There are more sources of LP and tail-end fund liquidity. There are more available capital commitments across the board. Capital markets have taken a significant tumble, but they have not frozen. While the market decline was faster, it that most analysts predict that the recovery will also be faster. And coming out of the Great Recession, private equity was one of the best performing asset classes. This definitely is not business as usual, but we know a lot more now, and have a lot more knowledge, than we did twelve years ago.