How did private equity-backed companies fare during the financial crisis and resulting recession? Were they more fragile than their peers, as many critics of the industry had predicted? Were they more likely to lay off their staff and default on their debts, exacerbating the impact of the crisis on the real economy? Did the pre-crisis exuberance of the buyout industry give way to an almighty hangover in the years that followed?
Not according to an academic study published earlier this year. That paper, by Bernstein, Lerner and Mezzanotti, looked at almost 500 private equity-backed companies in the United Kingdom and found that they were, on average, less financially constrained than similar companies during the crisis and were no more likely to become insolvent. The research suggests that – as well as helping their portfolio companies to renegotiate with lenders and engage in necessary restructuring – private equity firms also provided further funding to protect their investments, injecting additional capital to plug the gap that external funders were not willing to provide.
To those in the industry, that is not a surprising finding. But it should give UK policymakers pause for thought because some proposed changes to insolvency law could make it much harder for “connected parties” – including shareholders – to inject additional capital when the company needs it most, and when it is hardest to access from third parties.
The proposals, part of a package of reforms on which a public consultation ends next week, would enable the liquidator or administrator of an insolvent company to apply to the court to set aside a previous rescue financing by a connected party. There would be no need for the company to be insolvent at the time of, or as a result of, the transaction; the court would only have to be satisfied that the terms of the rescue disadvantaged other creditors “more than … commercially reasonable”. These restrictions on so-called “value extraction schemes” would sit alongside the United Kingdom’s existing insolvency rules that allow the court to set aside a variety of transactions that are unfair to creditors, as well as company law rules requiring directors to act in the company’s best interests when negotiating or agreeing the terms of any further funding.
The government’s proposals are clearly at an early stage: they lack clarity and need much more thought. But, given the political pressure for reform in this area, they could evolve into draft laws quite quickly. And it will not be easy to find the right balance between (on the one hand) imposing fair restrictions on those who seek to take advantage of a company’s situation at the expense of existing creditors and (on the other) those who are willing to take on additional risk in return for additional upside and some downside protection (in the form of security for the new debt). Certainly, discouraging those who are willing and able to rescue a company would not be a good outcome, especially for private equity backers whose “dry powder” can be a real asset to the companies they back.
The British government should therefore proceed with caution. And it should explain much more clearly why the UK’s existing rules do not go far enough before writing new ones.