Avoiding portfolio company legal risk

An increasing number of private equity firms are being held accountable for actions of their portfolio companies, necessitating strengthened due diligence.

In February, Dutch firm Bencis lost a court of appeal case against a fine levied by the country’s regulator in 2014 for the role its portfolio company Meneba played in a flour cartel. The Rotterdam District Court agreed the Authority for Consumers and Markets was right to extend the principle of parental liability to the private equity firm.

“Private equity firms can under certain circumstances be considered to form a single economic unit with their subsidiaries,” law firm Hogan Lovells said in a client note. “If a parent company exercised decisive influence over a subsidiary, there is a single economic unit and therefore a single undertaking for the purposes of cartel prohibition.

Legal experts agree the likelihood of a private equity firm facing court proceedings is increasing. This means private equity firms need to pay more attention to insure against litigation.

“For a long time, litigation has been an afterthought for private equity firms, but now they need to take a more corporate approach to thinking about legal matters as risk increases,” Timothy Mungovan, partner, private investment funds and commercial litigation at Proskauer, tells sister title pfm.

Private equity firms tend to take a controlling or significant minority stake in its target assets, which gives them more responsibility; as the industry grows, more and more private equity capital is in circulation thus increasing the risk.

“Risk tends to arise in two main situations; the first is when there is a sale. Perhaps the buyer doesn’t obtain what they thought they were buying, or there is a disagreement over the valuation of the asset,” Mungovan says.

PAH litigation trust v Water Street Healthcare is one example of a post-transactional dispute. In an ongoing adversary action in Delaware bankruptcy court, the PAH Litigation Trust claimed former Physiotherapy Holdings controlling shareholders Water Street Healthcare Partners LP and Wind Point Partners LP, along with several affiliates, orchestrated a scheme to make it appear the physiotherapy chain was worth roughly twice its actual value, designing a leveraged buyout at the inflated price, but transferring $248.6 million in borrowed funds to themselves and exiting “before the reality could catch up with them”.

According to the complaint, the deal made Physiotherapy instantly insolvent, leading to a Chapter 11 filing in 2013, and leaving creditors holding the bag and the new buyer’s equity investment gutted.

The second risk relates to “catastrophic loss”, which in the case of a private equity firm would be something such as a data breach. “It is clear the litigation climate for private funds sponsors is rapidly changing. But those who take early and proactive steps to manage their risk will be well positioned to weather the storm,” Proskauer said in its most recent annual outlook for private funds.

“In reaching its decision on the [Dutch] ACM ruling, the court of appeal considered whether portfolio companies independently determine their own conduct or whether portfolio companies have decisive influence.”

The behaviour and responsibilities of a private equity firm are different from those of a pure financial investor; private equity firms may have active management of portfolio companies, whereas pure financial investors tend to have little or no involvement with management.

“Proper due diligence can reduce the risk a private equity firm be held responsible for activities of its portfolio company,” Proskauer said.