December 8, 2008


The discounts at which portfolio company debt is currently trading have led an increasing number of private equity funds to consider purchasing this debt in the secondary market as an investment opportunity. Alternatively, many portfolio companies are considering repurchases of their own debt, to accomplish the twin goals of increasing equity value by retiring debt at a discounted price while reducing leverage during this volatile period in the global financial markets.

This newsletter highlights several legal issues for private equity funds and their portfolio companies to consider in evaluating a potential purchase of portfolio company debt.

Key Issues to Consider

Do the fund documents permit the private equity fund to make this purchase? The private equity fund's partnership agreements, side letters or other fund documents may restrict the ability of the private equity fund to purchase portfolio company debt. For example, these documents may contain diversification requirements that limit the percentage of total commitments that can be invested in a single company, limitations on investing in securities of an issuer where an affiliated investment fund owns an investment, restrictions on the types of securities that can be acquired by the fund, etc. All of the fund documents should be reviewed when a private equity fund is considering a purchase of portfolio company debt.

Will an investment in portfolio company debt be a "good VCOC investment" for the private equity fund? As with any investment by a private equity fund with at least 25% ERISA investors, the fund should consider whether the purchase of portfolio company debt will be consistent with its intent to qualify as a "venture capital operating company" ("VCOC"). To accomplish this, the investment must be in an "operating company" and the fund must exercise contractual "management rights" with the operating company.[1] A common structure for private equity investments results in the private equity fund owning equity securities of a parent holding company, with the debt issued by a lower tier operating company, so the contractual management rights that made the fund's equity investment a "good VCOC investment" may not be sufficient for the fund's investment in debt issued by a subsidiary. Accordingly, it may be necessary for the private equity fund to obtain contractual management rights with respect to the lower tier operating company, to ensure that the debt investment will also qualify as a good VCOC investment. Similarly, if the debt will be purchased by a different fund, the purchasing fund will need its own management rights.

Do the portfolio company's credit agreements and/or indentures permit the purchase by the private equity fund? Some credit agreements restrict purchases of debt by "affiliates," so a purchase of bank debt by an affiliated private equity fund may trigger an event of default under the credit agreement (this is rarely the case in indentures). Even if the fund is permitted to purchase the portfolio company's debt, the relevant credit agreement or indenture may prohibit the private equity fund from participating in voting, including votes on amendments or waivers.

Should the portfolio company itself make the purchase? A portfolio company considering a repurchase of its own debt should review its credit agreements and indentures with care, because amendments or waivers may be required to allow it to make the repurchase. Particular attention should be paid to the following provisions.

  • Assignment restrictions: Many credit agreements prohibit an assignment of loans to the borrower (or its affiliates), or require the consent of the administrative agent to assign loans to parties other than existing lenders. When assignment provisions restrict a purchase of outstanding loans, the borrower (or its affiliate) may consider purchasing a participation in the debt, which typically does not require administrative agent (or other) consent. This alternative may not solve other issues, however, as discussed below.
  • Pro rata sharing requirements: Credit agreements almost uniformly contain "pro rata sharing" provisions, which require that all payments received from the borrower must be shared ratably among all lenders. When these provisions were drafted, it may not have been intended that the purchase price paid by the borrower to a lender to repurchase (or purchase a participation in) outstanding loans should be shared with the other lenders, particularly when the purchase is at a discounted price. However, there are often strong arguments that these sharing provisions do require this result.
  • Covenant restrictions: Debt agreements frequently impose restrictions on a borrower's ability to make investments, and a purchase of outstanding debt may be considered an investment for this purpose. Another covenant that may be implicated is a restriction on the purchase of junior debt.
  • Consent requirements: To address these or other issues, an amendment or waiver may be needed. Depending on the provisions at issue, the necessary amendment or waiver may require the consent of a majority, a supermajority or even the unanimous consent of all lenders, which could effectively bar any such amendment or waiver. Many borrowers are considering, or are currently in the market requesting, the necessary amendments to permit a repurchase of outstanding debt. In these cases, the lenders have typically focused on several key issues in their amendment negotiations, including:
    • Source of funds for repurchase: Lenders may prefer to limit the funds used to make the repurchase to excess cash from operations (or new equity), and to prohibit the use of the revolver for this purpose.
    • Excess cash flow sweep: Credit agreements often require borrowers to use excess cash flow to pay down loans at par. The lenders may want to ensure that any cash used to repurchase debt does not change the amount of the loans that the company would otherwise be required to repay pursuant to the cash flow sweep.
    • Impact of repurchase on EBITDA: A repurchase of outstanding loans at a discount may result in an accounting gain for the borrower, and thus increase EBITDA. Because EBITDA is an important metric used in financial covenants and other provisions, lenders may propose to amend the definition of EBITDA or otherwise adjust those provisions to ensure that they are unaffected by the loan repurchase.
    • Liquidity needs: The implications of the repurchase for the company's current and projected liquidity needs and financial performance will be evaluated.
    • Effect on voting for future amendments and waivers: A portfolio company that repurchases outstanding debt may be required to surrender the voting rights associated with that debt to the extent this is not already provided in the debt agreement. Substantially all indentures already require this result.)

Other factors that may influence the decision as to whether the purchaser should be the private equity fund or the portfolio company include the corporate opportunity doctrine, if applicable (in particular, whether the portfolio company is able, financially and otherwise, to take advantage of the opportunity), the existence of material nonpublic information and other considerations discussed below.

Is the purchaser of the debt in possession of material nonpublic information? Before purchasing outstanding debt, the private equity fund investor or portfolio company should consider whether its possesses any material nonpublic information about the debt or the issuer, such as unreleased recent operating results or other unannounced material activities. U.S. securities laws, stock exchange regulations and/or common law fraud principles may require disclosure or result in liability for those who purchase debt while in possession of such information. However, a recent case suggests that a company can be silent and repurchase its debt while in possession of material nonpublic information (assuming that its existing disclosure is not "incorrect").[2] It may thus be preferable for the portfolio company rather than the private equity fund to be the debt purchaser at a time when there exists material nonpublic information that the portfolio company prefers not to share.

Will a purchase of debt have any adverse U.S. federal income tax consequences?The U.S. federal income tax consequences for both the private equity fund that purchases portfolio company debt and the corporate debt issuer depend largely on whether they are considered to be "related" for U.S. federal income tax purposes.[3]

  • Cancellation of debt ("COD") income: If the purchasing private equity fund and the portfolio company are "related" for U.S. federal income tax purposes or if the portfolio company itself makes the purchase, the repurchase of debt at a discount may cause the portfolio company to recognize COD income (in the case of the private equity fund purchase, as if the portfolio company had acquired the debt itself in exchange for a new note issued to the fund). These rules also would apply if the debt were acquired by a private equity fund "in anticipation" of becoming related to the corporate debtor.
  • Original Issue Discount ("OID"): If the related-party rules apply, the deemed new issuance of debt to the private equity fund would result in OID equal to the difference between the deemed issue price of the new debt (generally its fair market value at the time of the deemed reissuance) and the debt's stated redemption price at maturity (which, depending on the facts, may be different than its principal amount).
    • The resulting OID would be includible in income by the private equity fund and deductible by the issuer on an economic accrual basis, subject to generally applicable interest deduction limitations, including the applicable high-yield discount obligation ("AHYDO") rules and the earnings stripping rules. The deemed reissuance rule increases the likelihood that the AHYDO rules will apply to defer or deny interest deductions attributable to OID.
    • The special calculation of issue price and OID on the debt acquired by the related person under the deemed reissuance rule may also prevent the debt securities acquired by the related person from being fungible with other debt securities of the same issue that were not acquired by a related party.

Is there risk that debt acquired by the private equity fund will be treated as an equity investment if the portfolio company later goes bankrupt? If the portfolio company later goes into Chapter 11, the fund's ownership of debt when it also owns equity securities may lead creditors to assert that the fund's claims with respect to the debt should be "equitably subordinated" or otherwise recharacterized as an equity investment.

  • Equitable subordination: A bankruptcy court may subordinate a claim held by one creditor to claims held by other creditors if the court concludes that the creditor engaged in inequitable conduct that injured other creditors or conferred an unfair advantage on the creditor. Cases where equitable subordination claims have been successful have generally been limited to cases involving: (1) fraud, illegality or breach of fiduciary duty by the creditor whose claim is sought to be subordinated; (2) an undercapitalized company (either initially or at the time of the loan); or (3) control or use of the debtor for the benefit of the creditor.
  • Recharacterization: Recharacterization of debt as equity is similar to equitable subordination, but does not require a showing of inequitable conduct. Instead, courts analyze the debt transaction to decide whether the asserted claim should be considered to be true debt or, instead, an equity contribution disguised as debt. Recharacterization results in the claim being subordinated to the level of equity, unlike equitable subordination, which results in subordination of the claim to the claims of other creditors only to the extent necessary to offset the injury suffered by the other creditors.

A private equity fund should expect its past dealings with the portfolio company to be rigorously scrutinized in a bankruptcy proceeding, and that creditors may assert that any debt owed to the fund by the portfolio company should be subordinated or recharacterized. Even if the private equity fund is confident that it would ultimately prevail in defending such claims, the facts and circumstances of a particular case may cause the fund to settle such claims by agreeing to limit its recovery in the bankruptcy case.

Is the fund an "affiliate" of the issuer? If the debt issuer is an SEC "reporting company," Rule 144 would generally permit a private equity fund to resell the debt securities that it has acquired after six months, without registration. If the debt issuer is a non-reporting company, the fund would be subject to a twelve-month holding period. However, in each case, if the fund is an "affiliate" of the issuer, any sales after the applicable holding period would be subject to additional limitations.[4] Specifically, certain required information must be publicly available, the volume sold within any three-month period would be limited to 10% of the total issue, and the fund would be required to file a Form 144 to disclose the resales.

Does it matter how the private equity fund or portfolio company effects the purchase?  Purchases of debt can be made through open market purchases or privately negotiated transactions with individual holders, or alternatively by launching a tender offer. If structured as a tender offer, the purchases will have to comply with tender offer rules, which among other things require that the tender offer must be kept open for a minimum of 20 business days from commencement and ten business days from notice of a change in the percentage of securities sought, the consideration offered or a dealer's soliciting fee.[5] A portfolio company engaging in open market purchases or a tender offer should also consider any disclosure obligations it may have under the rules of any stock exchange where the company's equity or debt instruments are listed.

In light of the additional rules that apply to tender offers, a private equity fund or portfolio company may wish to structure its debt purchases to avoid classification as a tender offer and the expense and burden of complying with the tender offer rules. Unfortunately, the term "tender offer" is not defined in the U.S. federal securities laws and there is not a great deal of case law or SEC commentary on this topic.[6] Accordingly, the purchaser should work with legal counsel to carefully structure the purchases to avoid this classification. In general, a company wishing to avoid having its repurchase plan classified as a tender offer should:

  • solicit a limited number of holders, preferably sophisticated investors, so as to avoid a general solicitation;
  • make the repurchases over a fairly long period of time, with no deadlines or other types of pressure applied to holders to sell their securities;
  • purchase on different, separately negotiated terms and prices from different holders;
  • consider limiting the aggregate amount of securities purchased through open market purchases; and
  • if both a repurchase and tender offer are contemplated, to undertake them separately, including by introducing a "cooling off" period between the two events, to avoid the repurchase being aggregated into, and considered part of, the tender offer.

A repurchase that is later found to be a noncompliant tender offer could expose the purchaser to a variety of sanctions.

Some or all of the issues highlighted above may be implicated by a particular portfolio company and debt issuance. We recommend careful consideration of these issues and consultation with counsel prior to initiating any such purchase.

If you have any questions regarding this newsletter, please contact any of the lawyers listed below or your regular Davis Polk contact.

George R. Bason, Jr., Partner
212-450-4340 |

Kathleen L. Ferrell, Partner
212-450-4009 |

Sartaj Gill, Partner
212-450-6163 |

Michael Kaplan, Partner
212-450-4111 |

Paul R. Kingsley, Partner
212-450-4277 |

Nancy L. Sanborn, Partner
212-450-4955 |

1. We have explained the VCOC requirements in a prior newsletter entitled "What Every Private Equity Professional Should Know About ERISA's VCOC Requirements."

2. In Alexandra Global Master Fund, Ltd. v. Ikon Office Solutions, Inc., 2007 U.S. Dist. LEXIS (S.D.N.Y. 2007), a New York district court relied on the fact that a company generally does not owe a fiduciary or other analogous duty to its convertible noteholders, so the company may repurchase a portion of its outstanding convertible notes at a discount without disclosing to the selling noteholder its intention to redeem the entire issue of convertible notes at a premium shortly thereafter. Companies should be cautioned that other federal courts are not bound by this decision and could find to the contrary, and that creative plaintiffs could try to identify other claims, including common law fraud claims, where a duty to disclose may be inferred even absent a fiduciary duty. Private equity funds should be particularly cautious in relying on this case, as a court may find that the fund (or its director serving on the portfolio company board) does have a fiduciary or other duty not to use confidential information, and thus may be subject to Rule 10b-5 liability under the misappropriation theory.

3. A private equity fund partnership may be treated as related to its portfolio company for U.S. federal income tax purposes if the partnership directly owns more than 50% of the outstanding equity value of the portfolio company. A partnership that directly owns 50% or less of the outstanding equity value of the portfolio company may also be "related" to the portfolio company after application of certain "constructive ownership" rules. A tax advisor should be consulted to determine if a private equity fund partnership should be considered "related" to a particular portfolio company.

4. We have explained Rule 144's resale restrictions in a prior newsletter entitled "What are the Practical Implications of the Recent Amendments to Rules 144 and 145?"

5. The SEC has issued no-action letters exempting certain tender offers for investment-grade securities from the minimum offering period requirements.

6. Eight factors have been held to characterize a tender offer and thus are generally considered to be relevant to determining whether purchases of securities constitute a tender offer: (1) active and widespread solicitation of holders; (2) solicitation made for a substantial percentage of the outstanding debt; (3) the offer to purchase is made at a premium over the prevailing market price; (4) the terms of the offer are firm rather than negotiable; (5) the offer is contingent on the tender of a fixed minimum number of securities and is often subject to a fixed maximum as well; (6) the offer is open for only a limited period of time; (7) the offeree is subject to pressure to sell his or her securities; and (8) the public announcement of a purchasing program precedes or accompanies rapid accumulation of the target securities.