Private equity companies tend not to litigate but there are occasions when litigation makes sense, says Chris Smith.
As a general rule, private equity funds tend not to litigate. However, that is not to say that they do not come across potential claims from time to time. Such claims will typically fall into two main categories: acquisition related claims (for example, a breach of warranty claim discovered post-acquisition) and those that a private equity fund’s portfolio companies may consider bringing.
Acquisition related claims
A typical acquisition process will involve lengthy due diligence, the negotiation of a suite of warranties from the sellers, and the formulation of a detailed share or asset purchase agreement, all intended to mitigate risk and to ensure the purchaser fully understands the company or business they are buying.
There are, therefore, limited circumstances in which a claim may arise and these are most likely to concern a breach of warranty. In fact, when I was in practice, one private equity client was preparing a claim against the exiting management team of their new portfolio company for breach of a number of accounts warranties – they had allegedly misstated profits for the three years prior to the acquisition with the result that the client had overpaid for the company by a significant amount.
Despite the prima facie validity of this claim, it never saw the light of day. The client was concerned that issuing proceedings against an exiting management team would tarnish their reputation in the market and vendors would be less willing to deal with them if they perceived a higher than average risk of post-transaction litigation. Such is the competitiveness of the private equity market for quality assets that reputation is everything and for this reason alone we are unlikely to see many claims.
It’s also worth pointing out that even if a fund can get comfortable with the potential reputational impact of bringing a claim, they would have to fund it out of their management fee (which would otherwise be used to pay salaries and bonuses to the fund’s team). Perhaps here there may be an opportunity for litigation funders and private equity funds to work together? There is unlikely to be much volume, but where there are good claims, the private equity fund can continue rewarding their staff and covering their overheads while a litigation funder provides the financing for the claim.
Portfolio company claims
For those who are unfamiliar with the private equity model, it is simple (in practice, if not execution) – buy an attractive company, use an optimised capital model (i.e. leverage), drive operational improvement and/or buy into a growing sector, sell the company for more than you paid for it.
At the forefront of a private equity investor’s mind during their period of ownership of a company will be to maximise EBITDA and, conversely, avoid anything that risks impairing it. The accounting treatment of litigation means that its impact, even if the outcome is successful, can have a meaningful negative impact on the EBITDA and, therefore, the exit value a company may be able to achieve.
Let’s take a simple example. Company X has an EBITDA of £10m and multiples in its industry sector are 10x. The value of Company X today is, therefore, £100m. Company X gets embroiled in a claim with a £3m legal budget, with £1m expected to be spent in each of the next 3 years. Immediately, Company X’s EBITDA is reduced to £9m and the exit value to £90m – a £10m reduction. This EBITDA impairment will continue so long as there are litigation costs that need to be accounted for.
In addition, if the claim is successful, the damages recovered will not ‘repair’ the EBITDA, but rather be treated as a one-off exceptional item in the accounts. Whilst it may be possible to dividend out the money recovered, there may be structural or commercial issues that do not make this viable.
Litigation funding eliminates the financial disincentive for private equity funds and their portfolio companies to pursue claims. By taking the claim entirely off balance sheet, there will be no EBTIDA impairment and so no negative impact on the valuation the company can achieve on an exit.
Private equity firms operate in a highly sophisticated market and there are numerous factors they will rightly weigh up when deciding to pursue litigation. Litigation funding is a powerful tool that funds can utlilise to eliminate the concerns around lack of money at fund level for acquisition related claims or EBITDA impairment at portfolio company level when it is the company itself pursuing the claim.