Academic journal article Fordham Journal of Corporate & Financial Law

Private Equity's Overleveraging of Portfolio Companies

Academic journal article Fordham Journal of Corporate & Financial Law

Private Equity's Overleveraging of Portfolio Companies

Article excerpt

INTRODUCTION

In 2014 and 2015, over $1.2 trillion was invested in private equity, the industry's greatest mark since the financial crisis.1 The steady level of near-zero percent interest rates in recent years has certainly helped the industry. In the typical leveraged buyout, the private equity firm will buy a public or private company using about 60% to 90% debt financing mainly provided by banks.2 With the cost of borrowing so low, private equity managers have been able to expand their investing power, resulting in steady investment in private equity while other sectors of the economy have struggled.3

In the months following the U.S. financial crisis, the Federal Reserve instituted its own set of crisis-related special programs, such as the substantial purchase of long-term securities, which put pressure on longer-term interest rates and eased overall financial conditions.4 5 Consistently low interest rates set the stage for recovery over the past seven years.' More specifically, these rates have had an impact in private investment, and the private equity market, by spuming much debate about taxing private equity and handling liability for the underlying investments.6 While most of the debate has centered on how to tax private equity, this Note focuses on issues of liability for underlying portfolio company debt obligations.

Private equity activity has seen its fair share of borderline predatory overleveraging since the financial crisis. 7 8 However, this problem remains unaddressed by Congress, federal agencies, and the states/ On multiple occasions, private equity giants have added struggling companies to their portfolios; once in their possession, the firm essentially strips down the company, issuing more debt than it can handle and channeling the proceeds from the issuance to the general partners.9 The company is then left unable to pay interest on the outstanding debt. Accordingly, with decreasing rates, the amount of equity financing in leveraged buyouts, where funds typically borrow outside money, has also steadily decreased as firms opt to secure cheaper debt.10 The result of such an increase in debt financing has led to more and more portfolio companies overleveraging and eventually having to file for bankruptcy." This Note addresses the overleveraging of portfolio companies, how the private equity fund structure allows for it, and how to recover lost funds firms poach from these companies.

Part I discusses private equity funds and their limited partnership structure, as well as the relevant tax and bankruptcy law provisions that allow for debt financing. This section takes a look at the tax and liability benefits of the limited partnership structure, and then it explains the current policy debate regarding the treatment of private equity fund income and other private equity tax issues. It concludes by looking at two ways courts have ensured that private equity firms be held liable for their portfolio company debts. Part II consists of two case studies: Hellas Communications and Colt Defense, both of which were bought up by private equity funds, overleveraged, and restructured. Hellas Communications, a Greek telecommunications services provider, filed for bankruptcy in 2007, and although the company recently emerged from restructuring, it has remained the subject of multiple law suits in different continents for many years. On the other hand, Colt Defense, a nearly 200-year-old American weapon manufacturer, entered reorganization in the summer of 2015 and emerged healthy from bankruptcy in 2016. This section ends by addressing the current market trends of exit strategies and the role that debt financing has played in influencing certain strategies. Part III advocates for a solution in which sophisticated contracting parties take it upon themselves to ensure they do not suffer a windfall.

I. PRIVATE EQUITY FUND STRUCTURE AND LAWS

A. REFRESHER ON THE STRUCTURE OF FUNDS & THEIR TAX BENEFITS

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