It’s another symptom of a borrowers’ market, and one that is causing a fair degree of consternation among our sources: the growth of the ‘designated lawyer’ phenomenon.
In the cover story of our June issue, which incorporates a bold new redesign, we focus on addbacks as an example of the flexibility being granted to borrowers when it comes to defining EBITDA – a number that underpins essential aspects of a deal’s structure.
Perhaps inspired by this alleged transgression being increasingly out in the open, other objections are now being voiced. One relates to legal advice, the quality of which can easily be the difference between a successful investment and a damaging loss.
Private equity firms are increasingly appointing designated lawyers on private debt deals, often well before they have selected which lenders they will work with. Once the lender has been chosen, the sponsor assigns its favoured law firm to represent the lender on the transaction.
The rationale is that, in a fast-moving auction process, lenders need to be able to act quickly. Assigning a law firm that is already familiar with the details can speed things up significantly, thus ensuring that the sponsor can move ahead swiftly and secure the deal.
Traditionally, this is a practice only seen in larger deals involving investment banks, where there appears to be some justification for it. One lawyer told us: “The sponsors designate the lender counsel because bank lenders won’t pay the legal bills but still need some representation. In these deals, the lender is often mandated very late in the process, sometimes not until the day before signing.”
But industry insiders are now seeing the practice extend into the mid-market, where it is arguably less justified as lenders are usually chosen much earlier in the transaction. Moreover, debt funds find themselves working with law firms that are new to them and of which they have little knowledge. Some believe these firms can be heavily reliant on the sponsors for business and are therefore likely to put the borrower’s needs first.
“We’re also seeing this manifest itself as a squeeze on legal fees, which isn’t good for the lawyers involved either,” one GP told us. “This results in a lower quality of service as these firms are operating on very small margins and they’re under pressure to keep the sponsor happy so they can get deals in future.”
The greatest risk for a debt fund in this type of situation is that its lawyer goes soft on terms and fails to fully explain this to the lender. Weaknesses may not be apparent until it is too late, a covenant has been breached and the lender finds it does not have the rights it thought it had. In a world where terms and covenants have been weakening for several years, an already bad situation for lenders could be made even worse.
Watch out for our July/August issue, which will include a more detailed exploration of this topic.
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