Legal advice is at the heart of private debt deal-doing, and having a solid team of lawyers can be the difference between a successful investment or a crippling loss. But as debt markets increasingly favour borrowers, a new and worrying development could mean your legal counsel is not as reliable as you had hoped.
Lawyers and general partners have been in touch with PDI to raise their concerns about the growing use of ‘designated lender counsel’ in private equity-backed deals. They believe this phenomenon is leading to conflicts of interest and causing debt funds to get a raw deal.
Need for speed
So, what is designated lender counsel? It’s where private equity sponsors appoint lawyers for the private debt managers on their deals, often well before they have selected which lenders they will work with. Once the creditor has been chosen, the sponsor assigns its lawyer to represent the debt fund on the transaction.
The rationale is that, in a fast-moving auction process, managers need to be able to act quickly. Assigning a lawyer who is already familiar with the details of the transaction can, it is argued, speed things up significantly, thus ensuring that the private equity sponsor can secure the deal.
The practice has existed for years but has traditionally only appeared in large transactions.
One lawyer tells PDI: “This comes from very large-cap deals, with €1 billion or more of debt, which are usually underwritten by investment banks. 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.”
However, industry insiders are seeing the practice being extended into the mid-market in which credit funds operate. They argue it is less justified in this space as creditors are usually chosen much earlier in the transaction.
There is nothing inherently wrong with the practice, which could be viewed as similar to a mortgage borrower’s legal representative also working for that person’s lender. Nevertheless, recent developments have led to concerns within the industry.
“We’re in a very competitive market for private debt, and the last three or four years have exposed problems with this model,” one fund manager, who wished to remain anonymous, tells PDI. “This started with being given a list of three or four lawyers we could use. But these days, the sponsors will give us one choice and if we aren’t happy with it, we lose the deal.”
This has resulted in private debt funds having to work with lawyers they have not previously worked with and do not know very well. Credit funds are concerned that the lawyers they are being offered are heavily reliant on the private equity sponsors for their business, and are therefore likely to put the borrowers’ 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 says. “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 the future.”
The bigger risk for debt funds in these situations is that their lawyers go soft on terms and fail to fully explain how soft they are. However, this may not be apparent until it is too late, a covenant has been breached and the private debt manager finds it does not have the rights it thought it should. In a world where terms and covenants have been weakening for years, a bad situation for lenders could be made even worse.
A similar problem many credit funds now face is that of the commercial termsheet. “This is essentially a termsheet that’s printed off, often from a previous transaction, with fixed pages that feature all the key elements of a credit agreement,” according to one GP. “There’s no lender counsel and you can either take the deal or leave it.”
These sorts of tactics are predominantly being used by larger US- and UK-based equity sponsors, according to PDI sources, and are far less common when dealing with continental European private equity funds.
So what can private debt managers do to protect themselves from this at a time when the balance of power sits firmly with the borrower?
Unfortunately, in many cases the answer is simply that GPs will have to pay a lot more attention to their documentation and provide much of the scrutiny themselves to ensure they know what they are signing up to.
In some cases, larger debt fund managers have in-house legal teams that are able to analyse documents independently and advise deal teams on the full extent of their rights.
One manager of credit funds operating in the upper mid-market tells PDI: “We have a team with legal backgrounds in-house who know how to read these documents and who can provide additional advice on the transaction. But a lot of smaller managers don’t have this function and so have very little protection in the current market.”
The other option available to firms is to pursue action via regulators. One UK-based lawyer PDI spoke with says “a lot of fund managers are furious about the way they are being treated and are considering making a formal complaint to the Solicitors Regulation Authority”.
The SRA is the legal regulator in England and Wales and has powers to reprimand or even close down legal practices that break its code of conduct.
The SRA handbook states that solicitors “should always act in good faith and do your best for each of your clients. Most importantly, you should observe a) your duty of confidentiality to the client; and b) your obligations with regard to conflicts of interests”.
Designated lender counsel could be in breach of both these principles, which would be sufficient for the SRA to take action. However, a spokesman for the regulator confirmed, at the time PDI was going to press, that no formal complaints had been made.
Designated lender counsel do not necessarily do debt funds a disservice. Most legal advisors will take seriously their obligations to fairly represent their clients and will act responsibly. Debt funds also know that there needs to be a degree of compromise between both legal teams to get deals done.
The reluctance of firms to speak publicly about their concerns illustrates the sensitivity of the issue. In the current market, equity sponsors can hold significant power over their debt providers and many will be afraid to speak out for fear of losing out on deals.
But managers should remember that the market will not be benign for ever and their ultimate role is to deliver returns to LPs, not please equity sponsors. One or two significant losses caused by bad legal advice could wipe out all the good work in a portfolio and leave reputations in tatters.