Ongoing Capital Challenges Portend Continued Portfolio Company Litigation Risk In 2024 – Corporate and Company Law

Economic headwinds and the interest rate environment that
developed over the course of 2023 increased financial stress on
portfolio companies and portend heightened litigation risk in 2024
for portfolio companies and their private fund sponsors.
Specifically, interest rate increases that accelerated through 2022
continued in 2023, and compounded existing economic stressors
including tight liquidity and inflation coming out of 2020 and
2021, as well as increased cost and other burdens related to ESG
and regulatory compliance. These pressures put portfolio companies
in often unsustainable financial positions, causing them to
prematurely seek liquidity events, violate debt covenants with
lenders, and resort to bankruptcy, all of which has led to an
increase in disputes and litigation, which we expect to continue in
2024.

While some relief on the interest rate front is on the way, with
the Federal Reserve expected to begin to slowly cut rates in 2024,
and inflation appears to be easing, it may not be enough to
forestall portfolio company disputes and litigation for
cash-strapped companies in 2024. We saw this play out in a number
of ways in 2023, which may serve as harbingers of what’s to
come this year.

Difficult financial conditions strain a portfolio company’s
ability to continue to fund its operations, forcing the company
and/or its investors to seek liquidity events, for example with an
exit through the sale of some or all of the equity of the company.
Any of these options presents the possibility that aggrieved
stakeholders will raise disputes. Aside from the obvious risks of
running out of operational runway, disputes over a portfolio
company’s valuation are a common theme. Whether in an exit or
alternative capital raise scenario, certain stakeholders may argue
that they have been adversely affected by an unexpectedly low
valuation, resulting in post-deal litigation. In other
circumstances where less than all of the company is sold, other
disputes can arise, such as when existing investors find their
investment diluted or “crammed down,” a situation where
investors are forced by contract or bankruptcy law to accept exit
terms that they may view as unfavorable. A valuation process that
includes a respected third-party valuation firm that is fully
informed based on current and accurate portfolio company financials
can mitigate this risk somewhat. We offered some thoughts on
valuation issues in last year’s top 10, which remain
applicable to the challenges portfolio companies will face this
year.

Challenging economic times can also result in the breach of debt
covenants with lenders. Many portfolio companies carry significant
secured debt burdens. Decreased revenues have a direct impact on
maintenance debt covenants, as can increased interest expenses
resulting from higher rates. Covenant defaults can expose portfolio
companies to a myriad of issues from acceleration of outstanding
debt to unwelcome changes in control. Careful attention to
maintenance covenants, along with open communication about
headwinds and expected challenges, can avoid portfolio company
disputes with lenders. In other scenarios, restrictive debt
covenants can present a unique challenge, for example where lenders
or investors are willing to provide cash infusions, such
transfusions would trigger a default under the portfolio
company’s agreements with existing investors, leaving portfolio
companies and sponsors with few options to access the needed
capital. The inability to continue to fund operations resulting
from restrictive covenants can lead to reputational harms and
litigation with customers, vendors, and other creditors.

For some portfolio companies, these sustained economic headwinds
after years of financial pressure cannot be overcome and will
invariably lead to bankruptcy. Bankruptcy comes with its own set of
challenges beyond a loss of the sponsor’s initial
investment—from shining an unwelcome light on prior
management, to loss of control, to subrogation issues.

With each of these challenges comes the additional risk that an
aggrieved investor, lender, or other stakeholder will pursue claims
for liability against sponsors and managers themselves. For
example, minority investors who believe their investment has been
disproportionately impacted by a sponsor or manager decision may
pursue claims of unfair prejudice. In addition, board membership or
other control over the business and decision-making processes at a
portfolio company can increase the risk of litigation. As we have
discussed in our Portfolio Company Playbook, sponsors and
managers should pay careful attention to whether their portfolio
company oversight could open them up to fiduciary liability or
other claims.

This year is expected to bring economic relief on a number of
fronts, but managers and portfolio companies alike can look to the
outcomes of 2023 for lessons on how to protect their investments
and business, as well as to avoid litigation in 2024 and
beyond.

Read more of our Top Ten Regulatory and Litigation Risks for
Private Funds in 2024.

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