Navigating the Storm: How Sponsor Guarantees Can Help Your Portfolio Company Through Choppy Waters

Facing ongoing operational and financial performance issues, exacerbated by the sustained, elevated interest rate environment, private equity sponsors’ portfolio companies may face liquidity concerns and/or experience difficulty complying with financial covenants under their existing loan documentation. In exchange for covenant relief or other economic concessions and / or to provide lenders with comfort to extend additional credit under existing credit facilities where they may not otherwise, lenders may request additional credit support from the sponsor. 

While this credit support may take multiple forms, including the immediate contribution of equity to a portfolio company, it can be preferable for sponsors, from a capital efficiency and cost perspective, to provide such support as a guarantee of a portion of the portfolio company’s outstanding loan obligations or liquidity shortfalls, which may take the form of a binding contractual commitment or guarantee to contribute equity to the portfolio company (a “Sponsor Guaranty”). Although lenders are primarily concerned about their loan being repaid and view Sponsor Guarantees as a way of de-risking the near-term credit risk, depending on the company’s overall financial condition and credit profile (e.g. significant asset values vs. asset light business and the reasons for any present financial difficulties), lenders may also be focused on the longer-term viability of the company.  Accordingly, the use of proceeds of a Sponsor Guaranty can vary – such proceeds may be required to be used to immediately reduce a portfolio company’s debt, retained by the portfolio company for working capital needs or a combination of the foregoing.

Although this article uses the term “sponsor” to refer to private equity sponsors who hold a majority of the equity of the relevant portfolio company, note that where a portfolio company investment is structured such that the controlling equity interests reside with a group including the private equity sponsor together with its related co-investors, Sponsor Guarantees may also be provided by one or more such co-investors, which may raise additional issues discussed in more detail below.

While the details of Sponsor Guarantees will vary depending on the particular credit concerns and relationships between sponsors and lenders, discussed below are a number of issues to consider when evaluating Sponsor Guarantees in connection with covenant relief or other accommodations from lenders.

Sponsor Guarantor

The entity providing the Sponsor Guaranty is typically the fund or funds that are the existing investors in the portfolio company, rather than the Sponsor (i.e., the advisor to the funds), but consideration should be given whether the Sponsor Guaranty can be given from the equity aggregator vehicle in the structure (particularly where there are co-investors alongside the Sponsor investment in the underlying portfolio company).  Of course, lenders will require that the Sponsor Guaranty be provided by a creditworthy entity and will need confirmation that the entities providing the Sponsor Guaranty have, and maintain during the term of the guarantee, the resources to fund the Sponsor Guaranty, whether by calling on limited partner capital commitments or accessing available fund level leverage facilities. Though not common anymore, fund entities’ constitutive documents may prohibit or limit the provision of guarantees. In certain limited circumstances, most often related to availability of sufficient capital and/or concentration limitations, the sponsor guarantor may need a back-to-back guarantee or other financial support from a different sponsor entity in order to comply with fund governance or other limitations.

Guaranteed Amounts

The sponsor guarantor typically only agrees to guarantee a capped amount (which can be a set dollar amount or a portion of the obligations outstanding under the loan documents), some or all of which may be required to repay indebtedness of the portfolio company and/or be provided to the portfolio company to support its working capital needs. In addition, any expenses, fees, costs, etc. that are incurred by the agent or lenders in connection with the Sponsor Guaranty and its enforcement for which the Sponsor is responsible may be subject to a cap or reasonableness standard, although this is a negotiated point. To the extent that the business arrangement is for some or all of the guaranteed amount to be provided in the form of an equity contribution to be retained by the borrower, the maximum guaranteed amount should be reduced to the extent the sponsor (or potentially other investors that may not be guarantors) contributes equity to the borrower.

Note that Sponsor Guarantees are almost always guarantees of payment, and not guarantees of collection. This means that in order for a lender to make a demand under a Sponsor Guaranty, the lender does not need to have exhausted all, nor even pursued any, attempts at collection against the borrower before the sponsor must make payment to lenders, or contribute capital to the portfolio company, as applicable, under the Sponsor Guaranty. 

Trigger Events

Each Sponsor Guaranty will have a set of events (“Trigger Events”) that trigger the requirement for payment of some or all of the guaranteed amount to the lenders and/or making of an equity contribution to the borrower, as applicable. These events and how they are calculated are often heavily negotiated, and may include some or all of the following: 

• Breach of financial covenants, which may include:
  • minimum liquidity covenant; 
  • minimum EBITDA covenant;
  • leverage ratio covenant; and 
  • fixed charge coverage ratio covenant.
  • Note: Some of these financial covenants may not be included in the underlying loan documentation or may be introduced solely in connection with the Sponsor Guaranty and any associated credit agreement accommodations / amendments. In addition, the amount to be funded under the Sponsor Guaranty may tie to the amount needed to cure the applicable covenant shortfall.
• Occurrence of a payment or bankruptcy event of default.
• Any liquidation, sale or disposition of all or substantially all assets of the loan party group that does not result in the full discharge of all obligations under the loan documents.
• Acceleration of the obligations or termination (by lenders) of any revolving commitments.
• Any event of default under the Sponsor Guaranty (including the failure by the fund entity to maintain minimum capital availability – see Other Considerations for Sponsors below).

Delivery of Required Funds – Timing and Amount

Typically, the sponsor will be required to make a capital infusion down the ownership chain into the credit parties and/or make a direct payment to the lenders to repay outstanding indebtedness of the borrower within a specified period after a Trigger Event occurs. Each Sponsor Guaranty will set forth the required dollar amount and timing of such contribution / distributions or payments. The parties should also address how any cash contributed into loan parties is applied to any financial covenant calculations, both on a go-forward basis and for prior test periods. 

Whatever is agreed, it is important for the sponsor to manage related capital calls or reserves they may need to make or maintain as a result of these requirements, as well as any preemptive rights or other rights any co-investors may have. These factors can have important timing impacts, discussed more fully in the Other Considerations for Sponsors section below. 

Note also that in some cases consideration may be payable to a sponsor guarantor in exchange for providing a guarantee, separate from the consideration payable upon providing the relevant credit support. In these cases, it is important to assess any tax issues occasioned by the nature and structure of any consideration payable. Tax counsel advice should be sought by both lenders and sponsors in connection with any guarantee.  

Interplay with Equity Cures

Sponsors should consider how any contributions made by the sponsor guarantor are or should be treated under the equity cure provisions of the underlying loan documents and whether any amendments need to be made to reflect the business understanding between the sponsor and the lenders. Some Sponsor Guarantees permit any contributions made to be treated as equity cure contributions under the loan documents, so long as the equity cure is otherwise available for the relevant fiscal quarter that the contribution is made, and accordingly when the Sponsor Guaranty is funded, the underlying default or event of default would be cured. Sponsor Guarantees may also permit voluntary equity cures made while the Sponsor Guaranty is in place to reduce the total guaranteed amount. This could allow the sponsor guarantor to anticipatorily cure an upcoming default, while still getting credit against the overall guaranteed amount, thus reducing the amount subject to the Sponsor Guaranty.

Termination/Reduction

The sponsor and lenders should determine whether there are certain events or dates that will trigger a reduction in the guaranteed amount or the termination of the Sponsor Guaranty. For example, the parties may agree that the Sponsor Guaranty will terminate on a particular date or that the guaranteed amount will be reduced when certain financial or other milestones are met, or after specified financial covenant levels are maintained for a certain number of fiscal quarters.   

Other Considerations for Sponsors

In connection with a Sponsor Guaranty negotiation, a sponsor should take into account the following additional considerations: 

• Preemptive Rights: Executing a Sponsor Guaranty or funding any of the obligations under a Sponsor Guaranty may constitute an equity contribution that triggers co-investors’ preemptive rights. Complying with these rights will need to be factored into the timing of any capital calls, as discussed in the Capital Strategies/Deployment section below. Additionally, if the sponsor expects to be compensated for providing the Sponsor Guaranty – whether in cash or newly issued equity securities – the sponsor will need to determine whether any co-investors are entitled to or should be provided the opportunity to participate in the Sponsor Guaranty and receive a portion of such compensation.  To the extent the underlying equity documents permit, the execution of the Sponsor Guaranty itself could be structured to trigger the preemptive rights, which could save time to the extent the Sponsor Guaranty is triggered at a time when the underlying portfolio company is in need of funds.
• Form of Contribution: The sponsor should assess whether any cash they may be required to contribute should (and can) be contributed in exchange for newly issued equity or debt at each level of the portfolio company’s ownership structure. If contributed in exchange for newly issued equity, the sponsor should establish what the terms of those equity securities should be, particularly their valuation and any preferences, how to facilitate the participation of any employee co-investors, the impact on any incentive equity programs and the potential impact on the valuation of existing equity securities. In any event, the sponsor should consider any tax implications of the form such contribution will take.
• Capital Strategies/Deployment: A sponsor may need to carefully plan internal capital strategies to ensure compliance with the Sponsor Guaranty so they can meet any requirement to make payments or cash contributions to their portfolio company, by:
  • Making a capital call. What is the notice period required to investors? What are the content requirements of the notices? Are preemptive or other rights applicable, and if so, what are the timing considerations and what is their interplay with the capital call and guarantee performance timelines? 
  • Reserving capital. How do the funding deadlines under the Sponsor Guaranty align with the requirements under the fund documents for calling capital? Does capital need to be reserved if capital call notice periods do not align with deadlines provided in the Sponsor Guaranty?
  • Borrowing under existing capital call facilities. Does the fund have lines of credit available to bridge any gaps between making capital calls and receiving funds? What are the notice periods required to make borrowings under those facilities? Are there any borrowing conditions that need to be complied with?

The sponsor may also need to account for making multiple guarantees in connection with multiple portfolio companies, plus other demands for capital or borrowing capacity under any lines of credit. 

Although Sponsor Guarantees are generally unsecured, lenders may require representations and covenants in the Sponsor Guaranty as to the cash reserves and/or total capital call commitments that the sponsor guarantor must maintain while the Sponsor Guaranty is in effect. In addition, sponsors may be required to provide certain financial information and related certifications (including as to capital call commitments and/or cash reserve levels) on an ongoing basis and provide backup with respect to such certifications.