Liability

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As litigation claims against portfolio companies have increased, so have accompanying claims asserted directly against funds (and their sponsors). Plaintiffs’ reasoning for including funds as defendants is no mystery: funds often have greater financial resources than the defendant portfolio company, particularly where the portfolio company is in distress, and thus represent the proverbial “deep pockets.” This is especially true where a liquidity event involving the portfolio company either recently occurred or is on the horizon. Liquidity events, which range from major portfolio company transactions to liquidation or reorganization, often lead to substantial returns for funds.

Another source of litigation risk for fund sponsors are claims brought by portfolio company employees.  Sponsors should be aware of these risks, particularly when the portfolio company is in distress or is considering a sale or other transaction affecting the disposition of shares in the company.  We have set forth below just a few examples of litigation that can be brought against the fund, sponsor, and board designees by portfolio company employees, likely triggering at least indemnity considerations (which need to be evaluated in connection with insurance and indemnity at the portfolio company level), and might also affect the value of the portfolio company and in turn the value of the fund’s assets.

A significant ownership stake in a portfolio company has always raised the specter of claims against funds, sponsors, and sponsor-appointed board designees, if for no other reason than they are perceived by the plaintiffs’ bar to be deep pockets.  This risk has only increased in recent years, as it has…

Private funds frequently negotiate for special rights when making an investment in a portfolio company, such as the right to appoint one or more board directors, voting rights, and liquidation preferences. Fund sponsors often focus solely on the positive aspects of these special rights, such as increased control, without considering fully other implications. As the Peter Parker principle reminds us, with great power comes great responsibility. In the fund context, sponsors should remember the portfolio company corollary: with greater control comes greater exposure to liability.

Over the last few years, we have seen an uptick in litigation claims against sponsors and funds arising out of their interests in portfolio companies.  A fund sponsor’s participation on a portfolio company board, in particular, is a risk factor for the entire investment structure (the GP, the Management Company, individual members of the GP and Management Company, and the Fund) due to conflicts of interest, whether real or perceived, and related competing fiduciary duties.  There are, however, steps that fund sponsors can take to manage and reduce their risks.  The first step is to develop a full understanding of where, and why, risks lie in the investment structure.  With that understanding, sponsors can develop and implement practices to manage and reduce those risks.

Many portfolio companies continue to confront business disruptions as a result of the COVID-19 pandemic. Even prior to the pandemic, we were seeing an uptick in litigation claims against sponsors and funds arising out of portfolio companies. The liquidity challenges since March have increased those risks at some companies. For sponsors, many of these risks arise from director positions and conflicts of interest, whether real or alleged. Below we provide tangible ways for fund sponsors to identify risks, educate their directors, and mitigate risk.

Last Friday, the U.S. Court of Appeals for the First Circuit ruled that two co-investing Sun Capital private equity funds had not created an implied “partnership-in-fact” for purposes of determining whether the Sun Funds were under “common control” with their portfolio company, Scott Brass, Inc. (SBI) – resulting in a…