Increasingly, private equity funds are requiring that portfolio companies, in which the PE fund has invested, give the PE fund the right to “put” their investment to the portfolio company under certain conditions, including upon, and simultaneous with, certain changes of control. Seems harmless enough, right? Well, not so fast. Upon closer inspection, that put effectively creates a scenario where the PE fund is able to unload its ownership interest in connection with certain sales of that portfolio company, perhaps without having to be a party to the transaction documents. This is a perfect scenario for a PE fund (well, really, for anyone!); like being cashed out of a portfolio company investment with none of those pesky, lingering post-closing liabilities (e.g., indemnity claims, purchase price adjustments, and the like) associated with the sale, thereby completely avoiding, for example, a potential, years’ later request that the PE fund (and, by extension, its investors) give back some of the sale proceeds.
Some might say: “Where’s the harm?”
Well, what if there is another investor in that portfolio company? Based on simple math, it would appear that the other investor is potentially on the hook for a now disproportionate share of the post-closing liability, in effect, picking up a portion of the post-closing liability that would have otherwise been allocated to the now cashed out (i.e., via the put) PE fund. Not such a great outcome for that other investor.
That’s not all. What if a portfolio company neglects, or believes there is no need, to advise the other investors about the put (and the corresponding potential disproportionality), with the portfolio company thinking: “What’s the big deal?” In the absence of appropriate disclosure, the other investor may have, in effect, invested in a different security than the one advertised by the portfolio company. As a result, the portfolio company may have set itself up for a securities fraud claim (at a minimum!) by the other investor.
The problems don’t end there. What if the portfolio company is a Sub S corporation? Does the portfolio company now have two classes of stock because of the different attributes of the stock? If so, that would likely be a problem for everyone involved except, of course, the IRS.