Private equity funds are inherently optimistic—it comes with the territory. From the sponsor’s perspective, industry or operational expertise should enable a portfolio company to meet or exceed financial projections. However, not every investment is profitable. Indeed, a recent study found that nearly three-quarters of restructuring professionals believe that the default rate for a portfolio company is the same or higher than the default rate for a publicly-traded company in the same industry.
Aside from the obvious financial impact that these bankruptcies have on sponsors, there are attendant risks related to fiduciary obligations of officers and directors. Specifically, bankruptcy filings and general financial distress create an environment ripe for breach of fiduciary duty claims as out-of-the-money investors look to mitigate losses (and consider litigation to leverage a more favorable return). Given that sponsors typically appoint one or more board members for portfolio companies, these sponsors and their appointed directors must be keenly aware of directors’ fiduciary obligations and potential strategies for mitigating risk. These strategies may include: