It happens in every private equity deal; private equity firms engage outside legal counsel to conduct extensive pre-acquisition due diligence. The primary result of outside counsel’s hundreds – or even thousands – of hours of legal review is a thorough due diligence report highlighting actual and potential legal risks associated with the target company.
The other result of this effort: high legal bills. Assuming the risks identified in the legal due diligence phase of the acquisition are not too substantial – that is to say, unmanageable – for the private equity buyer, the acquisition is completed and the legal due diligence report is shelved.
But what of those pre-acquisition legal risks identified in due diligence? If not dealt with prior to the future exit by the PE firm, then inevitably those risks will be identified by legal counsel representing potential buyers. Counsel will highlight these risks in the next round of due diligence reports, which could negatively affect the value of the company or – even worse – delay or terminate a deal. The unmanaged risks may lead to an unsatisfactory exit structure: a special escrow or an asset sale, for example, each of which is less than ideal for a PE exit. Ultimately, a risk that was manageable at the outset of an investment to the initial buyer may be intolerable to future potential suitors.
What of the post-acquisition legal risks? After being acquired in a private equity deal, the portfolio company will inevitably encounter new circumstances, with their attendant legal risks. Without proper risk management and mitigation during the PE investment stage, these new legal risks could negatively affect equity value or the timing of an exit for the portfolio company.
Situations such as these should encourage private equity firms to see the value in having dedicated legal resources in-house at their portfolio companies. In-house counsel can deliver proper risk management in ways – and at costs – that outside legal resources cannot. In this way, legal representation can actually improve equity value: rather than being a necessary evil, legal counsel can be an integral part of a PE firm’s growth strategy for its portfolio companies. However, for many managers, the bottom line of creating value for their investors leads them to see in-house legal as an additional cost.
Conventional wisdom dictates that a company should hire corporate counsel when revenue exceeds a certain amount (typically $10-15 million USD) or when headcount exceeds a certain number (typically 200-250 employees) or when the company has a persistent legal need (for example, the company is in a regulated industry, requires intellectual property protection, or delivers a potentially harmful product or service). Most middle market private equity investments meet one or more of these criteria, yet very few portfolio companies have in-house counsel during private equity investment.
It is wise for private equity firms to engage dedicated in-house legal resources to serve their portfolio companies without traditional regard to the size of the investment or the type of company in which the PE fund is invested. Corporate counsel can manage the legal risks identified in pre-acquisition due diligence that were not mitigated prior to closing the initial deal. This results in the obvious benefit of preventing those risks from negatively impacting the PE fund’s future exit.
Risk is inherent to every commercial and corporate transaction. There is simply no way to eliminate risk altogether, and even if it were possible, risk elimination would not be practical. However, effective corporate counsel can manage and mitigate risk at an appropriate level. Other members of a management team and private equity principals are not trained to deal with risk in the same way; instead, equity value is supported best by management focused on other key tasks including sales, operations, finance, and marketing.
Dedicated in-house legal resources are better suited to identify and mitigate the company’s risk. As a full-time employee and member of the management team, a general counsel or chief legal officer has the valuable context that is essential to managing risk effectively. Compared with in-house counsel, even the most experienced outside counsel suffer from a lack of company knowledge. Having the proper background is essential to being effective.
Cost, too, is an issue. Corporate counsel can manage and mitigate legal risk so much more cheaply than bill-by-the-hour outside counsel. As in-house counsel traditionally earns a salary with a bonus tied to company performance, not only are incentives more properly aligned to the portfolio company’s, but compensation is more manageable than outside counsel bills. It is simply not cost-effective to have outside counsel manage most legal risks encountered by portfolio companies.
Corporate counsel can be particularly impactful to the benefit of the private equity investment in the context of an add-on acquisition. In one acquisition in 2014 alone, HOSTING, a cloud hosting services provider primarily owned by Pamlico Capital, saved over $200,000 in legal bills by relying on in-house legal resources instead of engaging outside counsel. Having in-house counsel manage add-on acquisitions creates synergistic results as well. In-house counsel’s involvement frees up other members of management to handle additional aspects of the deal or to focus on the day-to-day, non-deal-related parts of the business. The insiders’ perspective of in-house counsel helps to make this possible.
In-house counsel can also provide value to the PE investment in the traditional ways: drafting and negotiating large customer and vendor contracts and real estate or office leases, guiding human resources through difficult employee matters, ensuring the portfolio company’s compliance with regulations, and protecting a portfolio company’s intellectual property.
At appropriate compensation levels and structures, effective in-house counsel can have a significant impact on the value of portfolio companies. By reducing legal risk and costs, PE firms can protect and grow their investments, leading to more successful exits and great distributions for their funds’ investors.