How Does the Merit Decision Affect Private Equity Exit Strategies?

Concept

The 2018 Supreme Court decision in Merit Management Group, LP v. FTI Consulting, Inc. fundamentally recalibrated the architecture of risk for private equity exit strategies. It did so by dismantling a long-held assumption about the security of payments in leveraged buyouts and other M&A transactions.

The ruling directly addressed the “safe harbor” provision within Section 546(e) of the U.S. Bankruptcy Code, a mechanism designed to protect certain financial transactions from being unwound. The decision’s impact was to narrow the scope of this protection, exposing selling shareholders in private equity exits to a heightened risk of litigation and clawbacks in the event of a portfolio company’s subsequent failure.

The Merit decision eliminated the “mere conduit” defense, exposing private equity sellers to fraudulent transfer claims previously shielded by the involvement of financial intermediaries.

Prior to this ruling, the prevailing interpretation in most jurisdictions was that if a financial institution, such as a bank or an escrow agent, acted as an intermediary in the transfer of funds from a buyer to a seller, the transaction was shielded by the safe harbor. This interpretation viewed the financial institution’s role, however fleeting, as sufficient to protect the payment from avoidance actions by a future bankruptcy trustee. Private equity firms and their investors relied on this broad interpretation as a structural defense, ensuring that once an exit was complete and proceeds were distributed, the transaction was final.

What Is the Central Holding of the Merit Decision?

The Supreme Court, in a unanimous opinion, established a new, more precise standard. It held that the safe harbor protects a transfer only when the transferor or the transferee ▴ the actual, substantive parties to the transaction ▴ is itself a financial institution. The Court reasoned that the purpose of the safe harbor was to prevent the cascading failure of financial institutions, a goal that is not served by protecting transactions where such institutions are merely passthrough agents for non-financial entities. The focus shifted from the component parts of a transaction to the overarching transfer.

In the context of a private equity exit, where a portfolio company is sold to a strategic acquirer or another fund, neither the selling shareholders nor the buyer are typically classified as financial institutions under the code. Consequently, the payments they make and receive now fall outside the perimeter of this critical protection.

This reinterpretation means that proceeds from the sale of a portfolio company can be targeted by a bankruptcy trustee under the theory of “constructive fraudulent transfer.” Such a claim does not require any proof of malicious intent. It simply requires the trustee to demonstrate that the sold company was insolvent at the time of the transaction or was left with unreasonably small capital, and that the selling shareholders did not provide reasonably equivalent value. The sale price itself becomes a point of contention, and the sellers, including the PE fund and its limited partners, can be sued for the return of their proceeds years after the deal has closed.

Strategy

The strategic response to the Merit decision requires a systemic upgrade to the private equity deal-making process. The ruling effectively introduced a new, material contingency into every exit calculation. The primary strategic imperative is now the construction of a robust defense against potential fraudulent transfer claims.

This defense must be built proactively during the transaction process, creating a contemporaneous record that can withstand scrutiny in a future bankruptcy proceeding. The focus shifts from reliance on a statutory shield to a demonstrable, evidence-based validation of the portfolio company’s financial health at the moment of sale.

How Should Due Diligence Protocols Evolve?

A private equity firm’s first line of defense is a radical enhancement of solvency-focused due diligence. Pre-Merit diligence was primarily centered on maximizing sale price and ensuring the buyer’s ability to close. Post-Merit, the diligence process must also serve a defensive function, meticulously documenting the solvency of the asset being sold. This involves a multi-faceted analysis that goes far beyond a simple review of financial statements.

• Balance Sheet Test ▴ This involves a rigorous, fair-value analysis of the company’s assets and liabilities. The objective is to demonstrate that, at the time of the sale, the fair market value of the company’s assets exceeded its total liabilities. This requires more than book value accounting; it may necessitate formal appraisals of tangible and intangible assets.
• Cash Flow Test ▴ This analysis projects the company’s ability to meet its obligations as they come due following the transaction. It scrutinizes management’s financial forecasts, stress-testing them against various market scenarios to prove that the company was not left with an unmanageable debt load or insufficient liquidity.
• Adequate Capital Test ▴ This is a more subjective, forward-looking assessment. It seeks to confirm that the company was not left with “unreasonably small capital” for its business operations and industry risks. This involves benchmarking against industry peers and documenting the rationale for the company’s post-transaction capital structure.

The following table illustrates the shift in due diligence focus:

The Ascendance of Solvency Opinions and Insurance

A direct strategic consequence of Merit is the elevated importance of two key risk mitigation tools ▴ formal solvency opinions and Representation & Warranty Insurance (RWI). A solvency opinion is a detailed report prepared by an independent financial advisor that attests to the company’s solvency at the time of the transaction, based on the three tests described above. While once considered an optional expense, it is now a critical piece of evidence. It provides a third-party validation of the board’s judgment and serves as a powerful deterrent to a bankruptcy trustee, who would have to overcome the expert opinion to successfully press a claim.

A formal solvency opinion now functions as a foundational element of deal architecture, shifting the burden of proof in future litigation.

RWI has also evolved. These insurance policies, which cover losses arising from breaches of the seller’s representations in the purchase agreement, are being examined more closely. PE firms are now negotiating with insurers to ensure that policies provide clear coverage for defense costs and potential losses related to fraudulent transfer claims. The underwriting process for RWI now often includes a review of the solvency analysis, linking the insurance product directly to the core risk identified by the Merit decision.

Execution

Executing a private equity exit in the post-Merit environment is an exercise in precision and foresight. The objective is to build an unassailable record of a fair and prudent transaction. This requires a disciplined, multi-stage approach that integrates legal, financial, and operational workflows from the earliest stages of exit planning. Every step must be taken with the awareness that it could one day be scrutinized in a courtroom.

The Operational Playbook for a Defensible Exit

A modern exit strategy requires an operational playbook that hardwires solvency validation into the deal process. This is a procedural guide for the deal team to ensure all necessary defensive measures are implemented systematically.

1. Early-Stage Solvency Assessment ▴ As soon as an exit is contemplated, the deal team should conduct an internal, preliminary solvency analysis. This initial screen identifies any potential red flags and determines the level of third-party validation that will be required.
2. Engagement of a Financial Advisor ▴ The firm must select and engage a qualified, independent financial advisor to prepare a formal solvency opinion. The selection process itself should be documented to demonstrate that a reputable and objective expert was chosen.
3. Creation of a Data Room Annex ▴ The deal team should prepare a specific section of the virtual data room containing all documents related to the solvency analysis. This includes management projections, asset appraisals, and all drafts and final versions of the solvency opinion.
4. Board Deliberations and Approval ▴ The portfolio company’s board of directors must be thoroughly briefed on the solvency analysis and the final opinion. The board minutes must reflect a detailed discussion of these findings and a clear resolution that the company is solvent and that the transaction is in the best interests of the company and its stakeholders.
5. Negotiation of the Purchase Agreement ▴ The legal team must ensure that the representations and warranties in the purchase agreement align with the findings of the solvency opinion. The structure of the transaction should be clearly documented to show value exchanged.
6. RWI Policy Integration ▴ If an RWI policy is used, the team must work with the insurer to ensure the policy’s terms are aligned with the risks. The underwriting process should be supplied with the solvency opinion to secure the most favorable terms and coverage.

Quantitative Modeling a Solvency Analysis

The core of the execution process is the quantitative analysis that underpins the solvency opinion. This analysis provides the empirical foundation for the board’s decision. The table below presents a simplified, hypothetical model for a portfolio company, “OpCo,” being sold for $500 million.

This quantitative framework is the bedrock of a defensible exit. Each number in the table would be supported by extensive documentation, from asset appraisals to detailed, multi-year financial models. It transforms the solvency determination from a matter of opinion into a conclusion based on verifiable data.

Executing a transaction with a fully documented solvency analysis provides a robust shield against future avoidance actions.

What Is the Practical Impact on Selling Shareholders?

The ultimate goal of this rigorous execution is to protect the distributed proceeds. For the private equity fund’s limited partners and other selling shareholders, these measures provide a layer of insulation from future liability. While the statutory safe harbor has been narrowed, a well-executed, defensible transaction creates a formidable practical barrier for any bankruptcy trustee.

The trustee would face the significant challenge of discrediting a contemporaneous, expert-driven analysis of the company’s financial health. This disciplined execution is the new system for ensuring that when a private equity firm exits an investment, the returns are final and secure.

Reflection

The Merit decision serves as a powerful illustration of how legal and financial systems are deeply intertwined. A shift in judicial interpretation can fundamentally alter the risk calculus of a multi-billion dollar industry overnight. This reality compels a move beyond transactional thinking toward a more holistic, architectural view of portfolio management.

The knowledge of how to structure a defensible exit is now as critical a component of a firm’s operational framework as its ability to source deals or drive operational improvements. The ultimate advantage lies not just in securing high returns, but in building the robust institutional processes required to keep them.