The name Phoenix Equity Partners (PEP) was a natural choice for the managers of the European private equity group of Donaldson, Lufkin & Jenrette to select when they bought themselves out of the parent group back in 2001. After all, the senior managers of that team had originally applied their investment skills at Phoenix merchant bank, which was acquired by DLJ back in 1997. But, of course, the word Phoenix also has connotations of re-birth associated with the legend of the mythical bird rising from the flames. In this sense too, it could be argued, the choice was appropriate.
Steve Darrington, partner and CFO at the London-based mid-market buyout firm, says that the spinout offered the team the opportunity to start with a clean slate and plan the future from scratch. Reviews of many aspects of the business were consequently undertaken, among which was an examination of the appropriateness or otherwise of its insurance policies. When this study came to focus on directors and officers (D&O) insurance – which indemnifies company directors for losses sustained during the performance of their duties – the usefulness of the project became immediately apparent.
Darrington explains: ?We had two separate D&O and professional indemnity (PI) policies and, for us, there was a lot of overlap between the two. Some of the exposures were in both camps, and, in many respects, we were paying for double coverage.? The root of the problem, says Darrington, lies in D&O policies traditionally being pitched at the financial services sector as a whole, rather than taking into account the idiosyncrasies of private equity. ?The D&O policy treated us very similar to banks, and a lot of the wording was not relevant to us. When you read through it, it covered a lot of things outside our scope.?
The answer, as far as Phoenix was concerned, was to take out a ?tailor-made? policy that would cover only those exposures directly relevant to the firm's activities. To achieve this, the firm decided to go through an independent broker, Mark Williams, rather than through a large insurance company. ?Mark's an expert broker who went to the underwriters and said, ?These guys are venture capitalists, here's what they do, they don't need all this extra stuff,?? relates Darrington. The end result of those discussions was the creation of a combined, carefully tailored D&O and PI policy.
The most important aspect of this process, says Darrington, was getting the underwriters to understand exactly what type and level of risk they were dealing with. ?The way policies get improved is that the underwriters come to understand your business better. The policy needs to be written based on a thorough understanding of the risk. If it isn't understood, the underwriters will be conservative and will magnify the risk to be covered.?
And such a magnification of risk is likely to mean an escalation in the cost of what is, in any event, expensive coverage. Darrington says the cost of D&O/PI for Phoenix Equity Partners runs into six figures and accounts for around eight percent of the firm's non-salary-based overheads.
Investee bites back
What is more, the expense is despite the fact that all Phoenix's portfolio companies take out D&O policies on a primary basis rather than being covered by the umbrella of the Phoenix policy. This is not surprising given that the GP and portfolio company may well end up on opposite sides of any dispute. This is most likely to happen, says Darrington, in cases where a GP representative sitting on the board of a portfolio company provides what turns out to be extremely bad advice. For example, he says: ?There could hypothetically be a scenario where we tell a portfolio company to buy another business. They don't want to, but we force them to, and it turns out to be a disaster. They could claim we were only acting in our own interests and not in the interests of them and their shareholders.?
Fortunately, says Darrington, Phoenix has not had to activate the policy to date. ?We are very happy that we haven't had to put it to the test, even though it's something that we need – rather like the airbag in a car,? he jokes. However, just because the policy hasn't been used, he sees no room for complacency – which is why it is reviewed in tandem with the underwriters on an annual basis. ?We meet with them every year to help them understand the risks of our business on an ongoing basis,? he says. ?At the same time, they want to kick our tires to make sure that we have appropriate controls in place.?
One lesson from the experiences of Phoenix is to make sure that D&O policies are up to date and reflect business exposures accurately. Firms that subsequently find themselves in need of a new policy might just find that now is not a bad time to go shopping. ?D&O got very expensive post-Enron because underwriters could see the potential for some nasty exposures,? says one executive at a London-based insurance provider. ?But the market's gone softer now, and pricing is less aggressive.?