Unwanted exposure

Many private equity firms buy insurance policies to guard against the surprise expenses of lawsuits and seller misrepresentations. Most of these are glad they did. By Judy Kuan and David Snow

General partners pondering how much insurance to buy face a conundrum similar to that faced by anyone thinking about insurance – do they spend money on a policy that may never be useful, or do they live with risks of uncertain magnitude and spend the money on items of more apparent utility?

Increasingly, GPs are choosing the former option. This trend has a direct correlation to the amount of lawsuits in which today's private equity firms and people are getting entangled. Not only are the stewards of corporate assets now exposed to more risk today, but private equity has grown and moved into the mainstream. Private equity firms are now among the biggest employers, the biggest sponsors of debt transactions and securitizations, the biggest sponsors of initial public offerings. Private equity partnership interests are found in the portfolios of a growing percentage of institutional investors worldwide. As the number constituents grow, so too does the number of potential litigants.

Add to this a very competitive environment, where a single busted deal can impact a private equity franchise so severely that the next fund may not get raised. Certainly the biggest insurance against post-closing disaster is thorough due diligence. A back-up insurance in this regard is, in fact insurance, in the form of representations and warranties insurance.

With insurance, you tend to get what you pay for. Actuaries are skilled enough not to hand out cheap protection against serious risks. That said, private equity firms in the US, Europe and beyond have been spared enormous expense by dint of having taken out an insurance policy, as insurance professionals interviewed for this article confirmed.

Ploy named sue
The subject of insurance for private equity firms can sometimes be confusing because each insurance broker calls products by different names. Mark Cuoco, a New York-based managing director in the private equity and M&A practice of financial services and insurance provider Marsh, says that managers of private equity funds can think about the litigation liabilities in a simple grid. Looking at who might get sued, there are two options – there are lawsuits brought against individual partners, and then there are lawsuits brought against the general partnership entity. Any group or person that is a party to the activities of a private equity firm or partner might bring a lawsuit, and these parties have included other shareholders to a portfolio company, employees or management of the portfolio company, lenders to the portfolio company or, while this is rare, a GP's own limited partners.

Most GPs, if asked which of these many forms of risk they would like to mitigate against, will answer, ?All of the above.? In fact, many insurance companies will offer a comprehensive policy that covers most liabilities inherent to doing business as a private equity firm and private equity person. ?It all goes under the umbrella of private equity fund and management liability insurance,? says Cuoco.

Fortunately for general partners (and unfortunately for insurance providers), limited partners have not been frequent litigators against GPs. There are a number of reasons for this, chief among them the desire for serious LPs not to acquire a reputation as a litigious investment partner and therefore become an LP non grata among top GP groups. That said, limited partner suits have happened. The case brought against buyout firm Forstmann Little by one of its LPs, the state pension fund of Connecticut (settled in 2004), was a textbook example of an such a risk coming to life. Connecticut accused Forstmann Little of having breached its fiduciary duty and the terms of its partnership agreement.

Cuoco notes that lawsuits of this ilk can also stem from administrative problems within the firm. For example, a limited partner might sue if the delay of an in-kind distribution was mistakenly delayed, during which the price of the stock in question plummeted.
Much more common in private equity, however, is the lawsuit against an individual general partner who sits as an outside director on the board of a portfolio company. The insurance used to cover the liabilities tied to this position is typically called directors and officers insurance, or D&O insurance. Policies in this area are typically packaged by the seat. ?You want to make sure you have this coverage for any board seat that the private equity group puts someone on,? says Cuoco, noting that a good policy is designed to automatically cover each new portfolio investment where board seats are taken.

At the private equity firm level, D&O insurance is not as expensive as many general partners think. Usually the portfolio companies themselves pay for the coverage of their own directors as a primary policy. The private equity-level policies are typically structured with ?double excess? coverage, meaning the coverage only responds when the portfolio-level coverage is exhausted and when the portfolio company itself is unable to indemnify its directors or officers due to insolvency.

Indeed, portfolio company bankruptcies are usually the source of most private equity firm insurance claims, says Cuoco. Good insurance ?should protect the fund and its individuals against, basically, an ugly bankruptcy,? he says.

Lawsuits do not often occur in good times. But when a portfolio company fails, GPs on the board are sometimes accused of mismanagement. Unsecured creditors, in particular, are very likely to be aggrieved when a company fails and will seek redress from the individual board members or the private equity sponsors they come from. Cuoco notes that insurers have paid claims to private equity policy holders in cases where unsecured creditors have brought suit. He adds: ?Most of the bankruptcy scenarios we've seen have been with privately held companies.?

Claim game
Danyalle Brinsmead, an insurance professional in Marsh's London office, notes that her firm's European division has to date counted more than 50 claim notifications against Marsh's private equity fund and management liability policy. The majority of these have been related to a private equity professional sitting as an outside director on the board of a portfolio company. In most of these cases, a liquidation of a portfolio company is the trigger event. (However, a number of cases have involved aggrieved losing bidders as well as disputes with minority shareholders).

Not surprisingly, claims come from two of the markets where private equity is most active – the UK and Germany.

Such claim notifications are becoming a more frequent event. ?Whether this is because private equity firms have been encouraged by Marsh as their insurance broker to notify all potential circumstances [to us] or whether it shows that litigation is becoming a more frequent occurrence is unknown,? Brinsmead says.

Brinsmead relates two case studies to illustrate how claims are paid to private equity clients in real-world scenarios (of course, the names of all parties involved have been obscured). In the first case, a private equity firm had invested in a UK portfolio company and appointed a representative to the board of directors. As part of the deal, the founder of the company relinquished control but retained a significant minority stake. The company eventually crumbled and went into receivership. Several of the company's exdirectors then bought the company's residual assets, turned the new business around and profited handsomely. The founder sued the private equity directors for deliberately running the company into the ground in order to defraud him of his original equity stake and then turn a profit. The suit was eventually dismissed, but an insurance policy paid out more than £1 million to cover the private equity firm's legal costs.

A second true-life scenario, this time in Germany, speaks to the rising levels of debt across the industry. A private equity firm invested in a portfolio company through that entity's parent company. The firm appointed a partner to the parent company's board of directors. Both the parent company and the subdivision eventually went into liquidation. A group of creditors subsequently filed suit against the board members, claiming that the parent company had made a loan to the subdivision that unlawfully put the interests of the private equity shareholder above the creditors. In this case, damages were awarded to the plaintiffs. In response, the insurance policy has to date paid out more than £1 million to the private equity firm, with more claims possibly to come.

Reps and warranties
Private equity fund and management liability insurance usually goes into effect when a party claims that it has been the victim of private equity mismanagement or malfeasance.

Sometimes it is the private equity firm itself that claims victimhood. On occasion, due diligence is not enough to uncover the true state of a portfolio company's health, and the private equity firm does not realize this until after it is the owner of the asset in question.

Emerging in London in the 1970s, representations and warranties (R&W) insurance has long been used to cover unknown problems that might arise following the sale of assets from one party to another. In its early days, R&W was mainly packaged as off-the-shelf protection used by the seller of an asset to tie up unknown loose ends after a transaction takes place, protecting the seller against post-transactional claims from the purchaser of the asset.

R&W insurance has since evolved into both a defensive and a strategic tool that can be held by either the buyer or seller of an asset. Depending on the nature of the transaction, the seller of an asset may provide the buyer with total, some, or no indemnity – i.e., guarantees – against breaches of the seller-provided list of reps and warranties. ?What changes is the market place – not so much the insurance product,? says Gary Blitz, a managing director of Aon Financial Solutions Group who also has a 20-year legal background that includes developing transactional insurance products with insurers.

One of the key differences between R&W insurance and some of the other types of M&A and transactional liability products is that R&W addresses an unknown liability, whereas some of the other types of insurance address known risks – such as pending litigation and environmental remediation, says Henry Jennings of US and Europe-based insurance broker Integro.

The appeal of R&W insurance to private equity firms that are selling assets follows from the liquidity and returns requirements for which these close-ended, limited partnership funds are subject. ?When you're a large public company that is acquiring or selling a company, your wherewithal to bear these frictional risks is better than a private equity fund that is making an investment for a limited period of time and does not want to have its investors' returns adversely impacted by having to make provisions on its balance sheet for long-tailed liabilities,? notes Blitz.

For private equity firms that are purchasing assets, R&W insurance may be attractive in circumstances where the seller does not offer indemnity, says Jennings. This is often the case when the asset being sold is a public company, or if the asset is a private company but with scattered shareholders, or in bankruptcy situations. If the seller does provide indemnity – but not enough for the buyer to be comfortable – R&W insurance can also be used to provide additional coverage or extend the length of the coverage.

Such was the case for UK-headquartered mid-market buyout specialist Barclays Private Equity, which initially used R&W (better known as warranty and indemnity in Europe) to back up the warranties being provided in the sale and purchase agreement for a transaction where the seller was restructuring its balance sheet. With its positive experience using R&W insurance, Barclays again lined up coverage in a pre-emptive, strategic move for a transaction in 2004, although changing circumstances around the deal structure meant that the firm ultimately did not need to implement the policy.

In some cases, GPs selling or bidding for assets via an auction process can utilize R&W insurance to affect the pricing of a transaction. ?As a seller, you can direct a buyer to look to insurance [for indemnity]. If you're a buyer, you can make the deal more attractive to a seller by requiring less indemnity or escrow from the seller and supplementing the seller's indemnity with a R&W policy,? says Blitz.

Because the findings from the due diligence conducted by insurers can assist in the buyer's valuation of the asset, sometimes the result is a decision not to buy coverage at all. Consequently, while many insurers will conduct an initial consultation for free, they will require a fee – usually from $10,000 on up depending on the transaction – to initiate a formal due diligence effort by the insurance carrier, according to Rodney Choo, a principal at Integro. If a policy is purchased, the due diligence fee is then typically offset against the price of the policy.

Private equity firms' growing interest in R&W insurance is backed by numbers. For insurance broker Marsh, there was a 100 percent increase in buyouts utilizing R&W insurance put through by the firm for its clients in 2005 versus 2004, Andrew Hunt, head of Marsh's European practice for transactional risk in private equity and M&A insurance told sister publication Private Equity International.

At Aon, ?we do a lot of [transactional insurance] with corporate M&A, but the general sense is that, far and away, the private equity funds are the biggest users and the biggest source of inquiries – in my personal practice, there is a 50-50 split between strategic deals and private equity buys,? said Blitz, although he admits it has become harder to define because a number of the larger M&A deals seem to have private equity funds involved in some way or another.

Transactional insurance products, which also include tax insurance, environmental insurance and litigation buyout insurance, are widely used outside of the US for many of the same reasons that the products are used within the US, says Blitz, particularly in cross-border transactions where the acquirer is non-US and there is discomfort with the US legal system. ?Two of the more significant transactions this year have been acquisitions of US companies by non-US companies, to address concerns over our legal system – one involved R&W insurance and the other tax insurance,? adds Blitz. In the last year, for example, Aon saw cross-border transactions involving India, Mexico, France, Brazil, Chile, and Canada.

helpful aspect of transactional insurance policies is their flexibility, says Blitz, whether it's from a structuring standpoint or negotiating the words in the policy. For instance, within the context of club deals, in theory a policy could apply to just one member of the buying consortium. ?You need some cooperation in terms of the underwriting process, but there's no reason the insurance couldn't be approached this way,? says Blitz. ?However, usually the dynamic is to cover the entire transaction.?

A helpful aspect of transactional insurance policies is their flexibility, says Blitz, whether it's from a structuring standpoint or negotiating the words in the policy. For instance, within the context of club deals, in theory a policy could apply to just one member of the buying consortium. ?You need some cooperation in terms of the underwriting process, but there's no reason the insurance couldn't be approached this way,? says Blitz. ?However, usually the dynamic is to cover the entire transaction.?

Regardless of who is using the policy and for what reason, the key thing to remember for potential policyholders is that R&W insurance is not ?bad deal? insurance. As the saying goes, ?insurers don't insure burning buildings? – an adage that holds true in the realm of reps and warranties.

Insurance input
Getting extra help for reviewing potential policies not only helps to ensure adequate coverage, but can also help you land a better bargain.

Amid heightened governance and compliance requirements, particularly with the advent of Sarbanes Oxley, the US- and UK-based venture firm SV Life Sciences has taken out D&O insurance for virtually its entire portfolio, in addition to D&O insurance for the general partnership's own directors.

According to Don Nelson, SV's chief business officer, a crucial step to obtaining insurance coverage is having one's legal counsel review the policies. ?We have an attorney review every policy that we take out,? says Nelson. ?It's an important perspective to have, and an important step in achieving adequate coverage.?

For Carl Metzger, a partner in the Boston office of law firm Goodwin Procter, his work with private equity clients such as SV includes assisting them on the insurance front – such as evaluating insurance coverage for their portfolio companies, for the private equity firm itself, as well as specific types of coverage aimed at some types of transactions that GPs often engage in.

After a risk analysis determines that a GP would benefit from insurance coverage in a particular area, the task then is to assess the policies being offered by the insurers. While there tends not to be a set checklist of points to review, regardless of the category of insurance in question, not all insurance policies are created equal, says Metzger. ?Oftentimes, these types of professional liability policies can be improved by negotiation over the policy terms and conditions,? he says. Adds Metzger: ?In fact, without paying any additional premium, you can obtain enhancements to your policy simply by knowing what to negotiate for.?

What those points of negotiation are depends, in part, on which insurance carrier one is dealing with. ?Each carrier's form is different – it's not as if there is one standardized form used for D&O insurance,? says Metzger. ?So what is on the list of changes you should ask for will depend on the carrier, and it will also depend on where the insurance markets currently are for allowing changes.? Currently, the market is a ?soft? one, notes Metzger, where conditions tend to be more ?insuredfriendly? – that is, there is more negotiability in the terms and conditions of policies.

In terms of making changes to the policy form, Metzger also examines the specific operations of the GP in question. ?Even the same policy form might present issues for one firm versus another,? he says. For example, something as basic as the definition of ?private equity investing? might spur further questions, in terms of how the GP engages in its business and whether that qualifies as a ?covered activity.? Or, when defining which members of the firm are considered ?insured individuals,? additional clarifications may need to be made in the case of VC firms who have venture partners that are not ?partners? in the GP per se, but who the firm might want to include as insured parties in any case. To do so, the firm might need to make a special modification to the policy form.

?Private equity firms are spending more time now than they ever have before on looking at their overall litigation risk management strategy – insurance is a key part of that,? says Metzger. However, ?it's not as if every risk out there can be minimized by insurance, and insurance should not be thought of as a silver bullet solution. The question that every private equity firm should be challenging themselves with is, what are you doing to identify and mitigate the risks that your firm faces??