Q. What are some of the trends in the insurance industry that you see with regard to private equity transactions? I would say the market, as a whole, is now embracing secondary trades in a much more meaningful and meaningful way.
Q. For those reading this who may not be as familiar with this term, can you tell us more about what defines a secondary transaction? A secondary transaction is a vehicle used by many private equity firms that enables increased value creation, whereby a newly formed continuation fund acquires assets from an existing fund within a company’s existing portfolio. The GP participates on both sides of this same operation.
Q. Insurance markets can rightly be cautious in their approach to emerging risks. What challenges have secondary transactions had to overcome, initially, in terms of insurers’ responsiveness in the representation and guarantee (RWI) insurance market? RWI was created to facilitate conventional M&A transactions by allowing parties to assign all or part of the risk of a seller’s breach of representations and warranties under a purchase contract to a third party insurer and sales (R&W). Due to RWI’s rapid growth in the context of standard M&A transactions, insurers found themselves understaffed and with limited resources to devote to innovation. As a result, R&W insurers have often entered into secondary transactions in the same manner (and with the same limitations and exclusions) in which they might enter into a typical M&A transaction. This caused buyers heartburn and slower adoption by R&W insurers of RWI for secondary transactions. For example, an R&W insurer may expect the same level of diligence undertaken in a typical M&A transaction and impose broad exclusions of coverage if this diligence has not been undertaken. The insurer would also exclude coverage of certain seller’s obligations other than R&W breaches, thereby forcing the seller or general partner (GP) to provide indemnity to fill this gap in coverage.
Q. It appears the coverage continues to evolve, please explain how this coverage has improved recently? Insurers have recently started adopting RWI in GP-led restructurings and other structured side transactions. There are a number of reasons why the innovation has focused on the GP-led subset of secondary transactions, including the fact that the R&W insurer will require the GP’s cooperation in its underwriting process.
First, R&W insurers have changed their due diligence requirements. Secondary buyers in structured secondary institutions often perform a relatively minimal verification of the correctness of R&W in the purchase and sale contract, including those relating to holding companies (in recapitalizations of PE funds) or others. underlying assets or investments (in recapitalizations of hedge funds, funds or credit funds). In traditional mergers and acquisitions, R&W insurers rely heavily on buyer due diligence to reduce both the risk of fraud and the risk that a liability will not be discovered and paid on time (i.e. ie the “timing risk”).
With respect to the risk of fraud, due diligence can identify discrepancies or other information that reduces the risk of fraud by the seller. When it comes to time risk, careful due diligence can identify issues that would otherwise go undetected. Responsibility for these problems is then transferred to the seller either in the form of a reduction in the purchase price or a specific compensation.
Note that R&W insurers sometimes forgo buyer diligence in classic M&A transactions. Although most RWI policies insure the buyer (ie side ‘RWI policies). In seller-side RWI policies, the buyer does not share the results of their due diligence with the insurer. Instead of relying on buyer’s diligence, insurer R&W interviews the seller, company management and their outside advisors to reduce potential risks of fraud and timing.
In GP-led restructurings, R&W insurers have recognized the unique risk profile of these transactions by adopting an underwriting approach that incorporates aspects of the sell-side RWI. Specifically, the insurer expects to interview the GP, as well as its internal and external compliance teams, in order to reduce the risks of fraud and timing. The success of the subscription process depends on a cooperative GP who is encouraged to engage in this process.
Second, R&W insurers have recently started to extend the coverage of certain obligations indemnified by GPs. In most structured secondary transactions, the GP agrees to provide compensation not only for violations of R&W, but also for certain specific liabilities (“Excluded Obligations”). Excluded obligations generally include:
- liabilities related to transferred investments for which the General Partner is entitled to recover past distributions from the Partnership;
- certain tax obligations of sellers;
- violations of constitutive documents; and
- other acts and omissions, including GP breaches of fiduciary duty.
Historically, R&W insurers did not cover Excluded Bonds for a variety of reasons, including a lack of diligence on the part of the buyer with respect to these potential liabilities. Recently, R&W insurers have started providing this coverage when the PE sponsor has excellent compliance mechanisms and the GP agrees to take an active role in the underwriting process.
Q. What are the main areas to focus on when considering this coverage? Unlike other types of insurance policies, almost all of the terms of a RWI policy are open for negotiation. As RWI policies adapt to structured secondary transactions, attorneys for GPs and secondary buyers will play a valuable role in improving clarity of drafting and certainty of coverage, particularly in identifying situations in which terms policies that were designed for conventional mergers and acquisitions are unsuitable for structured transactions. secondary operations. As RWI’s policies for structured transactions continue to take shape, GPs and secondary buyers will likely focus their political negotiations on five key concerns.
- Comprehensive fraud protection: The secondary purchaser will ensure that their coverage is fully and fully protected against fraud, misconduct or knowledge of the general practitioner. Although the intention of these RWI policies is to provide such protections, careful drafting is necessary to avoid any possible ambiguity.
- Scope of complaint documentation: It is important to determine what information secondary purchasers are required to provide to the insurer in the event of a claim and whether these requirements conflict with the rights or obligations of the secondary purchaser under the contract of purchase and sale. .
- Administrative control: Since the GP will likely be considered an insured under the RWI policy, the secondary buyer will want to retain control of some administrative functions, including retaining the right (or exclusive right) to notify claims or even to direct the manner in which the proceeds of the policy are paid.
- Appeal order: When full coverage (rather than replacing) the seller’s indemnity under the purchase and sale contract or when the insurer covers both R&W violations and excluded obligations, buyers should bring particular attention to the order of recourse between indemnity and insurance. This forces the drafters to clarify when the RWI is the primary recourse or vice versa, and if paying for one type of coverage erodes the total amount of coverage available for other types of coverage.
- Limit claims against general practitioners: General practitioners will seek to limit the insurer’s ability to exercise subrogation remedies against them in situations in which they have committed fraud.
It is important to note that once these issues are negotiated and resolved under multiple RWI Structured Secondary Transactions policies, resolutions will likely become a standard feature of future policies as R&W insurers gradually improve their policies over time. .
Q. Where do you see this coverage in the future? It is common in structured secondary transactions for R&W relating to portfolio companies to be qualified by the knowledge of the GP, which is often the subject of a reasonable standard of investigation. One of the challenges with knowledge qualifiers in structured secondary transactions is that the secondary buyer has the burden of demonstrating that a breach has occurred. In this scenario, the buyer must demonstrate not only the inaccuracy of the relevant R&W, but also what the GP knew or should have found out if he had conducted a reasonable investigation. For this reason, “flat” or unqualified R&W are preferable from a secondary buyer’s perspective. At present, it is difficult to obtain RWI coverage for the R&W of flat holding companies without due diligence regarding the matters covered by these R&W, although there are signs that the coverage is failing. expands as insurers appreciate more the relatively lower risk profiles of structured secondary products. transactions.