Goulston & Storrs partners with HUB International, a Chicago-based leading full-service global insurance broker, to provide this blog series.

Q. What are some of the insurance industry trends you are seeing in relation to Private Equity Transactions?

I would say the market, overall, is now embracing secondary transactions in a much more significant and meaningful way.

Q. For those reading this that may not be as familiar with that term, can you elaborate more on what defines a secondary transaction?

A secondary transaction is a vehicle used by many PE firms which allows for increased value creation, whereby a newly formed continuation fund will acquire assets from an existing fund within a firm’s existing portfolio. The general partner (GP) participates on each side of this same transaction.

Q. The insurance markets, justifiably, can be cautious in their approach to new risks.  What challenges did secondary transactions have to overcome, initially, in terms of responsiveness from insurance carriers in the representations and warranties insurance (RWI) market?

RWI was created to facilitate classic M&A transactions by enabling parties to allocate to a third-party insurer some or all of the risks of a seller’s breaches of representations and warranties under a purchase and sale agreement (R&Ws). As a result of 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 often underwrote secondary transactions in the same manner (and with the same limitations and exclusions) in which they might underwrite a typical M&A transaction. This caused some heartburn for buyers and slower adoption by R&W insurers of RWI for secondary transactions. For example, a R&W insurer might expect the same level of diligence that is undertaken in a classic M&A transaction and impose broad coverage exclusions if that diligence was not undertaken. The insurer also would exclude coverage for certain seller obligations apart from R&W breaches, thereby requiring the seller or GP to provide an indemnity to fill that gap in coverage.

Q. It seems the coverage is continuing to evolve, please elaborate on ways this coverage has seen recent improvement?

Insurers have recently started to adopt RWI in GP‑led restructurings and other structured secondary transactions. There are a number of reasons why the innovation has focused on the GP-led subset of secondary transactions, including that the R&W insurer will require the GP’s cooperation in its underwriting process.

First, R&W insurers have modified their diligence requirements. Secondary buyers in structured secondaries often conduct relatively minimal diligence into the accuracy of R&Ws in the purchase and sale agreement, including those made about portfolio companies (in recapitalizations of PE funds) or other underlying assets or investments (in recapitalizations of hedge funds, real estate funds or credit funds). In traditional M&A, R&W insurers rely heavily on the buyer’s due diligence to reduce both the risk of fraud and the risk that a liability will not be timely discovered and paid (i.e. “timing risk”).

As to the fraud risk, due diligence may identify discrepancies or other information that reduces the risk of fraud by the seller. As to the timing risk, a careful diligence exercise may identify problems that otherwise would remain undetected. Liability for those problems is then transferred to the seller either in the form of a purchase price reduction or a specific indemnity.

Note that R&W insurers sometimes forgo buyer diligence in classic M&A transactions. Although most RWI policies insure the buyer (i.e., “buy-side” RWI policies) and are the buyer’s primary recourse for a breach of a R&W, certain RWI policies insure the seller for its indemnity obligation to the buyer (i.e., “sell-side” RWI policies). In sell-side RWI policies, the buyer does not share the results of its diligence with the insurer. In lieu of relying on the buyer’s diligence, the R&W insurer interviews the seller, company management, and their outside advisors to reduce potential fraud and timing risks.

In GP‑led restructurings, R&W insurers have recognized the unique risk profile of those transactions by adopting an underwriting approach that incorporates certain aspects of sell-side RWI. Specifically, the insurer expects to interview the GP, as well as its internal and external compliance teams, to reduce the fraud and timing risks. The success of the underwriting process depends on a cooperative GP that is incentivized to engage in that process.

Second, R&W insurers have recently begun to expand coverage of certain GP-indemnified obligations. In most structured secondary transactions, the GP agrees to provide an indemnity not only for breaches of R&Ws, but also for certain specific liabilities (“Excluded Obligations”). Excluded Obligations typically include:

• liabilities related to divested investments for which the GP has the right to claw back past LP distributions;
• certain of the sellers’ tax obligations;
• violations of governing documents; and
• other acts and omissions, including the GP’s breaches of fiduciary duties.

Historically, R&W insurers would not cover Excluded Obligations for various reasons, including a lack of buyer diligence into those potential liabilities. Recently, R&W insurers have begun providing that coverage where the PE sponsor has excellent compliance mechanisms and the GP agrees to play an active role in the underwriting process.

Q. What are the main areas one should focus on when considering this coverage?

Unlike other types of insurance policies, nearly any provision in a RWI policy is open for negotiation. As RWI policies adapt to structured secondary transactions, attorneys for GPs and secondary buyers will fill a valuable role in improving the clarity of drafting and the certainty of coverage, particularly by identifying situations in which policy terms that were designed for classic M&A are inappropriate for structured secondary transactions. As RWI policies for structured transactions continue to take shape, GPs and secondary buyers will likely focus their policy negotiations on five key concerns.

1. Complete Fraud Protection: The secondary buyer will seek to ensure its coverage is fully and entirely protected from the fraud, misconduct, or knowledge of the GP. Although the intent of these RWI policies is to provide such protections, careful drafting is needed to avoid any possible ambiguities.
    
2. Scope of Claims Documentation: It is important to consider what information secondary buyers are required to provide to the insurer in the event of a claim and whether those requirements conflict with the secondary buyer’s rights or obligations under the purchase and sale agreement.
    
3. Administrative Control: Given that the GP likely will be considered an insured under the RWI policy, the secondary buyer will want to maintain control over certain administrative functions, including retaining the right (or the exclusive right) to provide notice of claims or even to direct the manner in which policy proceeds are paid.
    
4. Order of Recourse: When coverage supplements (as opposed to replaces) the seller’s indemnity under the purchase and sale agreement or when the insurer is providing coverage for both breaches of R&Ws and excluded obligations, buyers should pay close attention to the order of recourse as between the indemnity and the insurance. That requires drafters to clarify the situations in which the RWI is the primary recourse or vice versa, and whether payment of one type of coverage erodes the total amount of coverage available for other types of coverage.
    
5. Limit Claims Against GPs: GPs will seek to limit the insurer’s ability to bring subrogation claims against them to situations in which they have committed fraud.

Importantly, after these issues have been negotiated and resolved throughout multiple structured secondary transaction RWI policies, the resolutions will likely become a standard part of future policies as R&W insurers improve their policy forms incrementally over time.

Q. Where do you see this coverage in the future?

It is common in structured secondary transactions for the R&Ws relating to portfolio companies to be qualified by the GP’s knowledge, which is often subject to a reasonable inquiry standard. One of the challenges with knowledge qualifiers in structured secondary transactions, is that the secondary buyer bears the burden of demonstrating that a breach has occurred. In that scenario, the buyer must demonstrate not only the inaccuracy of the relevant R&W, but also what the GP knew or should have discovered had it conducted a reasonable inquiry. For that reason, “flat” or non-knowledge qualified R&Ws are preferable from the secondary buyer’s perspective. Currently, it is difficult to obtain RWI coverage for flat portfolio company R&Ws in the absence of diligence with respect to the matters covered by those R&Ws, although there are some signs that coverage is broadening as insurers further appreciate the relatively lower risk profiles of structured secondary transactions.