January 26th, 2021

Private Equity, M&A and Tax

M&A Insurance on Secondaries Transactions

By: Tan Pawar

Utilising insurance to reallocate risk on GP Led Secondaries/‘Fund to Fund’ deals

Private equity and other closed-ended private funds typically require investor’s capital to be locked in for a considerable period of time. Investors, however, may wish to partially or completely exit a fund position earlier than they had initially anticipated by way of a ‘secondary’ disposal of their limited partner (LP) interest. Alternatively a GP led disposal of an entire portfolio can extend an investment cycle or release capital for all investors into the fund.

The transfer of an interest in a fund, as with the transfer of any asset, may result in risk that needs to be allocated between the parties. Set out below are examples of different dynamics of secondaries deals that have utilised warranty and indemnity insurance (W&I) which the team have advised on.

In this regard, warranty and indemnity (W&I) insurance has developed into the primary source of recourse for acquisitions and buy-outs for private equity, but has not typically played a significant role in the secondaries fund market.

However, in the last 24 months this has started to change, with an increase in the use of W&I policies being used in ‘Fund to Fund’ and General Partner (GP) led restructuring transactions, a trend we can expect to continue.

Given the underperformance of certain private equity portfolio investments in the current climate, there is likely to be an increase in the number of funds who seek fresh capital after an investment period has expired (rather than winding up its firm when the investment horizons have not yet been fulfilled) in order to maximise value. Given the underlying mechanics of a secondary transaction are fundamentally similar to a primary M&A portfolio disposal, the BMS PEMAT team, having worked closely with selected W&I insurers, are expertly placed to assist funds with their secondary deals.

Secondary disposals and W&I mechanics

Compared to the warranties given by management in relation to the disposal of a portfolio business, the warranties given by the GP on a secondaries disposal are limited. The warranties provided by the GP will typically consist of ‘fundamental warranties’, relating to legal title of the partnership interests and capacity to sell such interest, and a limited range of operational warranties, such as a general tax warranty and confirmation there is no ongoing disputes or litigation. Often many of the operational warranties given by the GP will be limited to “seller awareness” as those giving the warranties (the members of the general partner) will not be involved in the day to day running of the portfolio businesses so they cannot speak to their operational performance on the ground.

On the basis the limited warranty package provided is considered proportionate by the insurers vis-à-vis the level of due diligence and disclosure exercise that has been carried out, the structure of a secondaries deal lends itself well to a W&I insurance solution to provide additional recourse which, without W&I insurance would not be possible.

Insurers are comfortable insuring fundamental warranties on fund transactions as the ownership of the portfolio businesses that the warranties speak to can be diligenced and are often information matters that are publically available. Where insurers may find coverage harder to offer is on matters pertaining to the performance of the portfolio businesses specifically or more detailed operational warranties where there is limited due diligence available for them to review and form their own independent view of the risk.

As with W&I primary deals, due diligence remains paramount and should aim to mirror or match the warranties that the incoming acquirer of the interest is seeking to insure.

Another area that insurers may be willing to provide cover is for ‘Excluded Obligations’ in the underlying transaction documents. Insurance can step in here (if coverable in the circumstances) to remove this continued liability that would remain with the seller post transaction and allow this risk to be moved elsewhere (either within the W&I policy or within the tax and contingent risk market). Insurers will need to assess the scope and form of the excluded obligations as well as the information available to the selling LP regarding the trigger events that would crystallise the seller’s liability. This additional cover provides considerable value to assist a seller with a clean exit on the one hand, and allows a buyer to gain the comfort of recourse, on the other.

Due to the more limited nature of the warranties, insurers require very few coverage restrictions or exclusions in the policy. Typically these only include fraud by the insured or known matters. Insurers may consider cover for limited warranties speaking to the underlying portfolio assets, however, they will require comfort from conducting more detailed underwriting, in particular:

  • Due Diligence – what documents can be provided? e.g. financial information, board pack, data room, independent valuations etc.
  • Disclosures – what level of disclosure is available and from who? i.e. a GP board observer or the members of the portfolio company’s board.

When and why use insurance on a secondaries deal?

  • Insurance can allow funds to maximise the value of their portfolio investments by disposing of them efficiently and at a more advantageous time.
  • Insurance can provide credit risk protection to a new LP investor coming in to a mature fund.
  • The buyer / LP can potentially get a wider set of warranties insured than could typically be negotiated on a deal without insurance i.e. synthetic warranty package.
  • The M&A market is well placed to match what can be an extremely compressed transaction timetable.
  • This product provides a solution where a fund is underperforming or distressed and can be used in collaboration with or alternatively to other M&A insurance solutions such as:
  • Fund Liquidation Insurance (to avoid the ‘fund family’ i.e. GP, LPs, administrators as insureds having to worry about clawbacks in the future which allows full distribution of capital and a saving of annual costs to keep holdback provisions); or
  • Special Situations Insurance (including creating entirely synthetic W&I policies for companies being sold out of administration).

Process and Pricing

The insurers will expect to see all of the due diligence available and will provide underwriting questions for the insured to answer along with a short underwriting call. If the specific circumstances align for this insurance to be purchased then insurers will likely offer nil recourse policies and at a premium rate that is similar to a W&I policy or most probably lower given that the majority of the warranties will be fundamental in nature.

Case study 1 – Fund wind up

A GP disposed of an entire portfolio to another fund it managed which had a mixture of existing and new investors. The selling fund (Fund 1) was unable to wind up on the basis there would be no recourse for the acquiring fund (Fund 2) in the event there was a breach of warranty contained in the acquisition agreement. 12 months following the disposal, Fund 1 took out a ‘sell-side’ W&I policy that provided cover for the warranties which Fund 2 could make a claim against if necessary.

The GP set up an SPV and Fund 1 novated the policy to the SPV which allowed Fund 1 to wind up whilst providing Fund 2 with recourse in the event of a breach. The administration cost saving of Fund 1 winding up 4 years earlier than it would otherwise have been able was many multiples of the premium paid. It also had the added benefit that in the event of a claim Fund 2 did not have to pursue Fund 1.*

*Case study 1 references a transaction that the BMS team advised on prior to joining BMS

Case study 2 – Extend portfolio investment cycle

A large UK GP engaged the team early on in the disposal of a portfolio from one fund (Fund 1) to another (Fund 2) in order to extend the investment cycle of the portfolio. Fund 2 was managed by the same GP as Fund 1 but had new investors who were seeking market standard protection in the acquisition agreement.

Fund 2 took out a ‘buy-side’ W&I policy thereby allowing Fund 1 a ‘clean exit’ with a £1 financial cap which meant they could release capital for all investors in the fund without threat of a call on the capital in the event of a claim for breach of warranty. The team’s involvement early on with the new investors’ advisers meant that we could assist conversations as to the level of DD required by the insurers and facilitate a smooth transaction process.

About the BMS Private Equity, M&A and Tax Division

Every transaction is different and we pride ourselves on being able to structure tailored M&A insurance solutions with the broadest coverage in a clear and concise manner.

We have access to insurance capacity across the world and have developed strong relationships with M&A and Tax insurance markets in London, Europe, North America and Asia.

Our team is a group of multi-disciplined professionals with backgrounds in M&A, Insurance, Law, Tax, Finance & Accounting, and Litigation. With our global reach and experience, we have extensive expertise of cross-border and domestic M&A transactions.

We partner with our clients and their advisers to help them navigate efficiently through the course of a transaction. This entails an in depth understanding of the transaction dynamic, our client’s commercial goals and identifying potential obstacles as early as possible. This process allows us to provide innovative insurance solutions which facilitate transactions regardless of the complexity, size and sector, all within your transaction timetable.

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Pawar Tan

Tan Pawar

Head of Private Equity and M&A

T: +44 (0)20-7480-0264
M: +44 (0)7341-133-007
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Andrews Dean

Dean Andrews

Head of Tax and Restructuring Liability Insurance

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M: +44 (0)7876 815 643
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Wallace Sophie

Sophie Wallace

Divisional Director

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M: +44 (0)7824-605-613
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Leitch Harry

Harry Leitch

Director, Head of Deal Origination

T: +44 (0)20-7480-0346
M: +44 (0)7770-990-368
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