Insurance tends to be regarded by most people as, at best, a necessary evil. This probably holds true of all of the types of insurance being bought by private equity firms, except perhaps what the purveyors of insurance call Warranties & Indemnity (W&I) insurance, and its users call transaction insurance. The reason W&I can get an almost sanguine reception from venture capitalists is that it can overcome deal breakers at that all important point; when an investment is exited.
Directors & Officers (D&O) and Professional Indemnity (PI), however, insure against the unknowable, may-never-happens and as such have no immediate efficacy to rationalise the, sometimes prohibitive, cost against. But given that D&O and PI ultimately serve as personal wealth and integrity protectors, in today’s increasingly litigious environment the it-won’t-happen-to-me mentality looks faintly ridiculous and so the pertinence of D&O and PI has increased.
There is also something called Errors & Omissions (E&O), which is tantamount to PI, and, as one broker wryly observes, was probably only concocted by the pomposity of someone in the insurance market deciding they couldn’t possibly sell something called PI to anyone who couldn’t rightly be called a professional.
Buying insurance ought to be simple, although because the insurance market is highly regulated for the most part it is not possible, in the UK at least, to buy insurance direct from an insurer. Instead, anyone seeking the sorts of cover most venture capitalists are going to be interested in must find and appoint a broker to deal with the insurer on their behalf. The broker is also referred to as an adviser, since that is what it does for its clients, and the insurer is also known as an underwriter, in case the over-use of acronyms isn’t enough to confuse.
It helps to understand how the insurance market works because without that knowledge it’s difficult to ascertain where and if a broker is in fact adding value. The broker’s job involves having a solid understanding of the insurers involved in the space in which they need to obtain cover. That means knowing which insurers underwrite which types of cover: about 10 or 15 are in the market for D&O; just three or four on straight W&I; and only three will cover environmental issues. On top of that the broker must know which ones take lead underwriter positions, how much capacity they have, their minimum transaction size, contractual issues they will raise and what their immovable issues are.
The paucity of insurers operating in the private equity-related insurance space (D&O aside), explains the caution given by Barry Wingate at HSBC Insurance Brokers: “One of the worst things to do is to have two brokers going [into the market] because the underwriters don’t like it.” Clearly the insurers don’t like it because they effectively end up being asked to price the same business twice, albeit on the basis of potentially differing parameters as defined by the broker on behalf of the client. “Usually it’s a case of people asking us to come in and chat to us about [their requirements], they do a sort of beauty parade and then go with one broker,” says Wingate.
Having got a handle on all of that, the broker must get it right on the first approach because if one underwriter is known in the market to have turned down an underwriting opportunity it’s going to be hard to place that business elsewhere. But with the lead underwriter committed the broker can then go out to the rest of the insurance market to those insurers interested in taking non-primary layers.
Layers in excess of the primary are cheaper to place principally because, like the equity tranche in a private equity deal, the primary layer carries the most risk. This is because it is the insurer of the primary layer that will pay out first on any claim, up to the amount it has underwritten. Layers in excess of the primary only need pay out on a claim if it goes over the capacity of the primary layer. The good news, compared to the debt syndication market, is that once the broker has got the lead underwriter on board the rest of the market will fall in behind, and in acceptance of the terms and conditions agreed at the primary level. Clearly this is only good news if the broker has got the best deal in the first place.
This building of layers only applies to larger transactions, such as 3i’s sale of Go to easyJet last year, which required some £44m of insurance cover. Interestingly out of the four deals that HSBC Insurance Brokers arranged last year on behalf of private equity investors the easyJet/Go transaction was its smallest by a long chalk. Although that particular deal got a lot of publicity, most are so deeply bound in confidentiality clauses that they never get to see the light of day.
Part of the concerns with confidentiality is based on the fact that the very existence of insurance might encourage spurious, or other, claims, neither of which is in the interest of the policy holder or the insurer to cultivate, coupled with the fact that the private equity industry generally strives to maintain its opacity.
The sale of Go, the low cost airline bought by 3i from British Airways, to easyJet last year is well documented, largely by virtue of the fact that the boardroom corridors at 3i were said to be ringing with the sound of champagne corks popping on learning that easyJet had agreed to a £374m price tag and for the fact that the deal had not been helped by the detailed newspaper reporting of the reluctance of Go’s incumbent management, led by Barbara Cassini, to the deal.
“Most institutional investors are unwilling to give warranties so when buying from them you are not going to get as much warranty comfort. But the fact that you can insure the exposure can help the transaction to happen. Management teams, if they are the only warrantors, often feel they would like to take out insurance protection,” says Alena Watchorn of HSBC Insurance Brokers.
Institutional investors (venture capitalists) are unwilling to give warranties because to do so requires them to put money in escrow for a defined period of time, typically 18 to 24 months, but up to seven years for tax-related warranties. Being unable to distribute all of the returns on an investment to their investors will impact on the IRR, the performance of the fund. And, in turn, this will impact on the ability of the venture capitalist to raise a follow-on fund.
In addition to this reluctance, venture capitalists always point out that their role is as investors in a company, not hands-on day-to-day management and as such they could not possibly be in a position to offer up warranties and indemnities with impunity. So it falls on the shoulders of the management, typically the minority shareholders, to sign warranties and indemnities.
As Watchorn says, in such situations the management may look to insurance protection, which essentially means they offload the risk of a claim coming in by paying an upfront insurance premium. The management is then free to spend most of its gains without fear of anyone trying to claw it back at a future date. The insurer will, however, seek an alignment of interest, so there is typically an amount above which the insurer’s liability to pick up the claim kicks in.
For example, the management may be required to pay the first £1m of a claim, after which the insurer picks up the bill up to the full amount, providing it has insured up to that amount. There is also typically a minimum claim level that must be reached before an insurance policy activates. Such a policy, as described, in W&I terms is referred to as a seller or vendor policy.
“I started looking at W&I 15 years ago when there were only very simple seller policies. The seller would lay off their risk on the insurance policy for a premium of just over 1% of the amount they wanted covered, and the policies covered just about everything. They were very easy to do in PE situations where the PE firm was the seller and nobody wanted to be stuck with liability for giving warranties,” says Marco Compagnoni, partner and head of private equity at Lovells.
Back when seller policies were first being written they included cover for things like environmental issues and pensions liability. Today no one in their right mind would cover a pension fund liability, given that most actuaries point out that it is extremely hard, outside the exceptional cases, to determine whether a pension fund today will be adequately funded for any number of indeterminate tomorrows. Interestingly on the subject of environmental insurance, advisers today note that one of the first things they suggest a client does is search through its insurance archives because if it can lay hands on one of these old-style policies they generally have the insurer over a barrel when it comes to paying out.
Those cases are few and far between though, so for the most part it’s a case of going into this specialist market. Robert Martin joined ERM, the environmental consultancy, at the beginning of this year to start its financial solutions business, which looks to advise on insurance policies among other solutions.
Martin says of today’s market: “In America there are many types of policies, you can almost buy a policy for every type of risk you could envisage. For the rest of the world it’s a young market, there are five types of insurance but in reality you have to come up with customised solutions that fit your client’s needs.”
Outside of environmental and pensions and other negotiated exclusions vendor polices can in theory today include insurance cover for a whole host of maybes, although fraud on behalf of the seller is not covered.
Although vendor policies went out of vogue for a while they are to some extent back. In between times the purchaser or buyer policy emerged. Although vendor policies were usually signed over to the buyer at the time of sale, a purchaser policy is bought by the purchaser and designed to meet the buyer’s needs. For example, in the case of easyJet/Go it was a purchaser policy of £44m against a purchase price of £374m with £6m held in escrow and of that £6m, £3m was put up by Go’s management and £3m by easyJet.
A crucial difference between a vendor and a purchaser policy is that it covers fraud carried out prior to the sale of the business and issuance of the policy. Given the amount of due diligence carried out, and checked over by the insurer, it is not surprising that fraud is included since fraud would be of primary concern to the purchaser, who should have left no stone unturned in looking for anomalies. Another crucial difference is the pricing; vendor policies remain relatively cheap whereas purchaser policies can range between 3% and 9%, although you would struggle to find a policy at the lower end of that spectrum in the last couple of years.
It’s just as likely though that a deal will emerge with what brokers term a blended policy which is half vendor and half purchaser. This can suit private equity situations particularly where the management is only willing to give warranties and indemnities against what it has come away from a transaction with, or less. The buyer can then take out a purchasers’ policy to bring the insurance level up to that at which it feels comfortable that it can prove it has carried out its fiduciary duty.
“The purchaser policy will remain the growth policy because of the nature of its use for VC houses. The vendor policy is still utilised quite a lot: often you start talking about a vendor policy and it ends up as a purchaser policy. Where we have placed both vendor and purchaser policies the underwriters are going to have to look at due diligence that has been performed and the underwriter may raise points on the due diligence that the vendor is unaware of. But generally speaking it has not really caused us any major problems,” says Wingate.
For a while the purchaser policy ruled the day but then as venture capitalists became increasingly concerned about smoothing the pathway to exit, brokers claim that in the last 12 months interest in insurance solutions has balanced out between buy and sell side. Vendors for their part are seeking to work with a broker to identify what might arise as warranty issues on a sale with a view to achieving an insurance solution that will allay concerns of a potential buyer before that buyer disappears.
“I assume so many purchaser policies have fallen through that they are bringing back non-recourse seller policies as the market is much more in favour of them. Non-recourse seller policies are good because, as well as giving the warranting sellers peace of mind for the risks they actually cover, the insurance premium can usually be counted as a transaction cost for the sellers when computing their capital gains tax position. The premium is also usually shared (by agreement) pro rata across all the sellers, not just those giving the warranties. If the premium is £5m you will pay £1m of it if you own only 20% of the company,” says Compagnoni.
Unfortunately, insurance with all its clauses and exemptions, not to mention the exorbitant cost that has in some cases seen premiums rise four-fold over the last two years, is not a panacea. Matthew Judd, partner at Clifford Chance, says: “About one third of all the PE deals we see take W&I.”
“If you do a transaction properly and disclose properly you do not usually get warranty claims. In 18 years I have had two potential warranty claims come through: both got settled or went away. The number of real claims that come through still are quite small. The risk should be manageable if the sellers’ disclosure process is handled properly,” says Compagnoni.
Insurers for their part are not interested in deals where they have concerns that the parties involved are not acting responsibly. Jens Andreason, at AIG in Frankfurt says: “First is disclosure, second due diligence and third insurance. Insurance is a safety net for after one and two are complete.”
Even when disclosure and due diligence are handled properly and the insurer is able to satisfy the purchase or vendor’s policy requirements, insurance is not always the answer. “If there is going to be an issue [on a transaction] there are a number of ways to deal with it and insurance is going to be one of them. Other ways include retentions, escrows or pricing contingent risks. If we go down the insurance route there is a strong likelihood that it will not go the course and you may end up with one of the alternatives anyway. We often find the insurance broker gives their final quote and the buyer or seller says, ‘wow that’s a lot of money, let’s not bother’,” says Compagnoni.
The pricing issue
The insurance market has been what is termed ‘hard’ for quite a time now, which means that prices have gone up as insurers who suffered from a number of difficulties prior to September 11th and then as a result of September 11th gradually moved out of the market thereby reducing capacity. Some of that capacity has moved back into the market again and talk is of a ‘softening’, rather than a ‘soft’ market. This means pricing may improve for buyers, although it’s likely that insurers will move to becoming more flexible on terms and conditions before they start giving away cheap deals.
Directors & Officers (D&O) and Professional Indemnity (PI) Errors & Omissions (E&O) have suffered the same pricing surge, although there is the possibility of shopping around the ten insurers offering this cover to obtain a better deal. While E&O and PI/E&O fall into the realm of may-never-happens if it does happen the implications are potentially disastrous: lose part or all of your personal wealth and/or be declared bankrupt and lose the right to be a company director (under UK law), which would at best seriously impede the ability to function as a venture capitalist. As Mark Pangborn, co-founder of Howdens, an insurance broker specialising in D&O and PI cover, points out: “The law says a limited company limits loss. But if you are director of a company you have unlimited liability and there is no extent to which a genuine claim can be forestalled.”
One of the issues with D&O and PI/ E&O insurance is that there are plenty of brokers and insurers willing to put together such policies but not all of them understand how the private equity world works. Tim Coles of Howdens says: “Fifty percent of the policies that we look at contain contractual faults varying from the significant to minor. Ninety-five percent already have insurance, most take D&O cover and the majority take PI cover.”
Broadly D&O can relate to corporate governance issues of investee companies on which a board seat is taken and PI can relate to decisions taken on behalf of the management company, also referred to as the GP (general partner.)
But the lines quickly blur. Take the case of an investee company that gets into financial difficulties. A venture capitalist on the board of that company is bound to act in the interests of that company, even though those interests could conceivably be at odds with those of the general partner, which ultimately employs the venture capitalist and in which his personal wealth (typically through the shared profit mechanism) is tied up. If an insurance claim arose out of such a situation it is easy to image that both the D&O and the PI/E&O insurers might reject a claim on the basis that it fell outside their remit because they were simply unsure of the motivation of the venture capitalist, and what capacity they were acting in, at the time in question.
Pangborn suggests a remedy: “If you have PI & D&O policies with different underwriters it’s not impossible to make sure the policies dovetail. But if you have got the same underwriter it’s very hard for him to say it falls under neither policy. Having said that, if you bought two policies with different wordings, you could have a problem. My advice is that you want to get insurance products that are tried and tested and address the issues in language that is familiar and makes sense to you.”
However, he goes on to point out that while some regard the combination of D&O and PI/E&O in one policy as the ultimate solution, in the UK at least, that unfortunately opens another can of worms. “Even if you combine PI and D&O it is desirable to take and keep separate limits. There is a UK complication: the Income and Corporation Taxes Act meant there was confusion as to whether D&O was a benefit in kind because the company paid the policy premium. It was eventually determined that D&O would not be assessed as a benefit in kind if it only covered its subject matter and did not run for a period of more than 24 months,” Pangborn.
‘Only covered its subject matter’ rules out rolling PI/E&O into the D&O policy. It can be assumed that if a combined policy is treated as a benefit in kind at source then if a settlement arises as the result of a claim against the policy then that settlement payment could also be subject to the same tax treatment. Although Pangborn suggests it is desirable to take separate limits of cover for D&O and PI/E&O discussion arising from the private equity insurance seminar held by Marsh in London last month which indicated that recent hikes in premiums had led many venture capitalists to both lower their cover and in some cases continue with D&O but drop PI/E&O cover.
Interestingly at the same seminar Anthony Baldwin from insurer AIG’s M&A practice commented that the more clearly the insurer understood the modus operandi of a particular firm seeking such covers then the better the cover and pricing that could be offered. Baldwin acknowledged that uncertainty tends to be priced, upwards, into the premium. (This is converse to commentators experience of W&I insurance where it is sometimes felt there can be too much due diligence and the more due diligence that is done, the greater the premium is likely to be and more skimpy the cover actually offered. This attitude can cause deals to fall down though since buyers have been known to stall on due diligence in the expectation that the insurer will pick up the risk: invariably they don’t.)
With prices high and a choice of insurers that brokers can approach it’s worth leaving time to shop around. “A lack of time increases the bargaining power of the underwriter. It sounds ridiculous but it can take a month because this is a face to face market. Twenty-five percent of people we have seen who are going through the renewal process have been severely chronologically challenged, some with just three days to go. Extensions [on an existing policy] have draconian penalties if you take an extension and then don’t renew with them,” says Pangborn.
Making W&I, PI/E&O and D&O attractive and useful to private equity has involved the insurance industry, both brokers and insurers, building a good number of contacts within private equity and gaining a full appreciation of what it is that they do. As should be expected, that appreciation has been translated within these organisations as ways to sell more product to the private equity client base.
But it’s not all about supply, the demand is there too. “We are working with PE clients who are saying, ‘it’s all very good doing the deal stage but we have portfolio companies that have issues that come up outside the deal cycle.’ It’s these investee companies that they would like to give some assistance to on insurance matters,” says George Davis, co-leader private equity and M&A practice at Marsh.
Different brokers and insurers have approached the market in different ways. Some offer an across the board service and others will make internal referrals and others are sticking to their niche offerings. Marsh has opted for the full service offering, which it is calling PEML (private equity management liability.) This covers the staples of W&I, PI/ E&O and D&O plus crime, pre-acquisition due diligence and ongoing risk management.
Watchorn explains pre-acquisition due diligence: “Insurance due diligence work can be carried out when a PE firm is going to acquire a company. [The PE firm] will need to satisfy themselves that the insurance portfolio of the target company is adequate or find out what needs to be done to make it adequate, particularly where banks are going to come in and take security over the assets.” Ongoing risk management can encompass a plethora of insurance solutions, simply anything the broker or insurers has the expertise to broker/underwrite from buildings to environmental.
This potential for a full service insurance offering has changed the way brokers and insurers interact with venture capitalists. “The insurance solution has increasingly become overlaid with the other due diligence work that gets done, rather than due diligence being done and we are asked to comment on it,” says Davis. Although it’s fair to say it’s still early days. Even those that have recognised a wider relationship, beyond deal-by-deal and annual renewals, have only been operating in this way for a couple of years. Their efforts to date may not have reaped the rewards they might have hoped for initially but, given the hard insurance environment against which they have been operating, this is to be expected.
Beyond this there seems to be considerable interest in the emergence of W&I particularly in continental Europe. AIG is a leader in this area. “There are different traditions of how deals are done. There are also quite different legal environments governing sale and purchase across Europe and differences in how these are interpreted. For example, disclosures have an impact on actual exposure and therefore how we underwrite a transaction and how we structure a transaction so that it works in tandem with the underlying sale and purchase agreement. We have taken the view that we will amend products to fit with local customs and practices,” says Jens Andreason of AIG’s Frankfurt office.
As Andreason outlines, legal environments are one issue when operating in continental Europe, but an equally important issue is that of business culture. In France there is a culture of claiming and doing detailed accounting post deal completion. This saw a flood of small claims when the market there first opened and ultimately resulted in an exodus of insurers from the market when they realised how much the legal advice was costing them. Most contracts needed to be translated from French to English and then interpreted under French law. Part of that problem has been solved by raising the claim threshold within an insurance policy to €500,000. For the most part, in the case of W&I, the offering in continental Europe has grown in line with the growth of the private equity industry. France and the Netherlands have seen deal activity for some time but Germany’s long promised private equity deal flow yield has only started to filter through and so the market for W&I there is beginning to get underway.
While Europe will clearly offer expansion opportunities for brokers and insurers serving the private equity market so will the growth in secondary buyouts, where the seller is disinclined to give warranties and indemnities and the buyer is disinclined to buy without them. Distressed sellers of businesses have also contributed to the number of W&I policies that have been underwritten recently because if it is unlikely that the seller will be financially solvent enough to meet any future claim, insurance can be a solution. But as the economic situation picks up this source of W&I work may drop off.