Risky business

When PAI Partners announced in July 2006 the completion of a €1.04bn majority acquisition of SPIE SA, Europe’s second largest electrical engineer, everything smelled of roses.

Here was one of Europe’s oldest and most experienced private equity firms throwing its weight behind a European champion with international operations and high global ambitions.

SPIE’s chairman, Jean Monville, was effusive in welcoming on board PAI as a 87.25% shareholder in Financier SPIE – the holding company for SPIE – saying that it understood his business and would be supportive of development plans.

Yet on November 8, Financiere SPIE launched a criminal suit against PAI. It alleged that the Paris-headquartered private equity house had unjustifiably taken €12m in due diligence fees under circumstances that had been contested since earlier this year, when SPIE’s accountants queried it.

The language of the statement was frosty: SPIE’s 15 principal directors expressed a unanimous “loss of confidence in PAI”, adding that its “methods and practices are in total contradiction to SPIE’s values”.

By November 15, a joint press statement said differences had been definitively settled in a way satisfactory to both and that legal action was being withdrawn. There were changes at the top: Monville stepped down as president of the holding company to focus solely on the presidency of SPIE SA.

The spat underlined the rising risk of litigation against private equity, largely in the US, but now also affecting Europe. France itself figures prominently in this trend.

In other developments, industry players reveal a new category of claimant joining the club of litigants with dollar signs in their eyes, while one prominent insurance broker warns that higher risk could put a floor under the cost of cover.

Facing these challenges is a new breed of in-house, specialist risk manager, hired to ensure that the right kind and level of insurance is in place at the best price.

They have their work cut out as private equity makes increasing use of cover for management liability – Professional Indemnity/ Directors & Officers (D&O); transactions – Warranty & Indemnity (W&I)/ Tax Opinion etc; and for exits – Prospectus Liability etc.

Private equity firms are feeling edgier. When Marsh, a global leader in risk and insurance services polled them in the Americas, Europe and Asia Pacific two years ago, it found 40% expecting more lawsuits within 24 months. In a recent follow-up, that had risen to 47%, overtaking 43% who expected no change, while only 6% predicted less legal action.

In the US, a bellwether for litigation trends, federal shareholder class actions, one indicator of litigiousness, appeared to be rising again in 2007 after a decline in 2006, according to a September report from NERA Economic Consulting, a Marsh group company (see graph).

“Filings in the first half of 2007 increased 47% from the second half of 2006, indicating that the trend in filings may be changing directions,” NERA commented. Investor losses are a good leading indicator of filings, so warning of economic downturn in the US and elsewhere flag up the possibility of more and higher claims to come. Shareholder claims resulting from sub-prime losses are already on the rise.

Two years ago, private equity saw LPs as the most likely litigant. Now it is regulators – cited by 83% – a view at odds with Marsh’s claims database, which shows the biggest threat currently is minority shareholders of private equity-backed portfolio companies. These make up 46% of claimants in the US and 21% in Europe, while regulators account for only 2%.

Minority shareholders include, for example, those forced to sell out to private equity at the outset and others who stayed involved. Actions centre on claims that they had no say in how things turned out, or did not receive fair value, particularly when they see private equity firms exit with large profits.

Unsurprisingly, the most common lawsuit alleges breach of fiduciary duty, highlighting the duality of a private equity professional’s roles as equity investor and external director.

A new category of claimant has emerged this year, according to Neill Harman, senior vice-president at Marsh. It is customers of portfolio companies. Due to confidentiality, he could not identify parties involved, but noted that “people are increasingly seeing beyond the veil of the portfolio company to the private equity firm beyond.”

Insurers interviewed for the Marsh study cited excessive leverage and the greater size of acquisitions as two drivers of litigation. “If I was to add to that,” said Harman, “it is evident that private equity firms based in the UK are getting into ever more diverse territories, which brings uncertainties.”

In Harman’s view, litigants perceive there to be a deep pocket from overseas that is worth having a go at in a local court when things go wrong. Media reporting of private equity in general, and mega deals in particular, are deemed by some to have contributed to this perception.

“Our statistics back up that we’re increasingly seeing claims brought not in the UK but around Europe, though probably not extensively in Eastern Europe at the moment.”

Italy figures prominently in those stats, but the real stand-out figure is that 35% of the European claims notified to Marsh in 2006 were in France. “It just feels less and less UK,” says Harman.

The use of local courts is a headache for large, international private equity houses. “I’ve heard insurers say that if they’re in a provincial court in some territories, they will probably want to settle before trial,” says Harman. One reason is insurers’ perception that there is natural protectionism towards local businesses, employees and investors.

Geoffrey de Mallet Morgan, vice-president at Marsh, says private equity houses have responded in recent months by looking at how risk is transmitted through portfolio companies, how they interact with these, and what local jurisdictions can do about standardising ways of covering such liabilities.

“It’s very difficult to provide a rule of thumb or generic answer on the level of cover that people need,” he says. “The different countries around Europe have very different legal approaches and litigiousness.”

Private equity is not unaware of the risks. By nature, it deals with mountains of documentation and has longer deal-horizons, so tends to dot the ‘i’s and cross the ‘t’s carefully.

The great majority of private equity firms ensure that individuals are covered off, says Mike Lobb at Howden Risk Partners, brokers who specialise in management liability cover.

As lawsuits and payouts rise, more firms take out D&O insurance, raise the level of cover, and sift through contracts with a fine-toothed comb, having learned the hard way that what a policy excludes is what burns you.

With financial markets doing well in recent years, they have been pouring money into insurance, creating more competition and a ‘soft’ market where clients tend to be able to get broader coverage and for less cost.

‘Broader’ does not necessarily mean that private equity firms are getting what they expect from the market, cautions Lobb.

“Topical issues may not always be covered off. For example, extradition is a big issue for anyone exposed to the US.” (see separate article). So assessing exactly what is being paid for is essential.

Howden is one of few brokers writing its own policy wordings for management liability so they may say exactly what clients are getting and what they are not. Many brokers accept what insurers are willing to provide, then negotiate exclusions or additions.

“It is difficult to asses with certainty the percentage of M&A deals using transactions insurance, but we believe that this has remained around 10%-plus for the past few years,” estimates Teresa Jones, who heads up the Transaction Liability Unit for global risk manager and reinsurer, Aon.

However, she reports more private equity firms using transactions cover as their share of M&A activity has increased and insurance products have developed to the point where they are now “more likely to fit around the deal rather than forcing the deal to fit around the insurance”.

She adds: “A lot of underwriters in this field are now ex-corporate lawyers, so they’re very conversant with M&A language. Products are in plain English, more transparent, so it is easier to see what is in and out. If the deal timetable requires, you may be able to get these deals done in under a week.”

Jones’ colleague, Simon Tesselment, explains that with private equity now using insurance strategically, for example in auctions, it is assessing issues and talking to brokers earlier rather than viewing cover as a last-minute fix.

“We know of one firm at least that uses it on pretty much every transaction. And we did something recently where a private equity firm bidding in an auction used the product to allow the seller to give a much lower indemnity cap, then topped up with insurance to get where they wanted to be”.

Jones said Aon had done three or four deals in Q3 of 2007 to wrap up potential tax liabilities in insurance policies for private equity transactions.

Some private equity firms nevertheless report continuing difficulty getting warranty cover for issues outside of bog standard products.

“I think that’s part of the reason that we have never yet done a transaction with warranty insurance, although we look at it on every single one,” reveals Richard Babington, investment manager at London based NBGI Private Equity, an investor in established small to medium-sized ‘traditional economy’ businesses across the UK and which recently opened its new fund to external investors after achieving first close on £62.5m

.“When you go to an insurer with some issues, it can be the first time they have ever considered it, so they have difficulty formulating a commercial view on how or even if they can price it. Give it five to 10 years and familiarity with particular risks will increase, quoting will become more widespread and usage will rise accordingly.”

UK costs for standard transactions insurance have moved from around 2% to 4% of the insured deal limit two or three years ago to around 2% to 3% now, reckons Teresa Jones at Aon, although some private equity firms say this can rise to around 10% for special situations (e.g. specific known matters).

As activity has risen in Continental Europe, new entrants to underwriting have increased competition, bringing the range down from 4% to 8% to 2% to 4% over the same period, she adds.

Prices for insurance due diligence remain lower than for other aspects of investigation that are typically undertaken prior to the completion of an acquisition, says Richard Babington at NBGI PE.

“Part of this is the more commoditised nature of insurance due diligence, which drives up competition and suppresses fee quotes. But the key difference remains that insurance due diligence providers can often expect a future income stream if they end up broking the insurance package of newco. They can offset fees against income stream in a way that, just as for example, commercial due diligence providers would find difficult with a single, transaction-based payment.”

The risk officer at one private equity house, who wished not to be identified, said that his firm could usually look for a 15% to 20% reduction in the cost of insurance if paying for, say, a £100,000 policy. “£15,000 to £20,000 isn’t much on the bottom line, but it all helps at the end of the day.”

Some of the best insurance deals to be had are in doing carve-outs from larger companies, where private equity firms seek to have cover tailored exactly to the target company’s exposure. For example, a subsidiary of a massive conglomerate with environmental issues may itself have no such exposure. It is harder to squeeze more value out of insurers for standalone deals being done on a secondary basis.

Greater complexity and raised threats are starting to change the way in which private equity organises itself.

One example: Hays, the global recruitment agency, was searching recently for a Risk and Insurance Officer, an insurance specialist to work under an R&I Manager for a leading, private equity and real estate business in Asia.

Risk managers look set to play key strategic roles in many companies, private equity included. Their increasingly central role in organisations (see graphic) is expected to see them become among the few individuals that have a total view of their enterprises.

“We’ve seen this increasingly over the last six to 12 months,” said Amanda Fong at Marsh. “Typically, a few years ago, this would be the role of the CFO, FD or COO. Now we’re seeing newly recruited individuals that will focus on risk issues.”