See you in court

Private equity was served a sharp reminder of the slings and arrows of fortune when news broke in April that the Blackstone Group was facing a class action suit in the USA for allegedly hiding poor portfolio company performance in the prospectus for its IPO in June 2007.

In America, a barometer of shareholder litigiousness, the number of federal class action lawsuits increased in 2007 after two years of decline, report accountants and advisers PriceWaterhouseCoopers (PwC) in their latest Securities Litigation Study (April 2008). One hundred and sixty-three cases were filed, compared to 109 in 2006, an increase of nearly 50%, and the bulk of filing (63%) was in the second half of the year as the sub-prime fallout widened and the resulting credit crunch bit. Sub-prime-related cases accounted for 23% of the total, but 29% of those files in H2.

Sub-prime and the credit crunch are just two negatives lurking in a pile which includes rapidly deteriorating economic fundamentals that signal falling asset prices and lower returns. When the going gets tough, litigation, insurance claims, and the cost of such cover, tend to rise together.

In the December/January 2008 edition, EVCJ reported on rising litigation by minority shareholders seeking to go beyond portfolio companies to get to the deeper pockets of PE houses behind them. The trend is marked in the USA, but not unknown in Europe,

In one recent case, minority shareholders in an unidentified Spanish enterprise that went bust without the correct insurances in place tried to claim against the liability insurance of the board representative from the private equity owners.

The firm was ultimately admonished. “But this was a potentially catastrophic claim,” stresses Mike Lobb, at Howden Insurance Brokers, a leading specialist broker for business-critical risks. “We are talking in excess of US$12m, which would have made a big dent on either their own bank balance or the insurances they had at the centre.”

Howden routinely advises PE clients to consider the cover they should have as a whole, including their portfolio companies, and to demand tailored rather than off-the-shelf solutions.

“I expect fall-outs other than the impact that the credit crunch will have on the portfolio companies,” says Lobb. “For example, if there are big redundancies, PE companies will have to deal with those in the right way. They are under more scrutiny than six months ago.”

Taking GPs to court

Unsurprisingly, LPs in general showed no appetite for suing GPs during the days of sparkling returns. Memories of the Connecticut pension fund suing the US buyout firm Forstmann, Little & Co over money lost from retirement funds through investments in two telecommunications companies faded quickly after the suit was settled in 2004.

Now that returns are vulnerable, many in the PE industry still find it hard to conceive that the average LP could sue a GP in the UK.

“I don’t think they’re a particularly litigious bunch,” says Buchan Scott at Duke Street Capital, the London-based mid-marker firm. “It’s very difficult for LPs to make claims merely about bad returns unless there’s been incredible negligence. People make bad investments: it’s a risk game.”

Tim Green, managing partner at GMT Communications Partners, agrees: “It would be real stretch for an LP to start suing some of its biggest GPs because they’ve over-leveraged a deal. If you’re investing in a buyout fund, potentially you’re investing in people who are going to put leverage in deals. If returns fall, are you going to start to sue? Personally, I think that’s a very unlikely proposition.”

Yet both Scott and Green see potential exceptions: in general, where pension funds have fiduciary obligations to pursue realistic potential claims against GPs; and in particular cases where GPs have gone beyond an investment strategy detailed in a prospectus.

“Say they said they were going to invest in Western Europe and then invested in Kazakhstan, then I think they’ve got it coming,” says Scott. “With even the little litigation that’s been seen in the USA, it’s exactly the sort of thing that people have gone for. It could happen.”

Green adds: “Where somebody has been egregious – perhaps they’ve sold a business on to a following fund for a high price, highly leveraged, and the guys in the new fund are sitting on a loss, whereas the guys in the old fund maybe aren’t – I think there might be some exposure there. Again, you could see that potentially being in the US more than here.”

“I think the real concern could be where they’ve refinanced a deal, within a year have put in some very aggressive financing, taken cash off the table, taken a big chunk of carry in the process, and the business goes under. Again, I think it will depend who the GPs are. It’s difficult to imagine it being some of the biggest names in the industry. That said, I’m not sure we’d have expected to see Forstmann, Little & Co being sued. Do I think it’s possible? Yes, it’s conceivable.”

Warranty worries

Aside from considerations of fair value and returns, could the threat come from a different direction: trade and secondary buyers of the many portfolio investments that have been realised in recent years and continue to be?

During a fall in M&A activity in the early part of the decade, notifications of warranty claims under sale agreements rose: in a downturn, buyers are more likely to look at what they have bought and what they might recover.

“[But] a lot of those circumstances didn’t come to anything,” points out Alena Watchorn, recently recruited as an executive director for the Mergers & Acquisitions Practice Group at Willis, the global insurance brokers. “Buyers were clearly trying to see what position they did have, and a lot of the downturn was just an economic downturn which hit companies anyway.”

She also notes that PE generally resisted portfolio companies giving warranties in the sellers’ market of the past few years, so sellers have largely exited from investments with no liabilities.

“It got to the stage, probably in the first half of last year, where deals were essentially becoming warranty free,” says Charles Barter, head of private equity in the corporate department at London-based law firm Travers Smith.

“There were so few warranties, and the caps were so ridiculously low, and all hedged about with actual knowledge, it really wasn’t something to rely on if it said there was a warranty scheduled.”

Now that the market is moving back towards buyers, acquirers are starting to harden attitudes towards the number of warranties they want and the level of cover they expect.

“Increasingly, we’re seeing a lot of trade buyers not accepting low warranty caps,” says Watchorn.

With little money available in many deals to back up warranties, insurance is the obvious answer to any impending impasse between buyers’ fears and PE’s and portfolio company managers’ preferences for clean exits.

More flexible policies are adding to the attraction of insurance should demand rise. “The wording of policies has become much more favourable to the person who is insured over the past three or four years,” says Ian Shawyer, partner in the private equity side at Travers Smith. “Wriggle-room for insurers has been eroded by the market.”

One potential flashpoint could be escrow. “Everyone has tended to think that an escrow sits there for a couple of years then they get it back,” says Watchorn. “There might be a bit more litigation [over escrow] because of buyers suddenly thinking ‘what have we bought?’”

While rising notifications of claims, already underway, will inevitably put upward pressure on insurers’ costs, there is doubt about whether they could, or would want to, make price rises stick, at least in the immediate future.

“The cost of Directors & Officers’ (D&O) liability insurance has been coming down and was down again last year,” reports Buchan Scott. “But insurers tell us that their costs are going up, not because they’re seeing more claims, but because they are seeing more people looking at claiming.”

Lorraine Adlam, a Howden board member and financial lines practice leader for the broker’s global operations, says prices are already hardening in some areas of the market as sub-prime woes hit home.

“PE business is written by the same underwriters who write hedge funds – for example, the same underwriters who are writing D&O on the US mortgage banks – so it’s all in the same book of business. And those underwriters are certainly seeing claims come into their D&O books and PI books.”

Some hedge funds are seeing premium increases, and they can be substantial. Adlam says that at the extreme end of risk, a start-up CDO fund found the quote for its premium had increased sevenfold after sub-prime and the credit crunch kicked in.

“So we are seeing prices going up, and some underwriters withdrawing from the class in certain sectors. I think if we do start to see claims within the PE sector, the most likely result in the market is going to be prices go up. I’m not expecting us to be in a position where we can’t get risk finished, because at the moment there is over-capacity in the market. It would require something really extreme to happen for there to be such a withdrawal of capacity that risk could not be covered.”

Alena Watchorn at Willis comments: “It is likely that where there has been a significant increase in claims activity or risk profile in specific sectors, for example among financial institutions exposed to sub-prime, the pricing of insurance for their professional, directors’ and crime risks will increase. However, in general, across other classes of insurance, there is still overcapacity and competition in the market which, in our view, will continue to keep the market soft for the forthcoming year or two.”

For example, the price of warranty insurance has fallen by around 50% in five years. By way of further perspective, Watchorn reckons that in the mid-market sector, a client for warranty cover would normally pay 0.1% up to 0.6% of deal value as a rough guide; but would usually look to cover only the first 10% to 30% of a deal.

“I suppose there’s every chance that if it became a hugely popular device again, that we would see pricing coming up,” says Ian Shawyer at Travers Smith. “But I think right now people are just trying to reintroduce W&I insurance as an M&A tool and I think they would be reluctant to raise the pricing too quickly, otherwise they would just shoot themselves in the foot.”

Most people consider the likelihood of a warranty claim to be remote, according to Charles Barter. “People are doing far more due diligence than before. They are genuinely looking for quality assets. Whatever you say about it, if you buy a few million pounds of insurance cover, it’s going to cost quite a big sum, well into six figures, and I think people just struggle with that. That’s the governor on it.”

Instead, he expects there could be more use of bespoke W&I insurance for specific, real problems, such as an environmental liability, a tax claim, or litigation. “It’s easier to do that than to just say you’ll knock it off the price or something else.”