Transactional risk insurance – helping private equity unlock value, even without transactions

October 2023  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

October 2023 Issue

There has been no shortage of ink spilled about the slowdown of M&A activity in 2023 – and about private equity’s (PE) retreat in particular. PitchBook, among other sources, has estimated that PE firms are sitting on near-record levels of dry powder, as rising interest rates, wobbly banks and recession fears have all conspired to keep activity levels low.

Whether we are at or near the bottom of this trend, whether there are green shoots or it is a false spring, PE firms would be well advised not to let a ‘wait and see’ approach to deal activity preclude them from actively looking for value in their own portfolios – and utilising the full suite of risk transfer options currently available in their search. While some forms of transactional risk insurance are widely known and accepted in the industry, others – like contingent risk liability insurance – are rapidly developing and may benefit PE firms in a challenging environment.

Since the late 90s, when transactional risk first entered the US market, various iterations of transactional risk insurance have allowed private equity firms to maintain liquidity and unlock additional value. Representations and warranties (R&W) insurance was the first transactional risk product to definitively demonstrate proof of concept: after solving for appropriate pricing, streamlined underwriting and tailored exclusions, these policies reached a tipping point of widespread use and acceptance in PE transactions.

The positive effects on deal process and structure are profound and include those outlined below.

First, buyers are able to secure broader protection from an A-rated counterparty than sellers may be willing to provide. And, in competitive bid situations, buyers using insurance may find that their offers are preferred to those other options that require seller indemnity.

Second, insurance is a more efficient and economical use of capital versus escrow arrangements, allowing sellers to obtain immediate liquidity, as well as a clean exit from the transaction.

Lastly, the use of insurance limits removes tensions that could threaten post-closing management relationships where the seller management remained with the post-close operation.
Moreover, this widespread adoption has led to additional benefits resulting from a virtuous feedback loop: prices and retentions are lower, coverage has expanded, longer track records of claims payments have been established, and the placement process is continually improving. Deal counsel now routinely recommend or advise clients to explore insurance for transactions, and buyers have become comfortable with the insurance as the major form of recourse for breaches of sellers’ R&W.

In all, 2021 saw the peak of R&W insurance placements, with large markets binding over 1000 policies.

The success of R&W insurance, coupled with its inability to cover ‘known’ risks, kicked open the door of acceptance for other types of targeted insurance solutions that are particularly notable because savvy PE firms (and strategics) can utilise them either in or outside of the deal context to obtain certainty or overcome hurdles.

Tax insurance, where a party obtains coverage for a defensible tax position that may nevertheless be open to challenge by the relevant taxing authority, is perhaps the most well-known example. Although tax insurance predates R&W insurance, recognition and acceptance of tax insurance gained traction following the acceptance of R&W by M&A practitioners who were now comfortable with replacing traditional seller indemnities with the insurance policy. In addition, the ability to create partnerships with insurers providing the coverages provided further comfort to all the parties in a transaction.

More recently, contingent risk liability insurance has gained a foothold and should be on the radar of every PE firm managing litigation risks – whether they are currently active in the M&A market or not. The original use case for contingent risk liability insurance, when used as part of an M&A transaction, is straightforward and familiar: where a seller is facing a known litigation risk (say, a patent infringement action that could potentially result in large damages), the parties could seek protection in the form of a policy that would ring-fence potential future losses and thereby add a measure of certainty to deal valuation (and potentially allow the seller to free up capital from its litigation reserves).

In the context of pending litigation, (accurately if unimaginatively referred to as ‘adverse judgment insurance’), two points are of noteworthy importance.

First, parties can and should explore coverage whenever they are seeking to attain certainty against future exposure whether they are doing so in connection with an M&A transaction or not. Contingent liability insurance has been used by deal parties to ring-fence potential future litigation losses and thereby eliminate deal roadblocks, but the benefits of this type of downside risk protection can benefit litigants seeking similar certainty outside of the M&A context as well. Of course, not all risks are insurable – underwriters seek to cover only those instances where the litigation risk at issue is dependent on a purely legal issue and the factual record has been well-established via the discovery process.

Coverage is typically structured to protect against a ‘catastrophic’ outcome. Where liability is likely, but the amount is uncertain, insurance serves as a cap against the higher amounts. Keeping awareness of this product as litigation progresses (and starting conversations with brokers early) can help companies manage the exposure and be prepared to address these matters and assuage buyer or counterparty concerns when the opportunity for a transaction arises.

Second, adverse judgment insurance represents only a sliver of the contingent risk liability insurance universe. While PE firms may be most familiar with it to help cover off downside risk, contingent risk liability insurance can also be utilised to realise inaccessible upside hiding in their portfolio companies. For example, where a portfolio company holds a suite of patents that it is not otherwise enforcing, contingent risk liability insurance may make it easier to file meritorious infringement suits and preserve hard-earned damages awards.

If the portfolio company has retained a law firm on a contingency basis, the firm could obtain a policy to insure future fee awards, thereby allowing it to offer better terms (and perhaps expand its caseload as well). Or, if the portfolio company is working with a litigation funding firm, coverage can be structured to protect the firm’s investment principal, thereby allowing the funder to offer better terms (and stretch its money to bring more meritorious cases). Under either scenario, when the portfolio company obtains a favourable judgment (e.g., a large damages award), it can seek coverage to ensure the same outcome when the trial court decision is appealed. Just as there are varied forms of litigation and litigation-related risk, so too are there varied forms of contingent risk liability insurance to support litigants.

As with R&W insurance before it, we are witnessing the evolution of contingent risk liability insurance in real time – the marketplace for these bespoke policies is rapidly evolving with even more products in development, existing underwriters adding capacity, and new underwriters coming online. The upshot is that, even as M&A deal flow has yet to rebound to 2021 levels, creative PE firms can nevertheless benefit from the use of these ‘transactional risk’ products in entirely different contexts by re-examining litigation exposures facing their portfolio companies or to unlock value by exploring potential claims that their portfolio companies may be otherwise ignoring.

 

Connor Williams is contingent risk liability practice leader and managing principal at Vanbridge. He can be contacted on +1 (202) 262 9781 or by email: connor.williams@vanbridge.com.

© Financier Worldwide

BY

Connor Williams

Vanbridge

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