SECONDARIES V

In most market situations, secondary activity will generally follow buoyant primary activity. The secondary market for private equity assets is no different. Given that the use of “alternative” risk management solutions that utilise insurance capital has become widely accepted in the primary buyout market, we expect increasing interest in these solutions in the rapidly growing secondary market.

There was an element of early scepticism about the validity of a secondary marketplace where it was common to hear the argument that no-one would be interested in selling their interest in a good (and performing) fund. In a similar vein, there has historically been a certain amount of scepticism about the ability to use insurance capital to remove or manage some of the esoteric risks associated with M&A activity. It would appear that in both cases, these views are largely unfounded although the application of these insurance techniques in secondaries transactions is certainly in its infancy.

It is the intention of this feature to consider a number of the currently available solutions to common risk issues that arise in the primary market and relate them to issues that are currently apparent or expected in the secondary market. These insurance techniques are equally applicable to both the sale and purchase of assets and we would expect them to be applied upon change of ownership since this will normally be the driver for any identified risk issue to be negotiated.

THE RELATIONSHIP BETWEEN RISK AND REWARD
The potential buyers' view of contingent liabilities will be a significant driver in their valuation of the fund. In most cases, they will request the seller to provide an indemnity in respect of any identified contingent liability. This is the traditional approach adopted by any buyer whether it is in respect of a traditional buyout or a secondaries transaction and it goes to the core principle that the seller should retain liability for events that have occurred prior to the change of ownership. In theory, this is a sound approach. In practice, there are often operational or structural reasons why the seller is unable or unwilling to assume any form of contingent liability. It is in these situations where the ability to “outsource” the liability to a third party may be of significant value.

Not surprisingly, an inability to provide warranties is a common issue that occurs in many primary transactions and is often cited as a reason that the deal is prevented from closing. This is often due to the fact that when a fund or investor is selling, they will want to distribute funds back to the limited partner and, therefore, will have some difficulty in retaining any form of contingent liability.

It is our view that similar obstacles will occur in secondaries transactions whether they be single fund or portfolio fund transfers. The required outcome from any sale process will always be to maximise value and minimise contingent or retained liability. Solutions that can assist with the management of these, often opposed, matters will always be of value.

SINGLE FUND TRANSFERS
Single fund transactions or “direct” secondaries will generally be initiated by the general partner in their requirement to replace one or more of the existing limited partners. Clearly, the general partner will not be in a position to provide any warranties to the incoming limited partner. As such, the limited partner will need to rely heavily on their due diligence to determine any potential liability since there will typically be very limited recourse available.

It is entirely conceivable that the inability to provide substantive warranties could limit the pool of potential limited partner capital. It is also possible that the fund contains underlying assets that are themselves subject to known issues. For example, what approach would the investing limited partner take if they became aware of ongoing litigation at the portfolio level where the potential damages could be significant in relation to the overall fund investment? Indeed, the inability to receive warranties may have an impact on the valuation of the fund since any secondary investor will look at the value of the underlying assets to determine the purchase price. The value of these assets must surely be affected by the increased risk associated with buying assets on a no warranty basis.

PORTFOLIO FUND TRANSFERS
With the sale of portfolio or fund of fund assets, it is usual for the seller to provide some standard representations and warranties that will deal with good title to shares and capacity to enter into the agreement. They may also provide warranties that confirm that the vendor has funded the requested capital calls and that they have not breached the partnership agreement. It is also normal practice for the seller to indemnify the buyer against liabilities arising from events that may have occurred prior to the sale date which will include some standard claw-back provisions that deal with a situation where the buyer may need to make a repayment against a prior distribution received by the seller.

These warranties and indemnities do not appear to be unduly draconian and, indeed, form an important part of most sale and purchase agreements in primary transactions. There are some important considerations however;

  • i) On the basis that the seller will most likely want to distribute or reinvest the consideration received by the sale, is there an impact of providing these indemnities in terms of retained contingent liability?
  • ii) In most cases, the general partner will need to consent to the transfer of limited partner interest. Would the general partner have reason for non-consent if they felt that the incoming limited partner was not financially able to meet its obligations for prior liabilities due to insufficient recourse from the exiting limited partner?
  • iii) In the event that there is limited recourse from the exiting limited partner, would the incoming limited partner be concerned that the general partner may be able to use current fund assets to meet liabilities that arise from previous incorrect distributions?
  • iv) In the event that acceptable warranties and indemnities are negotiated with the exiting limited partner, is there still a concern about the strength of covenant and therefore, the ability to recover against the exiting limited partner? In most cases, there will be little ability to insist on a minimum level of capitalisation of the entity that has provided any indemnity.
  • INSURANCE-BASED SOLUTIONS
    The application of insurance capital to remove certain risks associated with primary merger and acquisition activity is relatively well established. It is helpful to distinguish between those matters that are known at the time of completion and those matters that are unknown.

    a) The insurance of unknown liabilities
    Whilst the primary purpose for requesting warranties from the seller is to force disclosure, the secondary benefit is normally to facilitate some method of recourse in the event that one of these statements later turns out to be false. If we ignore those issues that come to light during the due diligence or disclosure process for a moment, we are left with those matters that are unknown at the time of the deal completing. In a primary transaction, this would be the suite of commercial and tax warranties that normally form an important part of the sale and purchase agreement.

    The insurance of these unknown liabilities is relatively common and the insurance can be applied from either the seller or buyer side. If applied to the seller side, the seller will retain liability under the terms of the agreement and would then look for the insurance policy to provide “protection” in the event that they were forced to make a payment due to a breach of any warranty. If applied to the buyer side, the seller can limit their liability under the terms of the agreement and the buyer will use the insurance to replace the seller's recourse; in other words, a buyer side insurance policy will respond in the same way as the seller would have responded had they not limited their liability under the terms of the agreement.

    There are a number of motivations that drive the use of these types of insurance solutions and these are equally applicable to secondaries transactions. Some typical applications of these solutions could include:

  • i) The requirement for a buyer side policy where the seller is unable to retain any liability. The policy would provide the only recourse for the buyer.
  • ii) The requirement for a seller to have a high degree of certainty as to how they would deal with a breach of warranty or indemnity post-sale. As opposed to needing to make arrangement for the liability to be funded (perhaps from another fund), the selling entity could look to rely on an insurance policy.
  • iii) A concern by the buyer of the strength of seller covenant. A buyer side policy could be used as a backstop in the event that they failed to collect from the seller.
  • vi) A concern by the general partner that upon LP transfer, the new LP would be unable to meet the obligations to fund, for example, a claw-back requirement. It would be possible to structure a policy to deal with this situation.
  • The application of these solutions for secondaries transactions will be similar in terms of process and costing to primary market deals. We would expect most transactions to be capable of being underwritten within 10 to 14 days from provision of the transactional documents. In terms of costing, a typical costing should be in the region of 2 percent to 3 percent of the limit of insurance required as a one-off payment for a policy that would last for the term of the obligations under the agreement. In other words, a $10 million policy would cost between $200,000 and $300,000 and would last for up to seven years.

    b) The insurance of known liabilities
    As noted earlier, it is common for known issues to be dealt with by way of an indemnity from the seller. Whilst this may be a perfectly workable solution where the identified matter has a high degree of certainty towards the value of the issue, there can be significant issues when a true value can only be estimated. Often, a seller is uncomfortable with an openended indemnity since it can be difficult to establish the required reserves that will need to be made.

    It is often possible to use insurance capital to effectively manage these unknown matters. Consider a situation where a portfolio company is the defendant in a litigation suit. That party may be comfortable that they have a strong case and their advisors may be able to provide an equally robust opinion that confirms the fact that there is a reasonably high likelihood of success in any subsequent trial. This information is unlikely to be treated in the same way by any potential buyer of the vehicle that owns this asset. There will be a good chance that they will take a much more conservative view of this impending litigation and this will be reflected in their indemnity demands.

    If it was possible to provide certainty to this situation through the use of an insurance solution, this may alleviate the need for extensive indemnity negotiations that will be largely based around “guesswork” . In a situation where the defendant is optimistic that the outcome of the litigation will amount to no more than perhaps $500,000 of costs but a buyer is concerned that if the plaintiff is successful, the award could be in the region of $10 million, it may be possible to place an insurance policy that would meet the cost of any adverse award against the company. A typical policy would cost something in the region of 5 percent to 8 percent of the limit required; in the case above, a $10 million policy would cost between $500,000 and $800,000.

    The most common applications for this type of cover seem to be with taxation, litigation or environmental issues. The time required to put such a solution in place is largely dependant upon the availability of information and the complexity of the underlying matter. In most cases, a solution can be provided in two or three weeks from first instruction.

    CONCLUSION
    In the same way that these techniques are not applicable to all primary transactions, they will not be applicable (or indeed, required) for all secondaries transactions. The important consideration is that they are available and, in some cases, the ability to access this capital may be of substantial benefit to the structuring of a given transaction.

    As the secondaries market continues to grow, so will the competition for good quality assets. With this competition will come an increasing need for one bidder to differentiate themselves against others and these solutions offer one potential route for that differentiation. As the number of transactions continues to increase, it is likely that there will be a greater number of issues that arise that would benefit from this form of innovative approach.

    Daniel Max is a senior vice president, Private Equity and M&A Practice (PEMA) at Marsh.

    The above feature is taken from the Private Equity International book The Private Equity Secondaries Market, A Complete Guide to its Structure, Operation and Performance, edited by Campbell Lutyens. Copies of the book are available by calling +44 20 7566 5444 or emailing fran.h@peimedia.com. Go to peimedia.com/books for more information.