“Everything changes and nothing stands still.” – Heraclitus, Greek philosopher
With few exceptions investment funds were not meant to last forever. Investors seek to cash out, while new investors want to join in.
The challenge comes during the transition of the old investors leaving and the new ones entering:
- The original investors want one thing: their money (along with its accumulated growth) free and clear.
- New investors want to move forward without legacy risk.
Between these interests lies the General Partner (GP) or sponsor, who has a foot on both sides of the fence.
The biggest concern for new investors is potential Excluded Obligations – financial liabilities of the Seller Vehicle (SV, the original fund) that “leak” over to the continuing vehicle.
This can happen where the GP serves a dual role on the SV as well as the Continuing Vehicle (CV). Therefore, the risk of an expensive “wrong pockets” case can drag in new investors – something they keenly want to avoid and can be the source of protracted negotiations.
Enter a new risk transfer vehicle – Secondaries insurance.
This coverage is designed specifically to address this exposure by providing legal defense expenses as well as settlement and judgement costs protecting the CV’s assets.
This insurance is the natural by-product of Representations & Warranty (R&W) insurance, which has become a favorite of PE firms for more standard acquisitions (it’s featured in 90% of deals these days). R&W insurance elegantly moves financial risk from the deal parties to an insurer.
As was the case with R&W in its early days, Secondaries is new and therefore seldom used. But we expect Secondaries to become as ubiquitous as R&W coverage as PE firms and Independent Sponsors seek a smooth transition.
Just as R&W revolutionized M&A transactions, Secondaries serves as a facilitator that paves the way for original investors to enjoy a clean exit and new investors a clean slate for a Continuing Vehicle (CV) to move forward unencumbered.
There are a few types of transactions covered by Secondaries, but there are two main ones:
- Limited Partner (LP)-led transactions.
Here an LP investor in a fund wishes to cash out on the investment and sell its LP interests to a willing buyer.
- GP-led transactions.
In this type of deal, a GP, for a variety of reasons, wishes to “recycle” the investment stack by allowing some investors to cash-out and others to remain, while also inviting “new money” into the fund or creating a CV to extend the lifespan of a fund.
As is found in M&A transactions, the Buyer will have contractual recourse against the Selling LPs if any of the reps and warranties are found to be untrue or inaccurate post-closing.
Among the reps and warranties provided by the Seller:
- Schedule of R&W set out in the purchase agreement.
- Excluded obligations.
In the absence of Secondaries insurance, Buyers customarily require a holdback of a percentage of the purchase price for a period (12 to 24 months) to cover any liabilities uncovered after closing.
Secondaries insurance helps bridge this gap between Buyers and Sellers where Buyers receive certainty of risk allocation and recourse while Sellers secure a clean exit.
Importantly, Secondaries insurance can replace the withhold and allow full release of liquidity to the Sellers and their funders at closing without the risk of future claims.
Currently, the majority of Secondaries transactions are uninsured, simply due to lack of awareness in the market of its existence. But the benefits are clear:
- Premiums for policies are currently 1.75% to 3.5% of the policy limit.
- Limits on policies are generally 5% to 10% of the transfer price.
- Underwriting fees range from $25,000 to $75,000.
With Secondaries insurance now available, LPs and GPs have to consider if the risks and withholds are something they can live with, or do they want these problems eliminated… permanently.
If you have any questions about this innovative new coverage, I’m standing by to help you determine if it’s a good fit for your transaction.
Please contact me, Patrick Stroth, for more information on this coverage and other transaction liability, insurance options at pstroth@rubiconins.com.