Clifford Chance

Introduction

Representation and warranty (R&W) insurance has become an essential tool in facilitating secondary transactions as it can, among other benefits, reduce the risk of clawbacks or lower the amount of escrowed funds required. While we mostly see GP-led multi-portfolio company restructuring transactions, R&W insurance has been successfully deployed in other forms of secondaries transactions, such as single asset GP-led and LP to LP transactions. This Article discusses some of the intricacies of insuring secondaries with R&W insurance policies focusing on GP-led multi-asset transactions, highlighting some key considerations, discussing the underwriting processes, and setting out some challenges and best practices.

What are GP-Led Secondary Transactions and what are their Key Characteristics

GP-led secondary transactions, either multi-portfolio company sale or single portfolio company sale, are transactions in which the investors in a private equity fund (the "Original Fund") are given the opportunity to liquidate their interests in the Original Fund to a new investor. The GP-led transaction is often structured as a "Continuation Fund" or "CV" deal in which the Original Fund sells some or all of its portfolio assets to a newly created fund (the "Continuation Fund"). The General Partner of the Original Fund or its affiliate will continue to manage the subject assets as the General Partner of the Continuation Fund, and the investors in the Original Fund have the opportunity to exit their investments for cash, retain their exposure to the subject assets by "rolling" their interests in the Original Fund into an interest in the Continuation Fund or some combination of the two. The new investor purchases an indirect interest in the subject assets by subscribing for interests in the Continuation Fund, thereby providing the cash for the Continuation Fund to purchase the subject assets from the Original Fund.

A significant issue with insuring this type of transaction is that the Original Fund and the Continuation Fund are typically related or affiliated entities with the same or affiliated general partners – the General Partner of the Original Fund is, in essence, on both the buy-side and the sell-side of the transaction and therefore actual or perceived conflicts of interest could arise. In order to manage the potential conflicts of interest, the new investor – typically not affiliated with the General Partner - participates on behalf of the Continuation Fund in the transaction negotiation process. The General Partner will typically take numerous other measures such as hiring an advisor to conduct an auction process and obtaining a valuation or fairness opinion in respect of the final purchase price.

More recently, conflicts management has also included obtaining representation and warranty insurance with the help of an insurance broker.

When insuring a secondaries transaction, it is critical for all deal participants (the Original Fund and its General Partner, the Continuation Fund and its General Partner, Lead Investor and Underwriter) to understand the relationships of the parties and work with a team that has experience in these types of transactions and understands the relevant issues and deal dynamics.

Key Considerations in the R&W Insurance Underwriting Process

While secondaries transactions have some of the same characteristics as more traditional acquisition transactions, there are certain important differences which inform the R&W insurance underwriting process. The below are some of the key differences.

• Secondaries transactions, particularly those involving the sale of a portfolio of assets, typically have more limited representations than traditional third-party acquisition transactions and many of the portfolio company-level representations are knowledge qualified.
• Diligence is more limited and there are typically no written reports.
• If more extensive coverage of the portfolio companies is desired (e.g., non-knowledge qualified coverage of tax and financial statement related representations) written reports, such as a quality of earnings report and tax report, related to the entities to be covered are usually required by the Underwriter.
• If more extensive coverage is desired by the Continuation Fund/Lead Investor or LP purchaser, it is prudent to discuss the requested coverage at the quote stage so all deal participants understand what will be expected in order to secure the desired coverage levels.
• Solvency representations may be covered subject to appropriate lien searches being conducted.
• Scope of coverage for "Excluded Obligations" (liabilities, such as clawback risks, breach of fiduciary obligations, portfolio tax obligations) is a key consideration for potential insureds and may be a differentiating factor among Underwriters.
• While some portions of the Excluded Obligations are typically covered, Underwriters, working with their counsel, will likely carefully review the Excluded Obligations definition in the purchase agreement to determine their comfort level for coverage of each prong of such definition.
• Particular focus by the Underwriter on tax matters covered in the Excluded Obligations Definition is likely as Underwriters want to avoid any coverage surprises, such as inadvertently covering portfolio company-level taxes.

The Underwriting Process

• The non-binding indication letter (NBIL) is typically fairly detailed regarding various matters including coverage positions on Excluded Obligations, "Knowledge" and "Loss" definitions as well as providing that the portfolio company representations are deemed knowledge qualified to the extent they are not so qualified in the underlying transaction document.
• Underwriting calls are held with the Lead Investor and the General Partner of the Original Fund and no claims declarations (NCDs) are typically obtained from each of the Lead Investor and the General Partner of the Original Fund.
• The Original Fund General Partner typically has more information regarding the historical fund operations as well as the portfolio companies which is why such Underwriting calls are typically longer in duration than the Lead Investor Underwriting calls.
• Unlike more traditional Representation and Warranty Insurance Underwriting calls, secondaries Underwriting calls are brief, typically under half an hour for the Lead Investor Underwriting call and under one hour for the General Partner Underwriting call.
• Ideally, Underwriting calls include, for the Original Fund General Partner and the Lead Investor, the principal leading the efforts on the proposed transaction, an internal counsel, an internal financial officer and deal counsel, and for the Underwriter, the underwriter and its outside counsel team including, general corporate, funds and tax counsels.
• If coverage for tax or financial matters related to the portfolio companies is being sought, additional or longer calls are often required and additional participants, such as the outside financial or tax diligence provider, may be required to be on the underwriting call.

Challenges and Best Practices

Challenges

• As the diligence is typically less extensive, underwriting secondaries relies more on the processes and procedures undertaken by the deal participants and the dynamics of a secondaries transaction rather than more in-depth legal and financial diligence done by outside experts as is typical in a traditional representation and warranty underwriting.
• Due to the inherent conflicts of interest in certain secondaries transactions, underwriters typically focus on the transaction process and relationship the Lead Investor has with the Original Fund General Partner.

Best Practices

• Given the risk of conflicts of interest and the typically less extensive amount of formal third-party diligence conducted, understanding the relationships between the parties as well as the procedures undertaken by the deal teams is crucial to a successful secondaries underwriting process.
• Working with sophisticated counsel who understands secondaries transactions is important for a successful underwriting process.
• Outside advisors who have strong funds, tax and mergers and acquisitions practices can be critical partners of and resources for all deal participants.

Conclusion

Representation and warranty insurance coverage for secondaries has become a significant market and can be underwritten successfully but requires a shift in perspective from more traditional representation and warranty underwriting. Understanding the different dynamics of the secondaries market along with working with sophisticated advisors who understand relevant fund, tax and general corporate matters is key in a successful secondaries underwriting process.