March 2023 / 5 Min Read

Insurance in Secondary Transactions

Increased use of secondary transactions in the private equity market has created an opportunity for Representation and Warranties insurance.

Key Takeaways

Representation and Warranties (R&W) insurance has been common for years, but has only recently become common in secondary transactions.
The volume of secondary transactions is likely to continue growing, meaning the need for R&W insurance could grow as well.
There is a financial case to be made for using R&W insurance.

Insurance in Secondary Transactions

In recent years, a combination of factors has led to a steady rise in secondary transactions in the private equity (PE) market. Some of these factors include restricted access to debt financing and the slowdown in public markets, widening bid-ask spreads for M&A transactions, the desire for PE firms to hold their investments longer than previously envisioned, and broader macroeconomic volatility. A recent survey of mid-to-high net worth investors found that 82 percent sought liquidity from their funds¹ in the past five years, whereas the term on most funds is ten years or more.

What is a secondary transaction?

In private equity terms, a secondary is the sale of an investor’s stake in a PE fund before it reaches its maturity. Secondary transactions primarily occur because initial investors are seeking liquidity, and new investors want access to the fund and its current investments. Secondaries can take place directly between investors (existing and new) or through a PE firm-sponsored transaction, typically referred to as a general partner (GP)-led secondary. A PE firm may consider undertaking a GP-led secondary when it wants to maintain its ownership of certain assets longer than the term of the fund, while at the same time providing a monetization opportunity for its existing investors. In a GP-led secondary, the fund’s initial investors may choose to divest their interests at an agreed-upon valuation, or they may elect to roll their interests from the existing fund into a new continuation vehicle (CV) that will own the contributed assets going forward.

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Given the unique considerations of risk allocation in GP-led secondaries, representations and warranties (R&W) insurance is being more frequently implemented to effectuate the transfer of certain risks that are typically negotiated between the parties to the transaction.

In a GP-led secondary, new investors often require indemnities from the PE fund sponsor and existing investors. The result is that a portion of the proceeds from the transaction (usually 10 percent) are typically placed into an escrow account for up to one year or more, to cover any unknown liabilities that arise which are attributable to the transaction or to the assets being contributed. For example, if taxes were owed by the companies being contributed from the old fund into the CV, the new investors would not want their valuations to be impacted by the potential losses related to the payment of these taxes.

The new investors would then seek recoupment through the escrow, typically via indemnification procedures, which, if successful, would result in a reduction of the proceeds to be returned to the original investors. However, when R&W insurance is implemented, the new investors can make a claim against the insurance policy rather than seeking indemnity against the GP or the original investors. This allows the initial investors to “move on” after the transaction, without worrying that the new investors will come back looking to claim the escrowed proceeds. This can prevent acrimonious negotiations and even litigation, while enabling GPs to improve their balance sheet risks by eliminating potential claw back exposure and post-closing reserve requirements.

The financial case for R&W insurance

The cost for an R&W insurance policy for a secondary transaction is typically 2.0% - 3.0% of the insurance limit amount. For a secondary transaction involving assets with an NAV of $100 million, the costs would be approximately $250,000 for $10 million of insurance coverage. Contrast that with the opportunity costs associated with placing $10 million of proceeds into an escrow account for one year and the financial case for R&W insurance can be considerable. For example, if invested in a one-year U.S. Treasury Bill, the yield on $10 million could be $467,000.²

A Growing, Global Trend

While R&W insurance policies have been common in M&A for many years, they are a relatively recent addition to the toolkit for practitioners in secondary transactions. Utilization of R&W insurance for GP-led secondaries increased significantly beginning in 2020 and has continued to expand over the last two years. Volume in secondary transactions is expected to be strong in 2023, as many PE firms are evaluating strategic alternatives to M&A. With that anticipated growth, PE firms and new investors are expected to continue seeking unique risk allocation strategies that benefit all parties, which is a primary feature of R&W insurance.

While the use of R&W insurance was pioneered in the U.S. and UK, there is a global appetite for secondary transactions, meaning PE firms and investors from all geographies will be seeking to effectuate similar constructs as those used in the U.S. and U.K. Growth in EMEA is already beginning to take shape, as there is significant opportunity seen in countries such as Germany and France, and firms are setting up global platforms in order to accommodate the expected rise in volume.

An Opportunity

As economic conditions continue to be volatile, access to liquidity may be a continuing theme for investors. That in turn could lead to further growth in the volume of secondary transactions, and thus a growing market for R&W insurance policies as well. Unknown risks are inherent in all types of M&A transactions. Bringing certainty to the process with R&W insurance allows buyers and sellers of GP-led secondaries to make better decisions.

¹ https://www.trustben.com/wp-content/uploads/2022/03/Ben-liquidity-report-v1.pdf
² U.S. Treasury Bond rate as of December 2, 2022. Resource Center | U.S. Department of the Treasury

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