In this Ropes & Gray podcast, asset management partners Isabel Dische and Adam Dobson, and litigation & enforcement counsel Steve Kaye discuss the use of rep and warranty insurance in fund recapitalization transactions and why its use in the fund recap context has been less common than in other types of M&A transactions. They also share recent developments in the types of coverage available that may make rep and warranty insurance more interesting to fund sponsors and secondary buyers.
Isabel Dische: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on topics of interest for asset managers and institutional investors. I'm Isabel Dische, a partner in our asset management group based in New York and co-head of our institutional investor practice. Joining me today are Adam Dobson, an asset management partner based in our Boston office, and Steven Kaye, a counsel based in our Boston office who focuses on insurance-related matters. Today, we are going to be talking about the use of rep and warranty insurance in fund recapitalization transactions. We'll start with a brief explanation of what rep and warranty insurance is and why its use in the fund recap context has been less common than in other types of M&A transactions. We'll then discuss some recent developments in the types of coverage available that may make rep and warranty insurance more interesting both to fund sponsors and to secondary buyers. Finally, we'll discuss what types of fact patterns might make rep and warranty insurance more appealing for a particular fund recap and some considerations secondary buyers, in particular, will want to keep in mind as they explore using rep and warranty insurance instead of or in addition to a typical indemnity package.
Steve, would you like to kick-off our discussion with a quick overview of what exactly rep and warranty insurance is?
Steve Kaye: Gladly. In fund recaps, much like classic M&A, a seller makes various representations and warranties to the buyer, and the buyer typically wants some protection against breaches of those reps and warranties. As the name suggests, rep and warranty insurance provides coverage for a buyer in the event of a seller's breach of a covered rep or warranty. Coverage is a substitute for, whether in part or in whole, a seller's indemnity obligations. In classic M&A, buyers typically cover the cost of the policy, but in a fund recap, the cost of the policy is typically borne by the sellers. As with any other type of insurance, the policy will provide that coverage kicks in only after an agreed deductible is met (the "retainer") and is subject to an overall cap. There also are certain customary exclusions from coverage - for example, this particular exclusion is highly unlikely to be relevant in the fund recap context, but insurers won't cover asbestos-related claims. The pricing of the insurance coverage will depend, among other things, on the suite of reps being insured, the level of diligence performed, the retainer and the cap, and often the relevant industry. The insurance often allows the seller a clean break because the insurer assumes responsibility for ongoing liabilities relating to the seller's breaches of its reps.
Adam Dobson: Historically, though, secondary buyers haven't been ready adopters of rep and warranty insurance precisely because it is "rep and warranty" insurance and in fund recapitalization transactions, buyers are typically seeking an indemnity package not only for breaches of reps and warranties, but also for excluded obligations. These are obligations that expressly remain with the selling fund or the selling LPs in a recapitalization transaction - for example, partnership audit-related tax liabilities and other tax liabilities, liabilities stemming from portfolio companies that are either not a part of the deal or were previously disposed of by the fund, liabilities relating to claims that the sponsor has breached its contractual or fiduciary duties in connection with the recapitalization transaction or otherwise, and other uncertain obligations that are not expressly underwritten by the buyers. Until recently, rep and warranty insurers haven't been willing to underwrite excluded obligations coverage, which has meant that buyers have still wanted to have indemnity protection from the selling funds for such liabilities. And once a selling fund is "stuck" providing an indemnity for excluded obligations, many buyers and fund sponsors have found it easier and less expensive to simply have the selling fund provide the indemnity for both its reps and excluded obligations rather than using rep and warranty insurance alongside an indemnity package for excluded obligations.
Isabel Dische: Setting aside the issue of rep and warranty insurance being only a partial solution-as it hasn't historically covered excluded obligations-another reason secondary buyers and fund sponsors haven't pursued rep and warranty insurance historically has been the cost. In a typical fund recap, the sponsor offers existing investors the option of selling or rolling their interests. Investors who elect to sell bear the costs of the transaction, including the costs of any insurance, so insurance lowers the net proceeds to investors. Not surprisingly, this isn't popular with existing investors, who prefer to maximize the proceeds they receive from the recap. It also isn't ideal from the perspective of a fund's sponsor or a secondary buyer, as if existing investors aren't as supportive of a deal fewer may approve the deal and/or elect to sell, potentially scuttling the transaction or making it smaller.
All that said, there are certain instances where rep and warranty insurance may still be attractive in a fund recap. In particular, if the selling fund lacks an LP clawback or won't have meaningful assets after the transaction, or if the sponsor wants to wind down the selling fund quickly after the recap, insurance may be the only possible recovery source for the secondary buyer, even if it involves some price drag. Also helpful is that in recent months, we've seen rep and warranty insurers get comfortable underwriting excluded obligations, so for the first time, we've seen policies issued to provide such coverage. Coverage for excluded obligations is not cheap, but for the secondary buyers in those transactions it was a way to get protection against a set of potential obligations for which there wasn't another viable recovery source.
Steve, do you want to quickly run through some of the concepts secondary buyers and fund sponsors will want to keep in mind as they consider whether to use rep and warranty coverage in a fund recap?
Steve Kaye: Sure. First, as discussed earlier in this podcast, the parties will want to agree on what is being insured. There are four main options:
- all rep coverage, which covers breaches of all of the selling reps fund's reps;
- fundamental rep coverage, which covers breaches of any reps that are designated as fundamental reps in the underlying contribution agreement;
- "core" fundamental rep coverage, which covers breaches of a narrower set of 'core' fundamental reps, but doesn't include, for example, as fulsome of a no conflicts rep as parties often include in a fund recap; and
- excluded obligations coverage.
It is also possible to mix coverage - so for example, having up to an agreed amount of coverage for fundamental reps with even more coverage for core fundamental reps. (Not surprisingly, the core fundamental rep coverage is cheaper than the all fundamental rep coverage.) The parties also will want to navigate the insurers' diligence requests, particularly as the approach to diligence in a fund recap is very different from the diligence exercise undertaken when a PE sponsor acquires an operating business. Finally, the parties will want to address questions such as who will be the named insured with the power to pursue claims and what types of no claims declarations will be required. These are technical points, but matter greatly given the sponsor's role on both sides of these deals.
Adam Dobson: There are a lot of factors to evaluate, but it is worth noting that these are all issues that can be, and have been, worked through in the context of fund recapitalizations. As we've discussed, in certain circumstances, insurance is an effective bridge between the interests of the sellers and the buyers in these transactions. Insurance provides sponsors with a cleaner transaction from the perspective of its selling LPs if the cost makes sense and that the selling LPs will have fewer contingent liabilities on exit. This may make the selling option more desirable for institutional investors and end up creating a larger transaction size for buyers. Meanwhile, insurance can fill the liability gap for buyers when the selling fund doesn't have sufficient assets to cover possible indemnification claims. As mentioned, in scenarios where the sponsor is fully recapping a selling fund and intends to wind down the fund, buyers may utilize insurance to both extend the survival period for representation coverage and to enhance their recovery beyond what would be available from an LP giveback provision, which is the most common source of indemnification for wound down funds. The right mix of insurance and traditional indemnity sources will be different depending on the facts of each transaction and the cost and scope of a bill and insurance for a particular portfolio of assets.
Isabel Dische: Needless to say, there's a lot to consider, but rep and warranty insurance, particularly with the option of covering excluded obligations, may be an attractive option depending on the facts of a particular fund recap. Thank you, Adam and Steve, for joining me today for this discussion, and thank you to our listeners. For more information on the topics that we have discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we've discussed - please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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