Counting the cost of D&O protection

The stock market crash and its aftermath brought into sharp focus the potential liabilities faced by private equity firms. But as they seek out the protection offered by insurance, they are finding the cost of cover can be prohibitive. Will Swarts reports.

Call it an unpleasant surprise. When Preston Kavanagh, a partner and chief financial officer at Conning Capital Partners, recently renewed directors and officers (D&O) insurance for his newly independent private equity firm, the price of coverage had jumped 67 per cent. It was another sign that the effects of the post-boom crash are still being felt in the private equity industry.

Over the past two-and-a-half years, the worldwide slump has made private equity a more risky preoccupation for financial professionals – not due to an absence of sound investment opportunities, but because of a heightened awareness of liability issues. As concerns over these issues grow more important, so does the protection afforded by D&O coverage.

D&O insurance is closer to the forefront of GPs’ and investors’ minds than it ever was before

Fuelled by a litigious investor base in the US and complex regulatory and legal frameworks in Europe, the market for D&O cover has matured rapidly. Insurance brokers, lawyers and private equity executives are taking a closer look at how private investing leaves its practitioners potentially vulnerable to those seeking legal redress for failed investments, or portfolio companies that feel their interests haven’t been served by their private equity backers.

“When you see private equity firms on the Fortune 400 list, it doesn’t take long for a plaintiff’s attorney to see them as another deep pocket,” says Jonathan Legge, senior vice president and a specialist in D&O cover for private equity firms with global insurance broker Marsh McLennan in New York.

He says the booming late 1990s were obviously not risk free, but with firms producing strong returns, there was less thought given to the possibility of failure. Now, decisions about when to write off a portfolio company as a bad investment are commonplace, and the liabilities seem daunting. Insurers say that over the past 24 months in particular, parties on all sides of the risk management equation have realised that private investing carries a far greater degree of perceived risk than in the boom years of the late 1990s.

“Our view is that it’s become an area of much greater focus,” says Patrick Fox, a partner at Bridgepoint Capital, a London-based private equity firm. “I don’t think the risk has changed much, but underwriters have seen significant claims in D&O exposure across the market.”

Perception becomes reality
Legge says there is a wide range of potential liabilities that may require D&O protection. Alleged mismanagement is the most common basis for a D&O claim, though employment practices such as wrongful termination and sexual harassment are also areas of potential liability for a company director.

The private equity industry is in a somewhat unique position because its directors have dual responsibilities for their own firm as well as the companies they oversee. As shareholder-driven litigation increases, Legge says even start-up companies that fail to get funding from particular venture capital firms might hold them liable in future.

“If one of your portfolio companies looks at another company and doesn’t invest in it, and then one year later comes up with a similar piece of software to that business, there’s always the potential that the spurned company will accuse you of stealing their idea,” he says. “In the US, you may have to spend millions of dollars to extricate yourself.”

Without protection, private equity firms could be involved in some testing scenarios, such as the one facing Forstmann Little & Co, which is fending off claims of mismanagement and failure to adhere to its fiduciary responsibilities by one of its limited partners, the State of Connecticut.

While that type of litigation is very rare and largely confined to the US, John Burkhart, a London-based vice president at Chubb, a global insurer with claims a sizeable share of the D&O market, says his firm has seen a dramatic increase in out-ofcourt claims against the D&O policies of private equity firms in Europe.

A techfocused venture capital firm may pay up to $100,000 for every $1m of cover

James Enelow, the European practice leader for Marsh’s M&A division in London, says the litigious nature of dispute resolution in the US is having an effect on Europe as well. “In the US, the historic tendency to address many investorrelated disputes through litigation has far-reaching effects, with an increasing perception that litigation will rise more and more in Europe. For insurance companies, this perception is often viewed as a reality, with a correspondingly conservative underwriting philosophy.” As a result, insurance brokers such as Marsh, Aon, Willis and Howden Insurance Brokers are busy. “If you look at the penetration of firms like us in the UK and rest of Europe, it’s probably increased fivefold,” says Alistair Lester of Aon in London.

Burkhart says his firm had dozens of private equity and venture capital firms on its client roster in 1999. Now there are hundreds, with further additions expected, despite concerns there may not be enough capacity to handle the risk. “One could safely say that D&O insurance is closer to the forefront of GPs‘ and investors’ minds than it ever was before,” says Adam Codrington, a colleague of Lester’s at Aon.

Preparation is the best defence
Assessing one’s liabilities and being able to do something about them is by no means impossible, though the process may require more time, effort, insurance consultants and lawyers than private equity firms needed previously.

Insurance brokers say the heightened awareness of risk management among private equity firms has created better relationships, based on a mutual understanding of each other’s methods, requirements and concerns.

“We don’t want to make private equity firms buy something they don’t believe they need, but we do need to explain their risks and find a cost efficient and well-structured product,” says Lester.

“It’s better for a VC to sit down with an underwriter and make sure the risks are understood. If they don’t understand, they won’t get involved, just as a VC wouldn’t invest in a transaction it wasn’t comfortable with,” says Mark Pangborn, a director at Howdens Insurance Brokers in London.

Generally, private equity and venture capital firms are approaching their work with a better understanding of risk, sometimes advised by external lawyers. Andy Knox, a partner at Clifford Chance, the international law firm based in London, says this is no bad thing. “As private equity matures as an asset class, it is starting to take on more of the systems and controls of the asset management sector in general.” Problems arise most often when initial fund documents provide an inadequate foundation for risk controls. “As lawyers, what you help clients do is think of a rainy day and build in protection for risk,” he says.

Perry Yam, a partner in the M&A practice at SJ Berwin, a London-based law firm, says the same level of scrutiny applied to the initial documentation of a fund should also be applied to its operations. “Historically most deals and directorship roles would be less structured, and there’d be one or two people involved,” he says. “Post dot-com boom, all that has changed. VCs have decided to divorce their two roles, and have made a Chinese wall of independence between investment decision-making and advising a company. Now there will often be one person who leads the investment and one who protects the interest in that company.” He says detailed board minutes and clear documentation are critical for both parties.

Clear lines of reporting may not be a glamorous solution, but they are essential: there is no magic bullet for guarding against liability issues. Pangborn says private equity directors must be extra aware of their dual responsibilities. “If your portfolio company goes into receivership, the law says you have a duty to have managed the interests of your company and to treat all creditors with equanimity, but human nature dictates you would look at it from the perspective of your [private equity firm’s] investment,” he says. “A situation like that is fraught with exposure. What you can try to do is have a very thorough understanding of where your risk arises. It’s pretty basic – due diligence, proper respect for the corporate governance process, then whatever happens, you’re able to provide a potential defence.”

A hardened market
Some insurance brokers call D&O coverage the last line of defence against a shareholder claim. This is partly because, in today’s environment, it is more expensive and less comprehensive than it was in 2000. While the perception of risk can’t be quantified, the cost of insulating oneself and one’s firm from risk can, much to the dismay of some private equity professionals. Insurance brokers say they have seen D&O premiums jump anywhere from 20 per cent to 1000 per cent.

Preston Kavanagh at Conning saw this first hand when his firm, newly independent after a June spinout from its Swiss Re-owned parent corporation, had to renew its D&O coverage. After 18 years of getting indemnification as an attached rider to its parent corporation’s policies, Kavanagh says he was treated as a fledgling venture capital shop. “When I went into the market as a small independent venture capital fund, I sensed I wasn’t dealing with insurance professionals as much as I was dealing with wolves,” he says ruefully.

When you see private equity firms on the Fortune 400 list, it doesn’t take long for a plaintiff’s attorney to see them as deep pockets

He is not alone. Most multi-year policies that covered private equity professionals must now be renewed annually, and at greater cost. Where some firms once obtained $1m in D&O cover for as little as $8,000 a year, according to Jonathan Legge at Marsh, those costs have skyrocketed. Now a tech-focused venture capital firm may pay up to $100,000 for every $1m of cover, he says.

While costs in the UK and the rest of Europe are lower, the trend is much the same, says Walters. “Two things are happening – premiums are increasing, sometimes very dramatically, and coverage is being restricted in certain areas,” he says. D&O coverage is something private equity GPs can’t afford not to have, but are finding it harder to simply afford.

For those private equity practitioners recognising that their potential liability as directors and officers could be serious, these developments in the insurance market are not encouraging. However, whether every GP in the land actually thinks about these issues with the same sense of urgency is less clear. At the European Venture Capital Association’s Technology Investment Conference in Amsterdam in October, one item on the agenda was a roundtable entitled “VC directors liabilities and responsibilities”. Not one of the 400 delegates present at the event turned up. Of course, this might have been because there was no shortage of distractions: another dozen roundtables were held all at the same time. But maybe, just maybe, some of those present just didn’t want to be reminded that from a liability point of view, they are operating in a challenging environment.