Private Equity Fund Insurance

We are all familiar with companies such as Microsoft, Genentech, and Federal Express. However, what many of us do not realize is that behind the success of many of these now publicly traded companies were private equity funds (or “Funds”). Funds provided these companies with the money and knowledge needed to assist them with their development. In recent years, Funds have experienced explosive growth, gaining recognition as an alternative investment vehicle because of their historical investment performance. With over 1,000 Funds in existence, there are growing opportunities for underwriting the risks associated with these Funds.

or the past several years, the amount of capital flowing into Funds has increased in each successive year. This trend continues in 1998. According to the October 1998 issue of the Private Equity Analyst, as of September 1998, 210 Funds closed with capital commitments totaling $55.6 billion. Comparatively, by year-end 1997, 254 Funds closed after raising $54.5 billion. Also, as of September 1998, another 336 Funds had raised an estimated $42.5 billion and were still seeking additional capital. Institutional public and private pension funds have contributed over half of this capital, motivated by the potential for returns superior to other investments. Generally, the investment returns posted by Funds have exceeded market indices such as the S&P 500.

While Funds are usually organized as limited partnerships, recent changes in the tax code have allowed Funds to form either Limited Liability Partnerships or Limited Liability Companies. The advantages and disadvantages of each center on liability, taxation, and management issues. No matter what the organizational form, Funds ultimately invest in an array of entities, so called “portfolio companies,” over which they have a varying degree of control.

Funds differentiate themselves by their investment strategy. Variables such as the nature of the investment (debt or equity), industry sector, geographic region, or age of the company make each Fund unique. While many of the investments are high risk, Funds can mitigate such risk by developing a mix of portfolio companies with varying degrees of risk that still meet their investment criteria. Fund managers can also mitigate risk by obtaining representation on a portfolio company’s board of directors or providing strategic advice to the portfolio company in critical functional areas such as finance, marketing, and legal. The common objective: build a successful company that may be an attractive acquisition for another organization or alternatively, may be sold to the public through the issuance and sale of common stock.

Funds present some interesting and difficult exposures. These exposures can be classified into at least four categories:

(1) Securities Claims - Fund managers who serve as outside directors of publicly traded portfolio companies run the risk of being named as defendants, along with their Funds, in securities litigation brought against their portfolio companies. In addition, trading by Funds and their managers in public portfolio company securities may also trigger an investigation by the SEC or other regulatory agency.

(2) Other Third Party Claims - Portfolio company employees, creditors, or other third parties sometimes sue Funds and their managers for wrongs allegedly committed by the portfolio company itself on the theory that the Funds “controlled” the company.

(3) Claims by Portfolio Companies/Founders - Some portfolio companies’ founders have brought suit against a number of Funds and their managers alleging wrongful termination of the founders without adequate legal basis and for diluting their equity interests in the portfolio company through certain financial transactions. Managers and their Funds have also been sued for allegedly failing to provide promised financing to portfolio companies.

(4) Claims by Fund Investors - Funds and their managers are also exposed to litigation by their investors for poor investment decisions, conflicts of interest, or failure to adhere to the stated investment strategy of the Fund. Recently, a claim was filed against a Fund manager by an investor alleging mismanagement as a result of the Fund’s investment in a portfolio company that disclosed its inability to comply with Year 2000 requirements. Our underwriters have been providing insurance solutions to these Funds for the past ten years using a modified General Partners Liability Policy. Recognizing marketplace developments motivated us to craft the Private Equity Fund and Management Liability Policy, a comprehensive insurance product that addresses the specific insurance needs of these unique risks.

We believe that there is tremendous opportunity for premium growth in this area. While no statistics are available for the percentage of Funds purchasing this type of insurance, we estimate that less than ten percent (10%) of Funds have coverage in place. With over 1,000 Funds currently operating in the industry, there is great potential for new business. Our challenge is to make the brokerage community and those who have influence over insurance purchasing decisions aware of the considerable benefits of this insurance and the availability of a product that will allow Funds to operate more freely in their dynamic business environment.

David Garrison
Underwriter
D&O Liability