Representation and warranty insurance in private equity GP-led secondary transactions

As structured secondaries transactions become more prevalent in private equity (PE), the use of representation and warranties insurance (RWI) in connection with secondaries deals continues to rise. RWI underwriters continue to broaden their appetite to include insuring these transactions and have modified the underwriting process to accommodate the unique aspects of secondaries transactions.

What is a GP-led (structured) secondary transaction?

Structured secondary transactions typically involve a private equity fund general partner (GP) transferring certain assets to a separate continuation fund managed by the same GP. Historically, such transactions were largely limited to perpetuating “zombie funds” that were unable to find profitable exit opportunities for their limited partners (LPs).

In recent years, however, PE firms increasingly have used this technique to extend the duration of a GP’s management of high-performing assets, providing additional opportunity for the fund’s investors to realize an asset’s potential value. The transactions are structured to enable existing LPs to roll their equity into the continuation fund or cash out in favor of immediate liquidity. New LPs will then join the ranks of the rolling LPs by providing a cash infusion that is used to fund the cash out of the exiting LPs and supplement the continuation asset’s balance sheet.

The recent increase in number and size of GP-led secondary transactions consummated by high-quality PE sponsors has largely eliminated any stigma associated with these deals. Such changes also highlight the significant benefits they provide when executed, including:

• Allowing the GP to retain management of a known asset for longer, increasing the opportunity for value maximization
• Providing existing LPs with a liquidity option while offering infusions of unfunded capital commitments from new LPs to help grow the target business
• Offering the GP a chance to realign the fund’s economics by cashing out certain LPs and potentially reallocating future carried interest for senior professionals

PE investors’ recognition of these value drivers is evidenced by an increasing LP investor base, record levels of dedicated available capital and increasing fund sizes (with a rise in funds dedicated specifically to GP-led transactions). As a result, the volume of global secondary transactions hit a record $132 billion in 2021¹ (surpassing the previous record of $88 billion set in 2019), $68 billion of which resulted from GP-led transactions with at least 15 closed transactions valued at over $1 billion. Given present market dynamics, the growth in volume and size of GP-led transactions is expected to continue.

Adaptation of RWI to the unique structure of GP-led secondary transactions

In a typical RWI placement, carriers depend on the buyer’s and its advisors’ thorough due diligence to supplement the underwriting process. Accordingly, PE fund sponsors historically used RWI selectively, as incoming LP investors in GP-led secondary transactions typically conduct minimal diligence and rely heavily on the GP’s reputation, knowledge and track record when making investment decisions.

By contrast, in recent years the use of RWI in structured secondaries has increased dramatically. Their increased use is driven in part by carrier recognition of the relatively advantageous risk profile of secondary deals and their ability to adjust underwriting requirements accordingly.

RWI carriers increasingly recognize that, though secondaries LP investors’ scope of due diligence is limited, it supports the “fundamental plus” and knowledge-qualified representations provided by a continuation asset in standard GP-led secondary transactions. The typical diligence scope for a secondary investor consists of reviewing:

• Ownership and capitalization tables of the fund
• GP financial and tax statements
• Portfolio company governing documents
• Limited portfolio company diligence, including review of its litigation profile (including lien and litigation searches) and material contracts

A continuation asset’s representations in a typical structured secondaries transaction are generally limited to “fundamental plus” representations regarding the GP’s ability to consummate the transaction, certain limited tax matters and knowledge-qualified statements regarding the operation of the specific asset. Acknowledging that the above diligence scope sufficiently supports such representations, RWI carriers have adapted their underwriting requirements accordingly.

Benefits of procuring RWI and favorable policy terms in GP-led secondary transactions

Using RWI as an indemnification solution in structured secondary transactions benefits both new and selling LPs. Specifically, new LPs:

1. Receive more favorable transaction terms (e.g., longer indemnity periods and a broad “loss” definition)
2. Improve the competitiveness of their bid by offering LPs the ability to walk away without an indemnity or holdback (also incentivizing existing LPs to approve the transaction, improving deal certainty),
3. Avoid post-closing disputes with the existing GP
4. Have greater certainty of recovery for losses incurred as a result of a breach of a representation

Concurrently, the selling LPs:

1. Have less post-closing exposure to indemnification obligations, escrows and clawbacks
2. Receive more cash at closing
3. Spend less time and money negotiating complicated indemnity provisions

Terms provided by RWI carriers in GP-led secondary transactions generally are more insured-favorable, including lower rates, than those provided in the standard M&A context.

As RWI carriers continue to become more attuned to the benefits of covering such PE transactions, RWI is likely to become a standard feature of structured secondaries transactions.

Disclaimer

Willis Towers Watson hopes you found the general information provided in this publication informative and helpful. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal advisors. In the event you would like more information regarding your insurance coverage, please do not hesitate to reach out to us. In North America, Willis Towers Watson offers insurance products through licensed entities, including Willis Towers Watson Northeast, Inc. (in the United States) and Willis Canada Inc. (in Canada).

Footnote

¹ Jefferies, Global Secondary Market Review, January 2022