Building a Private Equity Insurance Program

Transcription

1 Building a Private Equity Insurance Program Houston, TX Thursday, November 5, 2009 John Ambrose Department of Financial Institutions Chubb Specialty Insurance Agenda I. Introduction / U.S. Statistics II. III. IV. Operations & Liability Exposures Claim Case Studies Insurance Coverage Overview V. Underwriting Program 1

2 What is VC/Buy-out Investing? A Venture Capital investment is a transaction in which a firm or individual, or group of firms or individuals, provides private financing to an early-stage company embarking on a new, expansion or turnaround venture, in exchange for a minority ownership stake; A Buy-out investment is a transaction in which a firm or group of firms acquires an under-performing or undervalued mature company; with such transaction entailing above average investment risk but also offering the potential for above average profits. Private equity fund types Venture Buy Out Mezzanine Fund of Funds DFI Program 2

3 Section I U.S. Statistics Capital Invested in U.S ($ in billions) Q09 Venture Buy-Out Source: Thompson Financial Program 3

4 Funds Raised in U.S ($ in billions) Q09 Venture Buy-Out Source: Thompson Financial Total Private Equity Investments by Sector 2008 Totals ($bil) Non High Technology Medical / Health / Life Sciences Information Technology Source: Thompson Financial Program 4

5 Investment Returns (As of 4Q 2008) (IRR %) Year 3 Year 5 Year 10 Year 20 Year Venture Buy-Out Source: Thompson Financial U.S. Market Buy-out The mega era came & went Credit Crisis Going Public? High profile / increased scrutiny International Program 5

6 U.S. Market Venture Capital Back to basics Disciplined investing / fund raising M&A most likely exit IPO exits non-existent International Section II Operations & Management Liability Exposures Program 6

7 80% of Income 99% of Capital Structure of a Fund Typically, a limited partnership or LLC Limited Partners or Members: Investors (99% of capital) General Partners or Managing Members: Investment Managers (1% of capital) Limited Partnership / LLC Funds Fund Investors Fund Managers 20% of Income 1% of Capital Advisory Board Fund 1% - 2.5% Annual Management Fee Management Company Portfolio Company Portfolio Company Portfolio Company Program 7

8 Four Stages of a Fund Critical Activities & Liability Exposures Stage One: Fund Raising Critical Activities Solicitation of institutional investors and wealthy individuals Lasts 6 months to 1.5 years Venture fund size: $10 million to $500 million Buy-out fund size: $250 million to $2 billion Program 8

9 Stage One: Fund Raising Liability Exposures Fraud and misrepresentation within the Private Placement Memorandum Vicarious Liability for partnership interests sold through a placement agent Stage Two: Investing in and/or Acquiring Portfolio Companies Critical Activities Due Diligence : Identifying, analyzing and investing in PCs Competing for attractive PCs Negotiating Financing Terms Lasts 3 to 6 years Program 9

10 Stage Two: Investing in and/or Acquiring Portfolio Companies Liability Exposures Breach of contract for not fulfilling investment promise or investment contract Liability arising from competitive bid situations with other firms Financing terms Dilutive financing (i.e. down rounds) Leverage/Bridge Loans Stage Three: Increasing Portfolio Company Value Critical Activities Fund Manager(s) take PC board seat(s) Fund Manager typically sits on many PC boards Special Dividends Fund Manager spends between 40 60% of their time on PC board duties Interview, hire and fire key executives Raise additional financing Operational & management decisions Program 10

11 Stage Three: Increasing Portfolio Company Value Liability Exposures Liability arising from professional services provided to PCs Employment related actions for hiring and firing of key executives or employees Acquisitions by portfolio companies Changes in strategy, product mix, etc. Stage Three: Increasing Portfolio Company Value Liability Exposures, con t Outside Directorship Liability Typical Director liabilities Breach of Duty of Loyalty and Duty of Care claims by PC against PC Director (real or perceived conflict of interest) Employment liabilities imposed against the PC Directors and directly against the firm ( i.e. tortuous interference of an employment contract) Program 11

12 Stage Four: Liquidation of Investments Critical Activities Venture investments, liquidate in 2 5 years Buy-out investments, liquidate in 3 7 years Three Exits IPO Sale Failure Stage Four: Liquidation of Investments Liability Exposures Portfolio company bankruptcy / insolvency (Credit Crisis) Special Dividends Sale that doesn t meet expectations Exposure to liabilities relating to the safeguarding of insider information Securities Law violations in IPO Down round dilution liabilities Program 12

13 Down Round Example $20 MM Valuation $10 MM Investment $30 MM Post Money Valuation 50% Lower Valuation $15 MM Valuation $15 MM Investment $30 MM Post Money Valuation Ownership 67% Management & Employees 33% VC Investor Ownership 33% Management & Employees 17% Previous VC 50% New Investors First Round 2000 Second Round 2002 Down Rounds Impact of a Down-Round: Dilution of previous investor s ownership (absent anti-dilution provisions) Valuation loss to previous investors Morale buster for Employees and Management Impacts ability to attract and retain talent Conflict of interest for Directors Program 13

14 Section III Claim Case Studies In-Kind Distribution Why Lend when you can Buy? Portfolio Company Bankruptcy Case # 1 In-Kind Distribution Program 14

15 Facts A well established VC participated in three investment rounds for XYZ portfolio company. Two partners from the VC joined XYZ s Board. XYZ had a successful public offering. At the end of the holding period, the VC elected to distribute the XYZ stock to limited partners in-kind, which was often the practice of the firm. Facts The VC used the services of a well known Distribution Agent to handle the stock distribution. No written contract existed detailing the Distribution Agents responsibilities. On a Friday, once trading was concluded, the VC notified the LP s, via fax, the distribution was going forward. The stock was made available for trading the following Monday. Program 15

16 Facts Six months passed... Discovery The largest LP, going through an internal audit of its capital accounts, discovers a discrepancy between their records and the Limited Partner report from this VC. The discrepancy is tracked to the stock distribution of XYZ. Upon further review, the LP can find no record of any notification from the VC. Program 16

17 Coverage Overview VC s investigation found that: No record can be found to prove notice was sent to this LP. The distribution agent can not produce any proof they notified the LP The distribution agent discovers a second LP account still containing the XYZ stock. The VC can not produce any proof the second LP was notified. XYZ price stock has dropped 75%. Coverage Overview LP s assessment of damages: Significant ($M s) direct loss due to the depreciation in the stock price over the six month period. Additionally, loss of use on the investment gains they would have received over the six month period. The amount was to be assessed against the total value of the distribution, not just the 75% investment loss. Program 17

18 Coverage Overview Final assessment base on add l info: The liquidity of XYZ stock during the six month period, plotted against the stock s rate of decline. The LP s prior history in selling new issues post distribution, specifically, the timing of such sales. Culpability of the distribution agent. Settlement Settlement was reached with the first LP based on an average stock price 55% below the distribution price. The same offer was extended to the second LP, who had not yet discovered the error, and reached a 50% settlement. Unsuccessful establishing 100% culpability of the Distribution Agent given the lack of detailed performance guidelines and speed of settlement. Program 18

19 Case # 2 Why Lend when you can Buy? Facts Company A (Not a PE firm) is looking to acquire two other companies (Companies B and C) and roll them into their own organization, creating Company ABC. Company A approaches Private Equity Firm and asks them for a loan to finance the acquisition of Companies B and C. Program 19

20 Facts Private Equity Firm decides not to grant Company A the loan, and Company A can find no other lenders to support their acquisitions. Several months later, Private Equity Firm buys companies B and C as part of their investment portfolio. Coverage Overview Private Equity firm charged with: Breach of duty of good faith and fair dealing. Fraud. Tortuous intervention and conversion. Breach of fiduciary duties. Program 20

21 Settlement The case goes to trial and after key testimony from one general partner from Private Equity Firm PE, the insured decides to settle for several million dollars. Case # 3 Portfolio Company Bankruptcy Program 21

22 Facts VC Firm owns two technology focused portfolio companies. One is struggling (PC1) and one is doing well (PC2). Over the years, a vendor had provided millions of dollars in electronic equipment to PC1. The VC Firm has the same general partner sitting on the boards of both portfolio companies. The VC Firm feels that the struggling portfolio company (PC1) would benefit if rolled into the more successful portfolio company (PC2). Facts The successful portfolio company (PC2) takes effective ownership of the struggling portfolio company (PC1) and liquidates PC1 s hard assets through a Chapter 7 Bankruptcy. All Secured Creditors including the VC firm are agreeable to terms of the liquidation. The technology vendor is not involved in the bankruptcy proceedings, and realizes months after the BK Proceeding, that PC1 owes them close to $1 MM in receivables for electronics. Program 22

23 Coverage Overview VC firm and general partner are sued for: Fraudulent conveyance. Breach of contract. Breach of fiduciary duty. Interference with prospective business advantage. Settlement The Plaintiff demands payment for the equipment. Neither Portfolio Company Carries D&O Insurance. Defense and Settlement > $500,000 Program 23

24 Section IV Insurance Coverage Overview Coverage Overview Combined line policy covering: Management Liability Management Indemnification Professional Liability (E&O) Outside Directorship Liability Program 24

25 Coverage Overview D&O - Side A/B Directors & officers General partners Managing members Equivalent executives of the above Advisory board / investment committee members Coverage Overview Professional Liability (E&O) Past, present and newly created funds Entity general partner or managing member Management company Investment holding companies Subsidiaries Any Insured Person including employees and advisory board members Program 25

26 80% of Income 99% of Capital Coverage Overview Outside Directorship Liability Any Insured Person, including any advisory board member serving as a director or board observer of a portfolio company. At the direction or request of the Insured Typically Covered Entities Fund Investors Fund Managers 20% of Income 1% of Capital Advisory Board Fund 1% - 2.5% Annual Management Fee Management Company Portfolio Company Portfolio Company Portfolio Company Program 26

27 80% of Income 99% of Capital Typically Excluded Entities Fund Investors Fund Managers 20% of Income 1% of Capital Advisory Board Fund 1% - 2.5% Annual Management Fee Management Company Portfolio Company Portfolio Company Portfolio Company Coverage Overview Key Definitions: Insureds Professional Services Fund Services Portfolio Company Services Portfolio Company Past, present & future Not a subsidiary Program 27

28 Coverage Overview Outside directorship liability: Double Excess Blanket coverage for board seats of not-for-profit organizations and private portfolio companies Automatic coverage period for board seats after registration for public offering Public board seats are scheduled Run-off coverage Coverage Overview Policy exclusions: Prior notice Prior & pending litigation Insured vs. insured (advisory board member carve-back) ERISA for employee plans (not PC plans) Bodily injury (mental anguish carve-back for PC employees) Personal injury Program 28

29 Coverage Overview Policy exclusions (continued): Pollution Personal conduct Liability assumed pursuant to a contract Intentional breach of contract Short-swing profits 16b New subsidiary prior acts Coverage Overview ODL exclusions: Prior acts / prior knowledge. Wrongful acts by individuals after leaving PC Board. Claims by an Outside Entity and directors, officers, etc. except: Independent claims brought by a portfolio company or its directors, officers, etc. Derivative suit. Cross claim. Program 29

30 Coverage Overview ODL exclusions (continued): Prior & pending litigation Coverage Pitfalls in the Market E&O coverage grant requires services performed for portfolio companies are done for a fee or under contract. ODL coverage grant includes a built in warranty. Policy requires that all entities be specifically scheduled. International exposures not appropriately addressed E&O claims must come from customer Apply EPL Related exclusions to D&O/E&O/ODL policy Program 30

31 Coverage Pitfalls in the Market Poorly constructed definitions create coverage gaps. Portfolio company programs that cover both the firm and the portfolio companies under a single policy. Intellectual property exclusion Tortuous interference. Style drift exclusion Failure to address ODL for PC s with Public Debt Coverage Pitfalls in the Market No coverage for newly created funds Contract may be cancelled mid term Program 31

32 Section V Underwriting Submission Materials What you ask for? Organizational Chart Why you need it! Used to identify all parties involved in the fund, investment managers, investors, management company, advisory boards / committees, etc. Private Placement Memorandum / Offering Memorandum This is the advertisement used to attract investors to the fund. Useful information includes biographies on investment managers, historical investment performance, and basic outline of the new fund. Limited Partnership Agreement / LLC Agreement Legal document that establishes the fund and general partnership or LLC. Culmination of negotiations between investors and investment managers over terms, conditions and compensation. Program 32

33 Submission Materials What you ask for? Fund Financial Statements Why you need it! Report to investors prepared by the investment managers. Describes each portfolio company s financial and organizational status, including the capital invested and current valuations carried on the books Portfolio Company Data Provides financial position of Port Co Port Co D&O insurance also valuable Limits of Liability & Retentions Carrier capacity: $10,000,000 Typical Retentions <$100 million under management $100,000 <$500 million under management $250,000 >$1 Billion under management $500,000+ Program 33

34 Customer Characteristics Portfolio companies are key area of exposure, while investors have not been Sophisticated buyer focused on the value of products first and the price second Will buy to protect their personal wealth and the fund s IRR Insured will often consult with their counsel to negotiate insurance, which emphasizes your strength in expertise Customer Characteristics Firms fully understand the professional services they provide to portfolio companies and quickly conclude that not all E&O is created equal Expense of management liability insurance paid as a fund expense, and not from the pockets of the general partners Investment managers are due diligence professionals Program 34

35 Breadth of Insurance Product Inventory Firm D&O/GPL, E&O, ODL Employment Practices Fiduciary Bond Property & Casualty Group Personal Excess Personal Lines Portfolio Company D&O / Side-A (incl IPO) E&O Environmental Impairment Liability Property & Casualty EPL Fiduciary Crime Personal Lines Questions? Program 35

36 Thank You & Good Luck! Program 36