The Rise of RWI in Secondary Financing

One form of transaction not historically seen is the use of RWI for “secondaries.” While that term means different things, in this case, the focus is Private Equity secondaries, which refer to the buying and selling of pre-existing investor commitments either from or to private equity and other alternative investment funds.

These transactions mostly fall into one of the below structures:

• Full or Partial-fund restructuring
• Purchasing LP interests
• Limited partnership interest is a stake in a business entity owned by one or more general partners and one or more limited partners.

The purpose of these transactions is usually to extend the fund’s life and give existing investors the chance of a liquidity event. There are several reasons why this might be done:

• It’s not the best time to realize the total asset of the fund perhaps because the business is about to enter a growth stage or could potentially acquire a sizeable customer in the next year or so.
• You have yet to address solvable operational issues, and this means you could achieve more value with more time, for example moving to a new location or consolidating the workforce more effectively.
• Expected change in economic/regulatory conditions that will affect value. For example, now may not be the best time to close a Ukraine fund, but after the war that situation could change. Alternatively, maybe the expected FDA clearance for a new drug is taking more time than anticipated.

Secondaries and RWI: What You Need to Know

Private Equity deals have used RWI routinely for many years and it is used in most standard PE (Private Equity) transactions. Only recently have they become popular because of the underwriting market resolving several issues to make using RWI for secondaries more viable. We discuss those reasons below.

Insurance Due Diligence for RWI: Expect a Different Process

Underwriters usually undertake lengthy diligence in a standard transaction. It involves a review of due diligence reports, full access to the data room, and an underwriting call. This can be perceived as an extra burden because M&A practitioners value speed and simplicity when getting deals done. Underwriters were unwilling to change this level of scrutiny because of the sense of security it offered them, which meant that the secondary market could not utilize the insurance.

However, there is a good reason secondary market transactions have far less diligence. Representations are knowledge qualified and pertain to fundamentals. The volume of claims for fundamentals is extremely low making it an attractive risk to insure. On top of that, qualifying something to knowledge creates a much higher bar for a successful claim for a breach of warranties. Some underwriters understand this and have adapted their due diligence to suit. These days, the truncated diligence for secondaries will consist of the following:

• Transaction structuring information—who is buying what, from who and in what format
• SPA/APA disclosure schedules and related transaction docs like ancillary agreements
• Limited buy-side due diligence focused on assets of the fund—overview of the portfolio, its economic performance, and any specific out-of-the-ordinary liabilities
• Comprehensive financial reporting data of the GP (general partners) and investment committee

Much of the remaining documentation required is merely copies of any incoming LP (Limited Partnership) requests, such as the following:

• Cap tables
• Portfolio company
• Financial statements
• Board minutes and corporate governance documents
• Material contracts and litigation history at the fund and portfolio company level

Important: Excluded Obligations

As part of the transaction, the buyer will often also inherit all obligations and liabilities of the seller. A liability is something a person or company owes, usually a sum of money. Liabilities are settled over time through the transfer of economic benefits including money, goods, or services. Recorded on the right side of the balance sheet. Liabilities include loans, accounts payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses. However, some of these obligations and liabilities are unreasonable to assume in the context of a secondary transaction and a line is drawn between certain historical obligations and current ones. Following is the realm of the excluded commitment.

• Breaches of certain representations
• Taxes related to sellers’ interest in the fund
• Clawback obligations
• Acts or omissions of the seller
• Unpaid management fees
• Breaches by the seller of the LP agreement

Some underwriters are willing and able to cover these excluded obligations, making the purchase much more attractive. Sellers, buyers, and GPs (general partners) can potentially benefit by being able to utilize RWI for the insurance of the excluded obligations. This acts as a backstop for the exiting LPs and protection for the incoming LPs, such as creating synthetic EOI in the RWI policy. GPs and LPs are protected from LP clawback risk.

Price and Acquire the Coverage you Need

Most reps are usually knowledge qualified and fundamental, as discussed previously, making pricing substantially less for secondary transaction coverage. However, an AP (Additional Premium) can apply if they need coverage for excluded obligations.

Using RWI for Secondaries will Continue

There is a tremendous amount of dry powder floating around. Currently, it is estimated that there is over $2 trillion dollars sitting in Private Equity funds waiting to be deployed, and with the incredible performance of Private Equity funds in the last decade, we see secondaries becoming an increasingly viable option, not only for the mega-funds but even for the smaller PE houses.

The competition from underwriters is growing and we think this will become an extremely competitive insurance marketplace over the next year.