How private equity firms can manage their unique risks

Private investment is a robust contributor to the U.S. and global economies, with private equity firms often moving fast to acquire target companies. By the very nature of their complex operations, private equity firms face risks that are unique to their sector. Successful transactions depend on careful due diligence that precisely identifies risks, determines total costs and assets, and evaluates earnings projections, among other tasks. And all of this often needs to happen on tight deadlines — where delays can cause deals to collapse and inadequate due diligence can undermine the success of an acquisition over the long term.

In this dynamic environment, the right insurance provider can be a critical partner. An experienced insurer with combined expertise in both private equity and target company sectors can help identify and manage myriad risks — and help push deals across the finish line.

Insuring transactions themselves with representations and warranties (R&W) insurance, tax indemnity insurance, and contingent liability insurance is an essential part of managing transactional risk. But critically, the long-term success of a deal also depends on acquiring the right insurance for the target company at a feasible cost. A strong risk management program can help minimize volatility of earnings and declines in valuation — and improve ROI.

For target companies — especially in the middle market — insurance can be a significant expense. Private equity firms need an accurate assessment of what a target company’s insurance costs will be post-transaction to avoid overpaying for the company. An experienced insurer can help private equity firms address the most difficult property and casualty coverage challenges, including:

• Volatility in the property market — In recent years, the market for property insurance has become highly challenging. Significant losses driven by extreme weather events and natural disasters have caused insurers to raise rates, reduce capacity, or exit some markets altogether. While increases have moderated since 2020 highs, the market is still tight. Depending on the type and location of assets of a target company, insurance costs and availability can weigh heavily on the value of a transaction.
• High-hazard occupancy — A company with high-risk assets — such as hazardous manufacturing facilities — may not meet the requirements of underwriters. With insurance rates and placement in doubt, financing options may become a barrier to completing a transaction. A strong insurance partner can help identify opportunities to mitigate risk and offer an insurance program that will help clients meet lender requirements — often on a tight timeline.
• Carve-out deals — Carve-out transactions present additional diligence complexity as risk profiles change when a unit operating within a larger company becomes a smaller divested entity. Certain properties may become prohibitively costly to insure or uninsurable by standard carriers when separated from a larger parent company or removed from a portfolio. Pitfalls in budgeting can also arise when allocated insurance costs for the carved-out business don’t accurately reflect ongoing post-transaction costs. An experienced, diligent insurer can help address these cost analysis issues, prevent a carve-out transaction from becoming derailed by identifying high-risk characteristics for property, casualty, and other coverages, and determine the best insurance options. In some cases, private equity firms may choose to assume greater risk, seek ways to transfer risk, or contract with secondary carriers to cover excess exposure.

When it comes to providing risk management counsel and placing insurance, private equity firms are different. Keep in mind the following challenges facing this sector:

• Diligence delays due to underwriting review — The common axiom, “Time is money,” is especially true in the world of private equity. Firms often need to move rapidly to seize a market opportunity or outpace a competitor. When purchase agreement deadlines are looming, deals can collapse if insurance and financing are not in place. In addition, once a transaction is completed, private firms do not want to be exposed to losses because of insurance gaps. A strong insurance partner for private equity should be able to conduct due diligence, develop insurance programs, and generate quotes on tight timelines.
• Higher costs from fragmented insurance — Private equity firms can face higher costs and diminished services when they insure portfolio companies individually or their carrier does not provide a holistic approach to insuring portfolio companies. Firms should look for an insurance partner that provides the broadest range of coverages and can help them drive down the total cost of insurance across their entire portfolio. Smaller transactions, for example, should be given a level of attention that reflects their association with the larger spend of the whole portfolio. Firms may be able to maximize their purchasing influence and achieve economies of scale by consolidating their insurance spend with a single carrier.
• Inadequate approach to risk engineering — Insurers that provide risk engineering services—or collaborate closely with risk engineers — can help mitigate risks, protect assets, and drive down the total cost of risk over the long term. By contrast, an insurer that fails to incorporate risk engineering may expose private equity firms to greater risks and even undermine deals. For some transactions, surveys conducted by risk engineers can help improve underwriting results and thereby increase returns.
• Limited global expertise — Middle market companies are increasingly conducting business across borders to drive new growth. An insurer without global expertise and reach can be a liability to private equity firms that are building a portfolio of companies with multinational operations. A global insurer with expertise in private equity can help identify and mitigate the special risks that come from operating in multiple jurisdictions.

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