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HUB International 2022 Outlook

Financial Institutions Industry

 

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More Deals, More Pressure on Private Equity

Because the number of deals in private equity has skyrocketed, firms that recognize and plan for the increased pressures on their funds will have more success in buying, running and selling portfolio companies in 2022.

Ongoing high pressure in public equity markets

With a resurgence of M&A activity, private equity (PE) businesses were busy in 2021. Even if the high level of activity eases in 2022, portfolio companies and managers will have to cope with plenty of risk management issues, no matter the temperature of the PE market.

Following a dip in M&A activity due to the COVID-19 pandemic, private equity had a massive rebound at the end of 2020 that carried through 2021 and could extend into 2022.

The private equity market has been so hot that underwriters can’t keep up with demand for R&W coverage

For the first five months of 2021, private equity deal volume rose nearly 22% from the same period in 2020, with 2,346 deals. Contributing factors include low interest rates, pent-up demand from PE firms, and sellers seeking to lock in gains at favourable tax rates before a potential capital gains tax hike in 2022. This has resulted in PE sitting on a record US$150 billion in dry powder, the funds available for doing deals.1

The market has been so hot that underwriters have been challenged as they try to keep up with demand for writing representatives and warranties (R&W) insurance coverage.

In addition, the PE secondary market is booming but involves new challenges as well due to the need for rigorous underwriting and customized contracts. Innovation and market expertise are advantageous.

Then there’s ongoing cybersecurity risk with portfolio companies, demanding heightened due diligence.

1 PwC, “Private equity deals insights: 2021 midyear outlook,” accessed October 1, 2021.

Here are major issues and risks that private equity will face in 2022:

Insurance premiums have soared and some underwriters won’t consider smaller deals

All risk concerns need to be identified, costs calculated and subsequently incorporated into a purchase price agreement

1. Rising premiums will create new pressures on profitability

Representations and warrantees (R&W) insurance is essential to facilitating deals in part by transferring risks from the buyer to an insurer. But getting coverage has not been as easy as it has been in the past.

Rates on R&W insurance have risen as much as 50% from 2019 to 2021, according to some reports, largely due to a flood of new business submissions which has overwhelmed underwriting staff: Consider it a perfect storm of higher volume and understaffing.

To account for squeezed staff at underwriters, insurance premiums have soared and some insurers won’t even consider smaller deals.

The pressures related to delays in underwriting new risks have been particularly acute for deals in heavily regulated sectors such as financial institutions.

It’s not just R&W coverage that’s been affected. For portfolio companies, general liability insurance and cyber insurance premium increases could top 20% at renewal.

Likewise, premiums could rise 15% to 20% for Directors & Officers (D&O) liability and employment practices liability (EPL) insurance for companies owned by private equity firms. These rising premiums are putting pressure on portfolio company profit margins.

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As a result, it’s essential to be thorough in due diligence when evaluating deals. Any details or risk concerns should be clearly identified, and costs calculated and incorporated into a purchase price agreement.

Working with a broker that has expertise in PE and portfolio companies is crucial to managing these challenges and adding value while completing deals.

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The PE secondaries market will continue its boom, putting pressure to underwrite highly customized policies

2. The secondary market will thrive

The secondary market allows PE firms to keep high-performing assets longer while creating an important additional source of liquidity, which is attractive to retail and institutional investors.

Business in the private equity secondary market is booming, with a record US$48 billion of transactions in the first half of 20212 and a projected all-time high of more than US$100 billion for all of 2021.3

It is common for secondary market R&W policies to be highly customized. What differentiates a best-in-class insurance broker is a deep familiarity with the market and its risks, along with the ability to negotiate an innovative, customized contract for secondary transactions.

As with the primary market, strong R&W coverage is essential for managing risk in the secondary market.

2 Private Equity Wire, “PE secondaries market sees surge in interest,” April 8, 2021.
3 Forbes, “The Key To Private Equity’s Growth Is The Booming Secondary Market,” June 21, 2021.

Some PE firms are taking an aggressive approach to portfolio-wide cyber liability insurance

3. Cybersecurity will continue to be an issue

Cybersecurity used to be nothing more than a blip on PE executives’ radar — in the past, they might merely check off a box to indicate that a target simply had cyber insurance.

Those executives are probably pining for those days again, as cyberattacks on their portfolio companies have become more common and managing that risk is now a major focus. Whether it’s data theft or ransomware, cybercrime can disrupt operations and the profitability of portfolio companies, as well as lead to reputational risks.

Ongoing labour shortages have compounded the risk as fewer employees mean overtaxed IT departments and security. Add to this the increase in employees accessing corporate networks from home, which has resulted in a higher number of cyberattacks overall.

Within private equity, the sensitivity of much private information has led many insured firms to opt for quick affirmative responses to ransomware attacks.

However, with ransomware attacks rising, underwriters are enforcing stricter guidelines and even some organizations with no losses are seeing annual premium increases of up to 40%. This makes it incumbent upon PE firms to make cybersecurity a priority at their portfolio companies.

Insurers are taking a close look under the hood, requesting details on policies and procedures that guide responses to ransomware attacks. How well are staff trained? What are the preventative measures and contingency plans?

Having a credible, effective cyber-risk protection plan in place at the portfolio company can make or break a deal. For that reason, some PE firms are taking a more aggressive hands-on approach to portfolio-wide cyber liability insurance. At stake is not only the risk of a multimillion-dollar payout and potentially costly business interruption but also far-reaching reputational risk.

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Moving forward in 2022

Insurance to cover the risks related to private equity deals is both critically important and in high demand. Securing coverage will mean allowing for an underwriting process that could take many weeks to complete.

The forces that have created uncertainty and volatility over the past two years are still with us. And the high volume of PE deals is expected to continue, along with the pricing pressures mentioned above. In 2022, PE firms will need to put a premium on risk management and work with an experienced broker that specializes in private equity.

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