In a secondary fund transfer, sellers will typically transfer their interest in the fund exclusive of certain obligations and liabilities which should more appropriately remain with them – these are known as excluded obligations.
Owing to the fact that buyers are now holding interests in the funds which were previously owned by the sellers, there is a risk that they will be held liable for certain excluded obligations as a result of, for example, a successful successor liability claim – in effect, these are secondary liabilities.
To protect themselves against secondary liabilities in connection with excluded obligations, buyers will usually require an indemnity from sellers (the excluded obligations indemnity or EOI).
The typical scope of the EOI addresses risks associated with:
- R&W: breaches of certain representations made by the seller in their original subscription agreement, side letter and other agreements signed by the seller;
- Taxes: taxes relating to the sale of the seller’s interest in the fund; and/or
- LP clawback: clawback obligations pertaining to the seller’s period of fund ownership which are payable by the LPs. This is where the GP claws back certain amounts from LPs to satisfy newly emerged GP indemnification obligations and expenses of the fund (often in connection with a problematic exit).
Whilst not usually included in the EOI, GPs are themselves exposed to the risk of clawback by LPs if the GP’s carry was overpaid (so-called “GP clawbacks”).
Insuring excluded obligations
R&W insurance is now a common feature of secondary deals where the GP and the incoming LPs (ie, the buyers) are covered against liabilities suffered as a result of a breach of the representations and warranties given by the GP and the exiting LPs.
In what should be a welcome development for secondary investors, underwriters are able to cover excluded obligations and the EOI. Previously, the EOI was excluded from cover.
Sellers, buyers and GPs can now benefit from insurance of excluded obligations liabilities with the policy able to cover:
- the exiting LPs by backstopping the EOI (ie, on a primary basis) in an LP to LP transfer;
- the incoming LPs by covering the EOI (ie, on a secondary basis);
- the incoming LPs by creating a synthetic EOI in the R&W policy, covering them for secondary excluded obligations liabilities;
- GPs or LPs for LP clawback risks provided the risk management procedures and guidelines of the fund can be reviewed;
- GPs or LPs for GP clawback risks provided the carry calculations are subject to auditor review and the portfolio investment sequence is satisfactory; and/or
- GPs and exiting LPs for taxes and breach of subscription agreements (and other fund documentation exposures) in line with typical indemnities for those issues in an EOI (ie, on a primary basis).
Coverage of excluded obligations will attract an additional premium over and above that which is charged for a standard R&W insurance policy for a secondary transaction. Underwriters do not require diligence other than that which would ordinarily be undertaken on a secondary transaction. However, any information which LPs or GPs have access to (depending on who is insured) will be of interest to underwriters and insureds should expect to provide it to them for their review.
Angus Marshall is the head of transaction liability at insurance company CFC Underwriting. Prior to joining in 2019, he spent more than six years with the M&A and transaction liability business of AIG. He is a former M&A attorney at international law firm Norton Rose Fulbright.