Private equity interest in 'purchasing' legacy liabilities is growing
Private equity interest in 'purchasing' legacy liabilities is growing
By Stephen Hoke, Hoke LLC and Jim Dorion, Willis Towers Watson
Legacy liabilities are serious financial obligations, operational distractions and disclosure nightmares, so there’s a huge appetite for solutions providing finality. Historically, certainty could only be achieved through an often-painful bankruptcy process or by purchasing expensive insurance, which doesn’t provide finality if the limits are insufficient.
However, there is a viable third option: the “sale” of legacy liability risk to a third-party that will assume the liability from the seller. There is a small but growing private equity market eager to “buy” these risks as evidenced by Enstar’s recent purchase of the asbestos liabilities of BorgWarner Inc.
This alternative involves isolating and selling the legacy liability to a third-party who manages, runs-off and pays the claims in return for a substantial payment to the buyer, along with a transfer or assignment of any existing insurance proceeds, as consideration for assuming the risk in total. Third-party buyers may be private equity firms, insurance entities or related third-parties with which the seller is familiar.
Most sales have been in the asbestos space. The mature nature of asbestos litigation provides data necessary to estimate future liabilities with greater confidence, resulting in more accurate pricing and enticing additional buyers into the market. Pricing may be becoming more attractive to sellers because buyers are using Internal Rates of Return more consistent with equity investing than conservative insurance investing, and the anticipated profits from investing the funds received is a significant variable impacting purchase price.
Typically, the loss portfolio is isolated, then converted or sold into a litigation shell owned and operated by the buyer. This approach provides the seller with financial and operational finality, except for the worst-case scenario where the buyer fails to meet its obligations and is forced into bankruptcy. The legal risk would likely then return to the seller. Although every transaction is unique, private equity transactions are arguably more “final” than loss portfolio insurance, but less “final” than bankruptcy. To date, the great majority have functioned as intended.
This method removes the liability from the seller’s balance sheet vs. loss portfolio insurance, where it remains a contingency on the sellers’ balance sheet. It should also eliminate the operational burdens of defending claims and interacting with insurers. The seller will need to work with the buyer during and immediately after the transaction to ensure a smooth transition of the defense. The seller will often be asked to provide institutional knowledge when questions arise post-transaction, although these requests should diminish over time. Claimants’ counsel ordinarily does not object to a sale if it does not interrupt the defense, settlement and payment of claims.
A disadvantage is the substantial cost of the up-front payment, driven principally by the valuation of liability offset by the value of any existing historical insurance and/or other assets. Little can be done to diminish a seller’s “sticker shock” upon first receiving a price quote, as asbestos risk continues to have a long and potentially expensive tail. However, prices should diminish as mesothelioma claims filings appear to have peaked. The buyer prices the transaction using the same metrics employed by any private equity business buyer including anticipated cash flows from investment, new revenue streams and improved operational efficiencies. New revenue streams might include identification of new insurance assets and more effective insurance recovery strategies. Operational improvements can include implementation of more effective litigation strategies or application of economies of scale.
The regulatory burden and discipline of the insurance industry provides a measure of security a non-insurer usually cannot provide. Given the possibility a third-party buyer may go bankrupt or dissolve, there is the fundamental question of whether the seller can trust the buyer to run-off the risk without misusing or absconding with the funds paid. Sellers typically cannot negotiate financial security into the transaction. Bonds are too expensive and personal guarantees from buyer-principals are likely deal-killers. Likewise, a letter of credit backstop would eliminate the buyer’s principal revenue stream of investing income. Payment terms might provide a measure of security but can implicate disclosure obligations. Trust is best established by means of due diligence of a third-party buyer’s experience and track record.
A marketplace alternative is to isolate the liability into a separate corporate form, selecting managers and professionals to run-off the liabilities with whom the company is familiar and trusts. This low-profile option is highly dependent on circumstances but is it has frequently been quietly successful. The legal structures implemented to pursue this strategy vary widely. The more independent the structure, the less likely claims like fraudulent conveyance, alter ego and piercing the corporate veil might succeed should the entity fail. With this option, companies must consider the risk/reward of ceding full independence in running off the risk as opposed to maintaining it in a subsidiary. A company might try to have it both ways, leaving the company partially, but not fully, independent. This raises issues concerning degrees of common ownership/management, consolidation of financials and access to corporate credit, that must be carefully considered.
However, the transaction is structured, the valuation of assets and liabilities exchanged in the restructuring is especially critical. Any assets separated from the liabilities must be professionally and credibly valued, as they will be challenged if the litigation shell fails. For defendants, the process will likely be a once-in-a-lifetime transaction. Conversely, potential buyers generally have a core competency in risk transfer. Thus, it is critical that sellers engage experienced financial, corporate structure and coverage personnel throughout the process.
About the authors: Stephen Hoke is a principal in Hoke LLC, a boutique law firm that represents corporate policyholders in high-value insurance recovery and successor litigation in the US and UK and consults on alternative risk transfer issues for asbestos and other long-tail liability policyholders.Jim Dorion is Head of Liability Claim Consulting & Carrier Relations for Willis Towers Watson. He provides senior level leadership of consulting and advocacy services for clients and is responsible for all service and strategy elements of WTW’s liability claims function.