In this guest post, Sarah Abrams, Head of Professional Liability Claims at Bowhead Specialty, examines Sovereign Wealth Funds’ increasing investment in U.S. private equity firms and considers whether there are unique regulatory and professional liability risk exposures for PE firms that partner with Sovereign Wealth Funds. I would like to thank Sarah for allowing me to publish her article on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is Sarah’s article.
Institutional investors have been aggressively seeking out opportunities to direct and co-invest in recent years to have more control of private equity (PE) transactions and bypass hefty fees charged by commingled PE funds. These funds have a similar fee structure to that of hedge funds, typically consisting of a management fee (generally 2%) and a performance fee (usually 20%)[i]. Sovereign Wealth Funds (SWF) have not only sought out this control, but in the past year have surpassed US institutional investors in executing on this strategy.[ii]
All of this activity begs the question, are there unique regulatory and professional liability exposures to PE firms that partner with SWFs?
April 2023 PitchBook data revealed that the Limited Partners (LPs) completing the most buyout and growth investments outside of a fund last year were SWF managers based in the Middle East, Europe and Asia.[iii] The majority of the SWF transactions were co-investment and direct investment opportunities.[iv]
D&O underwriters of PE risk must consider the liability and regulatory exposure the increased SWF investment brings along with its capital. As with all foreign investment, there needs to be consideration as to whether a direct or co-investment would fall under scrutiny by the Committee on Foreign Investment in the United States (CFIUS).[v][vi]
CFIUS has the authority to review transactions that could result in foreign control of a US business, which includes certain investments in US companies by foreign investors, including SWFs. CFIUS operates pursuant to section 721 of the Defense Production Act of 1950, and, through Executive Order, allows for the agency to review transactions for national security risks. New CFIUS rules published February 13, 2020 under the Foreign Investment Risk Review Modernization Act (“FIRRMA”) overhauled how CFIUS will review inbound investments into the U.S.[vii] On September 15, 2022 President Biden issued Executive Order 14083 underscoring critical role of CFIUS in responding to foreign investment.[viii]
The 2022 Executive Order by President Biden provides formal Presidential direction on the risks to consider when reviewing a covered transaction. The five specific sets of factors include (1) effect on resilience of critical U.S. supply chains (2) effect on U.S. technological leadership in areas affecting U.S. national security (AI, biotech, climate adaption), (3) industry investment trends that may have impact on U.S. national security, (4) Cybersecurity risks that threaten to impair national security and (5) risks to U.S. persons’ sensitive data.[ix]
The FIRRMA rules must be considered by PE funds with SWF investors, as certain non-controlling minority investments will be subject CFIUS scrutiny including those involving advanced technologies, critical infrastructure, or significant personal data of U.S. residents. PE fund insurers should be asking whether a fund’s non-U.S. limited partner interests may be subject to CFIUS review, and whether a non-U.S. fund entity may still be deemed a U.S. person falling outside of CFIUS’s reach.[x]
Coverage under PE D&O insurance for CFIUS regulatory exposure is certainly a legal defense cost underwriting risk, particularly responding to CFIUS document and interview requests of foreign nationals. In addition, other PE firm investments may come under federal or investor scrutiny after data production and any settlement. Along with this D&O exposure comes the added professional liability exposure to PE GP investors.
According to PitchBook data, Singapore wealth fund GIC completed 148 such deals last year—the same number as French state bank Bpifrance. [xi] Other active LPs include Abu Dhabi’s sovereign wealth managers Mubadala Investment Company and Abu Dhabi Investment Authority.[xii] Given the number of deals that SWFs are closing with PE firms, the financial impact to non-SWF LPs should also be considered.
Notably, a November 2022 FinReg paper review concluded with a large sample of international data showing that sovereign wealth funds (SWFs) earn lower returns and are slower to fully liquidate their positions relative to other types of institutional investors.[xiii] The involvement of SWFs as a limited partner is associated with a lower Internal Rate of Return (IRR) and Total Value Paid-In (TVPI) relative to the capital invested.[xiv]
Data presented in an October 2022 paper by business school professors Douglas Cumming and Pedro Monteiro indicates that SWFs are longer-term investors when compared to their counterparts, including pension funds, endowments, insurance companies, and banks.[xv] The investment horizon of the alternative asset fund may be longer when SWFs are involved if there is a political and strategic benefit to delay investment.
This is in contrast to the institutional, usually US based PE limited partners who generally prefer a shorter investment horizon as they may have liquidity constraints. Because, SWFs are longer-term investors when compared to their counterparts, including pension funds, endowments, insurance companies, and banks[xvi], PE firms disclosure to LPs tied to deals with SWFs should be done to level set return expectations.
PE firm underwriters of blended policies including E&O coverage for investment should be aware of both the lower return and slower liquidation timeline that may stem from SWF direct and co-investment. While the outside investment in current market conditions may be attractive, consideration of future E&O liabilities must be considered by financial lines underwriters. LPs seeking the increased and shorter returns may Monday morning quarterback firm GP decisions to include SWFs.
Financial lines underwriters armed with this recent trend should ask about SWF investment in client PE firms. Of critical importance if SWFs are coinvesting or direct investing, will be partner law firms with CFIUS experience to assist in minimizing regulatory exposure. In addition, disclosure to non-SWFs LPs to level set return expectations may decrease E&O risk.
[iv] Co-investments allow SWFs to back individual PE deals alongside a deal and direct investing allows SWFs to target a specific fund asset for acquisition often independent of the traditional PE general-limited partner (GP)(LP) relationship.
[v] CFIUS is a US government interagency committee that reviews certain transactions involving foreign investment in the United States to determine their effect on national security.
[xv] Cumming, Douglas J. and Monteiro, Pedro, Sovereign Wealth Fund Investment in Venture Capital, Private Equity, and Real Asset Funds (October 24, 2022). Available at SSRN: https://ssrn.com/abstract=4258254 or http://dx.doi.org/10.2139/ssrn.4258254