Private equity risk: Protecting human capital

Insurance professionals — brokers, agents and consultants — are faced with increasing demand for their knowledge and expertise in advising venture capital and private equity firms.

Venture capital, or VC, is defined by Investorwords.com as “Funds made available for startup firms and small businesses with exceptional growth potential. Managerial and technical expertise is often provided. It is also called risk capital.”

The brilliant minds who are business creators, CEOs and computer programmers behind venture capital deals are case studies of nature at work. Very often, the venture capital and private equity deal may be centered on a product or an idea, but the heart of the deal is anchored to the person or team of people who originally developed the opportunity for investment. Therefore, insurance brokers, agents and consultants are being asked for the best solutions to protect the “human capital” exposure should key people become disabled or die. As those deals and transactions grow in frequency and in value, there is new pressure to solve this specific financial exposure.

Insurance professionals need to ask clients, “What is being done to insure and protect the human capital risk?”

In 2005, there were approximately 3,000 VC transactions completed. Of each deal, the average investment was $5 million to $10 million. Those transactions created between $15 billion and $30 billion of invested capital into the economy. The sudden loss of a key individual can mean the:

1) Loss of the entire investment;

2) Dissolution of the entire company; and

3) Loss in the reputation of the venture or private equity company itself.

What happens to the $5 million or $10 million-plus investment of venture capital or private equity money should a key person become disabled? The immediate loss of the key individual(s) from a disability can cause both short- and long-term loss of continuity and momentum.

Very often, human capital exposure goes ignored in a final investment analysis. A broker, agent or consultant can bring priceless advice and solutions to such high-end venture capital clients and private equity firms.

An executive or entrepreneur is only as good as his or her health. Yet as investors plow millions of dollars into new venture capital and private equity deals in the United States and abroad, the risk is not fully understood or adequately protected — but it can be.

Disability is worse than death. Implementing the appropriate plan to protect the loss of the brilliant individual from his or her inability to work is critical to the success of the venture capital or private equity deal. A plan can protect and stalls against an economic loss where statistics show a 45 year old has a 4:1 chance of being disabled lasting 90 days versus death, and a 2.67:1 of a disability lasting 365 days versus death.

Here are four fact-finding questions an insurance professional must ask each client in to sufficiently understand the human capital risk:

1. Is your human capital investment fully evaluated in the due diligence process?

2. How is your human capital investment calculated?

3. Can your investments withstand the loss of key individual(s) from a disability within the first one or two years?

4. Have you made contingency plans for disability or death of your critical talent? How will that effect your investment in the short and long term?

The answers to those questions will lead to a greater, more detailed understanding of the overall investment risk. The answers also will help determine whether insurance is needed to hedge against any unforeseen loss of investment.

Following is an example, based on the answers of the fact-finding questions asked above by an insurance professional:

A venture capital firm invested $5.5 million into a biotechnology startup. The startup company brought together the brilliant minds of four individuals who were experienced and respected in their fields, which created immediate credibility. The necessary financial due diligence, proformas and analysis were completed, and the venture capital firm decided to commit to the investment.

The insurance professional uncovered an issue that they had not taken into consideration in any other financial analysis: the short- or long-term human capital value exposure. The true economic risk to the investment, as well as the value and hope of any future initial public offering, hinged on this team’s collective togetherness. If any member were not able to contribute his or her unique and exceptional mind during the critical startup time of one to three years because of disability or death, the investment could be completely lost.

An insurance solution for those individuals requires an experienced and knowledgeable market and underwriter(s) who understands the risk. In the end, the insurance professional proposed a three-year policy for $5.5 million of disability coverage with a 12-month elimination period for each person. Those policies insured the economic and contractual investment of the venture capital firm. The venture capital firm was the owner and beneficiary of the policy, and it defined disability from own occupation, giving further protection to the investment of the four people.

To design and solve insurance exposures, professionals must dig deep and ask laser focused fact-finding questions with confidence. Private equity and hedge funds are not immune to these issues either. If insurance agents fail to ask those probing risk management questions, they may not fully understand the human capital exposure.

This topic is often misunderstood and overlooked because other insurance coverages such as workers’ compensation and property and casualty in most circumstances are required by law to maintain business. However, to stay in business, protecting human capital exposures is a must.

Glenn Dorr is vice president of prestige underwriting for HCC Specialty Underwriters Inc. E-mail: Gdorr@hccsu.com.