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Getting a grip on how profitable insuring private-equity companies is and how profitable that market is likely to be in the future is like trying to hop onto a moving train.

To explain, the market is young. It's been a little more than 10 years since insurance companies started crafting policies that were specifically tailored to meet the needs of private-equity companies.

But that was then and this is now, as a master of teenage novels once wrote.

And what is happening now is that private-equity companies, which were previously scant purchasers of insurance policies, are starting to buy a lot more insurance, and for good reason.

These days, if a public company's stock takes a headlong tumble, or, heaven forbid, the company's circumstances weaken to the point that it must enter some form of bankruptcy protection, attorneys for investors and bankruptcy trustees won't just stop at devouring the directors' and officers' coverage that was purchased to cover the company's executives.

They are also going to come hunting for the outside directors on the company's board, and that is going to include the limited partners of any private-equity company that leveraged themselves into seats on the board when the private-equity group purchased substantial or controlling interests in the host company and added it to their portfolio.

Nowhere was that point driven home recently with as much force as in the aftermath of the bankruptcy of the Birmingham, Ala.-based sporting goods retailer Just For Feet.

The company filed for bankruptcy in 1999, and in April 2007, five former outside directors of the company agreed to pay the company's bankruptcy trustee $41.5 million to settle charges that included conflicts of interest, bad faith and breaches of fiduciary duty.

The settlement is considered to be one of the largest of its kind ever. By way of comparison, it dwarfs the little more than $10 million shelled out by outside directors in the aftermath of the collapse of Enron.

There are at least three significant exposure points for general and limited partners in private-equity companies that Conca and others say someone who purchases insurance for a private equity company might want to be conversant with.

Point No. 1 is to insure the management of the private-equity company against lawsuits by its investors.

Historically, there hasn't been a lot of this type of litigation because investors in a private-equity company are generally more sophisticated than your average shareholder in a garden variety retirement mutual fund.

"You are really dealing with very sophisticated investors. Even if they lose money, they tend not to sue because they understand the risks involved," says Conca.

The second type of exposure is that previously mentioned outside directors' exposure. The third is the exposure a private-equity company may face from litigation that runs upstream.

That is, a lawsuit brought by the portfolio company against the private-equity company alleging that its management or directors violated the terms of professional services contracts that the private-equity company and its limited or general partners agreed to when it took on more of a management role in the portfolio company.

In the past, experts say, insurers that wrote coverage for these kinds of risks did very well.

"Historically, it has been much more profitable than compared to commercial, public D&O," says James O'Brien, a New York-based managing director and co-leader of Aon's private-equity and transactions solutions practice.

But in the past two years especially, forces have started to converge that are increasingly making private-equity D&O less of a good risk.

For one, private-equity mergers-and-acquisitions activity skyrocketed in the go, go, go years of 2006 and much of 2007. That put private-equity partners on a lot more boards of publicly traded companies.

A case in point was the overture to shareholders made by billionaire investor Nelson Peltz and partners in his Trian Fund Management LP that vaulted him and associate Michael Weinstein onto the board of the H.J. Heinz Co. in 2006.

And now the financial-sector instability brought about by the American housing market collapse has come calling in the form of the bankruptcies of numerous financial services companies, plummeting values of their shares and an intense degree of class-action litigation.

So as plaintiff's attorneys in increasing numbers take aim at the D&O coverage of these financial-sector companies, outside directors and their investment companies stand a much better chance to be in the crosshairs.

For example, a class-action lawsuit filed in November against Bremerton, Wash.-based WSB Financial Corp. in District Court in Seattle, also names D.A. Davidson Co., a Great Falls, Mont.-based company that provided investment banking services to WSB.

Aon's O'Brien says he sees one of the chief dangers being bankruptcies of all types of portfolio companies, not just financial firms.

"We have seen a number of portfolio companies file for bankruptcy in the last two months so we think that is going to continue," O'Brien says.

O'Brien points to the February bankruptcy filings of two catalogue retailers--the San Francisco-based Sharper Image Corp. and the Virginia Beach, Va.-based Lillian Vernon Corp.--as examples of portfolio companies where action against outside directors or investment firms was a possibility.

That doesn't mean that private-equity coverage will become less profitable than traditional D&O coverage for financial institutions. But it does mean that everybody involved in the market has got their ears cocked and their pencils sharpened.

"We're now closely monitoring the amount of debt used by private-equity firms to finance acquisitions over the past two years and the current credit quality of that debt, with our concern being pronounced heightened potential for lawsuits against sponsor firms involving these portfolio companies, particularly in a bankruptcy," says Aon's O'Brien.

As things stand, the financial sector has not given a solid enough indication that it knows the true depths of its subprime exposure and how well it will weather the credit tightness brought on by the U.S. housing market weakness.

For now, at least, the private-equity insurance news is good. It remains more profitable than standard D&O for finance companies and more insurers are getting involved in it.

The slowdown in the pace of deals involving private equity means that there's more time for companies to do their due diligence to make sure that directors and officers are playing by the rules, according to Brian Hickey, vice president of Professional Indemnity Agency in Mt. Kisco, N.Y.

Carl Metzger is a partner in the Boston offices of Goodwin Proctor LLP who advises private-equity clients in insurance matters.

Based on what he has seen so far, he has a lot of respect for how the insurance industry has handled itself as it concerns the private-equity market.

"I think the carriers have done a good job of looking at this risk and pricing it accordingly," says Metzger. "There are more carriers who are interested in writing this over the past two to three years than there were five or 10 years ago, which tells me that this is an attractive market for insurance carriers," Metzger says.

Metzger also says that, for now, the substantial shifts in the financial sector mean that this type of coverage can be looked at as an expanding market for insurers, but not one that at this point represents a potential pitfall.

"I will tell you that, from my professional experience, I tell my clients that I think they should have this coverage. It doesn't mean that I think they are all going to get sued."

DAN REYNOLDS is senior editor of Risk & Insurance®.

May 1, 2008

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