Insurance Protection for Key People is Becoming Critical in Private Equity

Insurance Protection for Key People is Becoming Critical in Private Equity

Let us consider the men and women of private equity. They’re different from you and me.

Whether they read F. Scott Fitzgerald or not, we cannot say, but among the readership, they stand out like the novelist’s characters: they shine. In no financial sphere is the individual so important to success. At the top of the glittering pyramid (we’ll tone it down, shortly) stands the visionary, the guiding hand, the irreplaceable leader. If she or he goes down, the project, no matter how promising, is sunk.

Venture capitalists and other private equity practitioners, and the investors they carry along with their dreams, know all about it. Providing life insurance for that key leader, the figurative Alexander, Bonaparte or Jobs, has long been a required feature of most private deals. In some markets, it’s still called Key Man Insurance, reflecting its progenation in times before everyone wised up and opened the field to the full talent pool. The concept remains sound, no matter what we call it.

A range of techniques are used to value these key employees. The easiest and most common method is multiples of income: take the salary and benefits of the vital manager, multiply by five or so, and buy that much life insurance. Replacement cost is another technique, which sums up the expense of hiring, training and paying a suitable alternative. Finally, there’s the contributions to earnings technique, easy to figure when applied to sales staff, but difficult to apply to generic C-suite personnel.

These valuations don’t work so well for venture capital teams, where the top leader’s death (in fact, there may be a small, symbiotic team involved) usually means the project’s demise. When key leadership is lost, clients may back out, contract delivery suffer, and new business become hard to generate. Debt repayment can rapidly become an issue.

Everyone is replaceable, they say – don’t tell this to Alexander the Great’s heirs, who survived one of the greatest ‘loss of key people’ sagas of all time – but with resources short, replacement candidates by definition few, and the time window slamming shut, pulling it off can be close to impossible.

The key person’s deal-related life insurance must be sufficient to cover outstanding debt, salaries and other wind-down expenses, and perhaps return some fraction of invested capital to the disappointed and perhaps even bereaved backers.

Private equity deals not uncommonly involve tens of millions of dollars. One million dollars of coverage can cost up to $1,000 per year, assuming the executive in question is healthy – expect a rigorous health exam. If coverage is needed for the entire board, things can get pricey, but the expense is not an option. It’s hard to imagine investors in a project, one that is risky by nature, who would sign a deal without life insurance in place. If you delve into VC and other types of private equity business, you’ll need to bite the bullet.

As with everything else, from shopping to schooling to pizza delivery, the coronavirus pandemic is making its mark on the VC industry and related attitudes towards insurance. Business continuity has emerged as a hot topic, with practitioners and investors alike now keenly aware of the need for backup staffing plans and key person insurance. Perceptions are changing in defining adequate coverage, too, and life policies alone may no longer be sufficient – we know what a pandemic looks like now, and must get ready another, or something similar in impact, if not worse.

The exact number of key executives struck down by coronavirus is unknown, as there’s no regulatory requirement to release personal medical information. However, panicky and often misinformed stories in the international press have encouraged some business leaders toward full transparency on their health.

They report a range of experiences. Dr. Cedric Francois, CEO of Apellis Pharmaceuticals Inc., was down for the count for nearly three weeks; NBC Universal CEO Jeff Shell was seriously ill, but able to work remotely. That’s how the virus worked: some were incapacitated, others able to soldier on, though perhaps in limited capacity. Dr. Francois told the Wall Street Journal he was “fortunate” because the company’s executive committee was able to step up quickly and take on his duties.

No matter how we wish it would stop, the coronavirus crisis won’t cease giving us lessons. Encouragingly, we see a determination in the business community not to fall into the pattern of “learning and forgetting and learning again.” Key personnel, in private equity and other realms, must be insured. Operating procedures must be codified and meticulously hard coded, so when anyone goes down, their duties are covered. Taken together, these point to another issue, somehow long avoided or ignored: key people commonly have their lives insured, but why aren’t they covered for accidents and illness?

A virus or other debilitating disease, after all, is a form of accident. A vital executive might be lucky and live after a bout of coronavirus, meningitis, hepatitis, influenza, dengue fever or malaria – we’ve personally seen all these and more – but medical care can be costly and business losses severe.

Disabling injuries are a greater threat than commonly believed. Specialist insurer Founder Shield reports that in the US, an incapacitating injury occurs every 1.5 seconds – an accidental fatality, every five minutes. By age 65, 25% of the population will have spent a year or more temporarily disabled. They expect the market for key person disability insurance to expand substantially in the coming months and years, as the experiences of the pandemic sink in, and professionals have time to consider just what else might go wrong.

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