Key Person Insurance - a strategic tool for private equity firms to protect their investments
Providing financial stability in the event of the loss of a key individual
Key person insurance and private equity often intersect because private equity (PE) firms invest in companies where a few key executives or founders are instrumental to the company's success.
In its 2021 State of the Nation SMEs Report, L&G stated that one-third of newer businesses would cease to trade immediately if they lost a key person. In the same report, the top three risks for businesses and the importance of key people were highlighted showing the increasing need for protection.
Key Person Insurance: An overview
Key person insurance is a life or critical illness insurance policy taken out by a company on the life of an essential executive or founder. If the insured executive passes away or becomes disabled, the company receives a pay-out.
This insurance mitigates the financial impact of losing a key individual, covering the costs of finding and training a replacement, and compensating for potential lost revenue or value associated with the loss.
Importance in Private Equity Investments
In the context of private equity, where investments are often made in companies with limited but highly effective leadership, key person insurance is particularly important. Key people (such as founders or CEOs) may have specialised knowledge, relationships, or leadership abilities that are hard to replace. There are a number of reasons why PE firms might require Key Person Insurance:
Protects Investment Value
PE firms invest with the expectation of value creation driven by the key leadership. If a key person suddenly leaves or becomes incapacitated, the company may suffer a decline in performance or valuation, which affects the investment.
Exit Strategy Protection
Private equity investments are usually made with a clear exit strategy (e.g., an IPO or a sale). If a key person is lost before this exit, the timeline and value of the exit could be jeopardised.
Risk Mitigation
PE deals often involve high levels of leverage. The loss of a key person could destabilise operations, making it difficult to meet debt obligations, which could lead to restructuring or bankruptcy.
How Key Person Insurance Works in Private Equity Deals
Policy Ownership and Beneficiary - The company usually owns the policy and is the beneficiary, but the PE firm may specify terms for its use or be directly involved in the policy’s structuring.
Coverage Amount - PE firms may determine the coverage amount based on the potential loss associated with the key individual’s departure, often ranging from several million dollars to cover recruitment, transition costs, and lost value.
Policy Duration - The insurance is often maintained throughout the investment period, covering the time until an exit. After the PE firm exits the investment, the company may maintain or discontinue the policy.
Private Equity's Role in Structuring Key Person Insurance
Due Diligence and Identification - During due diligence, PE firms identify individuals crucial to the company's success and negotiate key person insurance as part of the deal structure.
Implementation as a Deal Covenant - In many cases, PE firms include key person insurance as a covenant in the acquisition terms, making it a requirement for the company to maintain the policy for specific individuals.
Risk Management Strategy - The policy can act as a hedge, providing financial stability if a key executive is lost. Some PE firms may also establish contingency plans, like accelerated succession planning, in tandem with the insurance.
Benefits of Key Person Insurance for Private Equity Firms
Protects Financial Returns - Helps ensure that the financial returns from the investment aren’t overly affected by the loss of a key individual.
Provides Stability in Debt-Financed Deals - Ensures that the company can continue meeting its debt obligations even after a key individual is lost.
Adds Value for Future Buyers - When selling the company, PE firms can assure potential buyers that risk associated with losing key executives has been managed, potentially enhancing the company's attractiveness.
How much coverage is needed?
It is vital that you engage with your expert advisor at an early stage. This will ensure you have the correct cover for your business’ requirements. Determining the amount of key person insurance coverage involves evaluating several factors, which include:
- Role and salary of the Key Person
- Business Revenue and Profit Impact
- Replacement Costs
- Debts and Obligations
A thorough assessment of the company’s financial position, growth stage, and key person’s value is essential to determine the right coverage. Here’s where PIB come in.
Why choose PIB to secure your Key Person Insurance?
Our colleagues at PIB Employee Benefits have an unique approach – centred around overseeing the whole process instead of what can often be a disjointed broker and insurer-led relationship. It means they can place clients at the heart of the experience, taking accountability from beginning to end and ensuring a discreet, managed service throughout.
In summary, key person insurance is a strategic tool for private equity firms to protect their investments. It provides financial stability in the event of the loss of a key individual, helping ensure that their investment performs as expected until a profitable exit. For an unique approach to financial peace of mind, contact Head of Protection at PIB Employee Benefits, Daniel Beament on 07756 875 268 or email using the button below.