Note: This article was written without the assistance of generative AI, aside from grammar- and spellcheck software (which we all know may not be that helpful).
If reading is believing, generative AI is the future of… well, everything. Even in its current infancy, generative AI offers a myriad of potential benefits. Its applications apply across many industries, from the front office to the back office. It can perform basic tasks and aid human performance of more complex projects.
Private equity professionals are not only investing heavily in generative AI companies, but they’re also integrating it into the execution of their day-to-day business operations at both the fund and portfolio level. As the industry continues to embrace ways to use AI, however, PE firms must be fully aware of the potential liabilities and complications it can present.
Opportunities and risk exposures
Investment-related AI tools are already delivering critical value to private equity firms. For example, some firms are using AI to gain rapid access to robust market analytics, which can facilitate more comprehensive deal due diligence and better-informed valuations. These tools can allow users to source and overlay thousands of data points at once, allowing for greater accuracy and stronger trend analysis — all of which potentially helps increase the chances an investment will be successful.
AI can also enable significant efficiencies in logistics, as well as any repetitive task or data analysis need. This can help reduce costs and preserve a private equity firm’s cash and human resources, which can be redeployed to other areas of the business to help drive growth.
But with regulators — notably, the Securities and Exchange Commission (SEC) — hyper-focused on private equity, it’s vital that you examine internal processes related to AI at the fund level, understand potential AI-related risks that portfolio companies might bring, and have the right insurance program in place to mitigate your risk.
What’s your fund-level approach to AI?
Have you articulated your organizational philosophy and internal guide on how to use AI responsibly? If not, now may be good to develop such a plan, keeping in mind just some of the areas of focus for the SEC and others. These including AI washing, or falsely telling investors you are harnessing the power of AI in your investment strategies, and potential conflicts of interest, such as training AI to put the interests of the firm ahead of its clients.
It’s also vital to be mindful of these potential regulatory quagmires:
Ownership of AI-assisted intellectual property: The private equity world has historically considered data, processes, algorithms, and products to be proprietary intellectual property (whether by trade secret, copyright or patent), and fiercely guarded them as a result. Emerging case law and regulations, however, maintain that generative-AI-assisted works are generally not proprietary.
Antitrust: As with any business activity, the use of AI is subject to the Sherman Act, and both the Department of Justice and private plaintiffs can potentially bring litigation where AI is allegedly being used to create an unfair competitive advantage for a group of users sharing this technology and using it to control deals and pricing. With the “Club Deal” litigation still in recent memory, private equity firms should be particularly aware of this exposure.
Ethical considerations: While AI will bring great efficiency and reduce the need for humans to do repetitive job functions, how is the private equity industry looking at the possible retraining of any potentially displaced workforce in the future? While the prevailing view today is that replacing human workers with technology does not constitute discrimination, this may evolve and pose reputational risks to the industry. Likewise, the use of AI in prioritizing and selecting candidates also raises the question of how AI is being taught to make appropriate and qualified candidate selections without discriminating based on age, gender, race/ethnicity, sexual orientation, and other factors.
Understanding AI exposures within your portfolio
Getting your arms around AI exposure can be complicated. There is only limited precedent from which to work, yet a myriad of unintended consequences.
One notable AI-related exposure from portfolio companies can be seen in the form of Illinois’ Biometric Information Privacy Act (BIPA) and similar legislation enacted or being considered by close to 30 other states. These laws impose standards for the collection, use and sharing of individuals’ biometric data by companies, with often harsh penalties for violations.
With AI technologies increasingly being embedded in biometric data applications, such as voice and face recognition software, the potential exposures for companies are vast. So it’s critical that private equity firms understand how portfolio companies are using these tools and if they are doing so in Illinois and other states where biometric privacy laws have been passed.
Effective insurance for portfolio companies and funds
AI remains a relatively unchartered legal and regulatory territory, and your firm needs to be prepared in case of an unforeseen lawsuit or regulatory action. When evaluating your fund-level insurance programs — including general partnership liability, cyber liability, fidelity bond, and other coverages — or diligencing or arranging portfolio company policies — such as directors and officer liability, cyber liability, employment practices liability, and professional liability — consider how these forms of coverage each address your AI risks.
For example, will they respond to alleged antitrust violations, BIPA violations, intellectual property disputes, regulatory investigations, and claims of discrimination, conflicts of interest, and AI washing? Do they contain express coverage for these areas, or do they have exclusions or limitations that might restrict or remove coverage altogether? How do the various policies coordinate with one another if a claim implicates multiple policies at the portfolio company level, or at the port company and fund level?
As private equity firms continue to venture into this new and exciting territory, they will need to make sure they are protected from potential legal and regulatory pitfalls. At Lockton, our team of experienced alternative investment insurance brokers is available to help review your current insurance program and provide recommendations to maximize claims recovery, giving you piece of mind and allowing you to to spend that energy on other areas of your business.
