How Deal Insurance Improves M&A Transaction Execution
How Deal Insurance Improves M&A Transaction Execution
The use of representations and warranties (R&W) insurance in mergers and acquisitions has grown significantly over the past several years and has become an increasingly integral component of the transaction process. This article focuses on how buyers and sellers use R&W insurance for both strategic and risk management purposes to improve deal execution by accelerating the parties’ ability to reach agreement, thereby expediting the close of a transaction.
What is R&W insurance and its key features?
Loss Insurance: In general, R&W insurance shifts risk to an insurer by providing coverage for indemnification obligations resulting from breaches of representations and warranties made in a transaction agreement. R&W insurance principally is designed to cover risks and exposures that are unknown at the time the policy is bound. It protects the insured from losses that become known after the closing which were unknown or unanticipated at the time of the signing of the deal. The risk of loss often arises from reliance on the seller’s representations about financial statements, rights to ownership or use of intellectual property, pre-closing tax indemnities for potential exposures, or lack of compliance with laws or regulations, to name a few.
Replacement for Holdbacks or Backstop for Specific Claims: R&W insurance may serve as the recourse and substitute for escrows or other forms of purchase price holdbacks. Contingent liability insurance, including tax indemnity insurance, may be used in conjunction with R&W insurance to provide coverage for one or more known exposures in an M&A transaction that may be expected to arise after the closing of the transaction. A combination of R&W insurance and contingent liability insurance could attempt to place the insured in approximately the same risk of loss position as intended to be covered under the indemnities and by the proposed holdback amounts and mechanisms. Contingent liability insurance usually requires an estimate of the exposure amount and an assessment of the probability of the occurrence of the matter insured. R&W insurance and contingent liability insurance may be negotiated to be either the sole source of recovery for exposure obligations or as a back-stop to a failure to satisfy the obligations of a transaction agreement.
Key Roles of Due Diligence for R&W Insurance: The performance of financial, tax, legal, IT, operations, human resources, and other areas of due diligence is essential in a transaction for many purposes, including to gain a better understanding of risks for purposes of the R&W insurance coverage. An insurer may tend to be more comfortable with the issuance of a policy if the insurer receives thorough due diligence reports from independent third party due diligence specialists. The insurer reads and makes inquires with respect to the findings in the due diligence reports to assess the risks of the insurance coverage. Furthermore, the specialists involved in conducting the due diligence on behalf of either the buyer or the seller could assist post-closing in the estimate and validation of the claims that may be asserted under the R&W insurance policy. These functional specialists may have an in-depth perspective as to some of the details that form the background associated with a claim or dispute.
Process and Timing: Either the seller or the buyer may purchase R&W coverage. The policies are customized on a deal-specific basis. It is not necessary for the party seeking insurance to inform the other party of its intention to purchase insurance. These arrangements generally are made prior to the closing of the transaction. After its selection, the insurer would begin an underwriting process that would include a review of the completed due diligence reports. The insurer typically interviews those involved in planning the transaction and the advisors that conducted the due diligence. R&W insurance policy pricing and underwriting may be completed in approximately ten days if necessary.
Amount of Coverage and Estimated Cost: The coverage and related costs associated with R&W policies vary depending on the insurer, scope of insurance coverage, and the size and complexity of the transaction. In general, liability coverage is based on a percentage of deal value. Currently, coverage is capped at approximately 10% of the transaction value for most deals. In turn, the pricing of a policy is based on a percentage of the coverage limit. In general, the cost of coverage is 3%, more or less, of the coverage limit. The premium is paid in full at closing. In addition, the terms of a policy typically provide the insured bears responsibility for a certain amount of the claims under the policy as a deductible. The deductible is required to be exhausted before the insurer makes a payment. In general, the deductible amount is approximately 1% of the value of the transaction, although this amount may vary based on negotiations with the insurer. In addition, contingent liability insurance and tax indemnity insurance policies often are costlier.
Example of R&W Insurance: Assume a deal has a $100 million purchase price. In general, it would have a $10 million R&W insurance coverage limit. The R&W insurance premium might be priced at approximately $300,000. In addition, a deductible would be established. If contingent liability insurance is requested, the amount of the premium would be greater. A seller may receive deal proceeds reduced only by the premium payments to the insurer. As a matter of comparison, under the more traditional manner of handling potentially unknown exposures, it is possible a far more substantial hold back or escrow might be proposed and negotiated. Thus, assume in the same transaction, about $10 million of unknown liabilities are considered to potentially exist before the transaction and are at risk of arising and needing to be remediated after the transaction. At closing the seller may receive proceeds substantially reduced by an escrow or another form of hold back mechanism representative of this amount for purposes of resolving these unknown liabilities in the event they arise after the closing.
Stapled R&W Insurance as a Trend: A recent trend has been the use of stapled R&W insurance, particularly in an auction setting, in which the terms of the R&W insurance are attached to the overall deal terms from the outset of the sales process. Prior to commencing the sales process, an insurance carrier may be requested to propose the terms for the insurance policy with suggested exclusions from coverage. The sample policy and the insurer’s proposed pricing may be included along with other terms of sale. This approach is comparable to attaching a draft of a proposed transaction agreement to the terms of sale, so the seller may consider the bid from each prospective purchaser subject to each of their respective differences from the initial baseline terms of sale.
What are some of the other benefits of using R&W deal insurance?
Improved Risk Management: A buyer may effectively manage risk by using R&W insurance to increase the amount of the maximum indemnity the buyer may recover for the seller’s breaches of the representations and warranties in the transaction agreement. This is important in situations in which the buyer: 1) has concerns about the credit risk of the seller after the close; or 2) plans to acquire a widely held public company or a troubled company, which in either case the buyer has little or no practical recourse for the satisfaction of claims. Further, the insurance may provide a mechanism to ring fence difficult issues with an acceptable level of exposure. If significant exposures are identified in due diligence, a buyer may estimate a worst-case scenario and determine whether a pricing arbitrage might exist between: 1) insuring the outcome, and 2) a purchase price adjustment imputed by valuing the risk. Due diligence and valuation specialists often may assist buyers with such assessments to help keep the deal on track and to expedite the closing.
Improved Deal Execution and Value: The foregoing improvements in risk management may have additional positive consequences in reducing the time and efforts spent in negotiations. The buyer and seller may derive other improved deal execution advantages from the use of R&W insurance. A purchaser might use R&W insurance to distinguish its offer in a competitive situation by reducing the focus on representations and warranties and the indemnification by the seller with R&W insurance coverage acceptable from the standpoint of the buyer. For a seller, the use of R&W insurance may help to increase deal value by attracting more participants and better offers in an auction or competitive situation.
Survival Periods for Indemnities: For sellers, R&W insurance may be an effective way to limit exposure on indemnifications with long survival periods for representations and warranties. The R&W policy may be used to extend the period of a special indemnity under the transaction agreement. This is important for private equity sellers, especially if there is a plan to distribute the deal proceeds to the owners and the end of the life of a private equity fund is approaching. Also, this feature is useful for handling tax exposures, since the statute of limitations liability period usually is longer than the general indemnity period for other claims under the transaction agreement.
Tax Indemnities: R&W insurance may be used to protect the insured from unique tax exposures or from an adverse ruling by a tax authority concerning a tax position taken by the seller – or the buyer – in the transaction. A tax indemnity policy typically covers the tax owed as well as related penalties, interest, contest costs, and other amounts to make the insured whole. The cost of these policies is higher than the cost for R&W insurance. Seeking the advice of a qualified tax advisor is important to conduct an accurate assessment of these risks.
Can sell side due diligence improve on some of the potential limitations of R&W insurance?
Known and Unknown Exposures: In general, exposures identified by the purchaser during buy side due diligence are excluded from R&W insurance coverage. This is because the insurance is designed to cover risks unknown at the time the policy is bound. Further, most R&W policies include a variety of exclusions and limitations. In addition, some R&W policies exclude certain categories of losses, whether known or unknown to the buyer. Some of these matters may include pension underfunding, transfer pricing, and knowledge of breaches by the deal team of the insured. Therefore, the buyer in some cases may not be able to recover losses whether the buyer learned about them as findings in due diligence or whether the seller disclosed them in the transaction agreement or its attached disclosure statements. A buyer should press forward with its due diligence and seek price adjustments for exposures identified in its due diligence.
Importance of Sell Side Due Diligence: With buyers seeking price adjustments, regardless of the use of R&W insurance, a seller should conduct sell side due diligence well in advance of a contemplated disposition to potentially identify and remediate risks that are likely to impact the value of the company during its sale process. Sell side due diligence may reduce the likelihood of significant price reductions for issues identified by a buyer in the performance of its due diligence since there would be little or no recovery available to the buyer based on its R&W policy coverage. The sell side due diligence team may assist in understanding the interplay between the potential exposures, the R&W insurance coverage, and the transaction agreement.
A buyer and a seller each should consider the use of R&W insurance in their deal strategy. The use of R&W insurance may provide several benefits to the buyer and seller from the perspective of improved risk management and deal execution. Its use has a strategic role in the bid process in that it may affect the value of the contemplated transaction. The buyer could be at a disadvantage relative to other competitive bidders if it does not incorporate R&W insurance in its offering package. For the seller, its use of this insurance may result in better offers, and it may potentially increase proceeds at close. Nevertheless, the use of insurance is not a substitute for thorough sell side due diligence or buy side due diligence. Rather, R&W insurance should serve to close the gap between a buyer and seller in their negotiations and thereby help to expedite the closing of a deal.