By Regan Guth
Have you ever thought of using insurance in the Mergers & Acquisitions process to improve the terms of the deal, gain a competitive advantage over other suitors or simply close more deals? If not, you may not be securing the best possible deal with the lowest amount of risk. From early stage ventures to distressed buyouts, and everything in between, a common thread to all M&A transactions is risk. Risk is not a new concept to buyers and sellers in the deal community, but how these risks are addressed in a transaction can greatly affect the outcome of the deal process – even long after the deal closes.
Representations and Warranties (RWI) Insurance is a mechanism designed to transfer risk from one party to another as it relates to M&A scenarios. The key benefit of RWI policies is that they provide a viable alternative to escrow funds or similar indemnity requirements, which are used to protect buyers in the event of a breach of any of the representations and warranties contained in transaction documents. In the deal process, buyers and capital providers want guarantees for the contractual representations that sellers make during the due diligence and deal negotiation phases of a transaction. Reps & Warranties insurance is an efficient tool to provide such guarantees.
For example, if a potential liability is identified during the due diligence process, a buyer will typically seek a representation from the seller and require a warranty or other form of indemnification from a seller in the event the potential liability materializes post-closing. As an alternative, the buyer could purchase an RWI policy that would cover the potential future liability and, knowing that the risk is fully transferred to a third party, negotiate more favorable terms for both the buyer and the seller (lower purchase price, improved seller-indemnification, or an extended survival period of the representation.) In an auction process, transferring the risk outside the scope of the deal could become a competitive advantage over other suitors.
Similarly, an RWI policy may be utilized to the benefit of sellers when a strategic acquirer purchases a business that was bootstrapped and initially funded by friends and family investors. In order to provide complete indemnification to these minority, passive shareholders, the seller could purchase an RWI policy that would allow benefactors to completely walk away with their gains.
While coverage can be designed to protect buyers and sellers, it should be noted that differences exist between buyer policies and seller policies. Buyer policies are purchased far more frequently (> 90%) as these policies generally offer greater flexibility with respect to the amount of coverage, breadth of coverage and the overall terms and conditions. However, seller policies, while potentially more-limited than buyer policies, still provide unique advantages to sellers when other options or resources are not available in a sale.
Reps & Warranties insurance has been available for a couple of decades, but the uptake has increased exponentially in recent years. A recent study revealed that roughly three out of every four deals sought coverage for R&W insurance as part of the transaction. With the increased demand for the coverage, the number of insurance companies competing in this space has nearly tripled to a recent count of more than 25. As a result, overall coverage terms and conditions have become broader – insurance companies are now willing to cover liabilities that, not too long ago, they were quick to exclude, such as tax liabilities, intellectual property infringements, product recall, product liability, environmental risks and regulatory risks. Along with improved coverage terms, pricing has dropped (~11% in the last year alone) from a range of 4%-6% to 2.8%-3.5% of the primary policy limit (indemnity limit). Retentions and deductibles have also decreased 25-50% to about .5% – 1.0% of deal value, down from 1.5%-2% a few years ago.
Just as the deal market has remained strong for several years and healthy valuations persist, the market for representations and warranties insurance has expanded rapidly. With the improvements to coverage, pricing and overall terms and conditions, now is the time to incorporate Reps & Warranties insurance to your M&A toolkit to increase deal value, reduce risks and add greater certainty to the success of the transaction.
About Regan Guth
Regan Guth is a Shareholder and Senior Vice President with Diversified Insurance Group’s Venture Practice. Regan has been involved in numerous M&A transactions providing risk management and insurance due diligence services to several private equity clients and their portfolio companies. He has significant experience with management liability and transactional risk / representations & warranties insurance products.