Going into an M&A deal there is always a “courtship” period where the Buyer is wining and dining the target company. If things go well, this leads to a Letter of Intent, which essentially states that the Buyer wants to buy the company, and the Seller agrees.
This is where things get more complicated. The courtship – and romance – is over.
Considering that a typical M&A deal is about as hard to complete as a Hollywood blockbuster, it’s a miracle these deals ever go through. There are so many elements that could derail them at any stage until the purchase and sale agreement is signed and the closing takes place.
So what happens?
If you’re a target company, you need to be aware of the mindset the Buyer takes on when approaching a deal.
It helps you manage expectations when you sit across the table. As the target, you must realize that as desirable as you may be, you might not have as much leverage after the Letter of Intent.
The Buyer’s attitude is that if they’re paying full price, then the target company has to perform to expectations or better once they assume control, even if there are unknown factors that come into play through no fault of the Seller. The Buyer believes the shareholders of the target company should take on all risks of the unknown, despite the due diligence they have done.
That’s why in these types of deals, a significant portion of the sales price (8% to 10%, generally) is held in escrow for a period of a year or more, with the Buyer basically free to take funds if there have been any breaches with the representations and warranties in the sales contract to pay for the financial losses. They can even clawback more money beyond that amount.
Understandably, Sellers aren’t eager to take that risk… or take home significantly less funds at closing… money which owners and shareholders are eager to use to retire or invest in new projects.
But, as we’ll see in a moment, there is a remedy that allows Sellers to protect themselves and not be required to leave any funds in escrow. In fact, they no longer have an indemnity obligation at all.
On the other side, the Seller maintains they can only give assurances for issues they know about and outline in the representations and warranties in the contract. The target thinks the Buyer should take on all the risk after those issues are outlined.
Clearly, the two sides are at odds. And this can make for difficult negotiations.
But there is an insurance product that can make both sides happy, remove the need for money to be held back in escrow and fulfil any indemnity obligations in the event of a breach of the Seller reps. Deals as low as $15 million will be considered by insurance company Underwriters.
Representations and Warranty insurance does this by transferring the indemnity obligation from the target to a third party – an insurance company.
For example, say a chain of restaurants is purchased. But post-closing, the Buyer discovers that there are $1M of gift cards out there yet to be redeemed. Without R&W insurance, the Buyer would have to go after the Seller to cover their financial losses. But with this coverage, they simply file a claim with the insurer.
Another big bonus: with this coverage in place, a deal is EIGHT TIMES more likely to close. Because the indemnity obligation has been removed from the Seller’s shoulders, that’s one less thing to negotiate. The process becomes that much smoother.
The vast majority of policies are “Buyer side,” where the Buyer is the Insured Party, although often the Seller is the one to pay for it, and happy to do so, considering all the benefits.
Securing this coverage is easy, and its cost is low. To secure a policy takes a couple of weeks at most, as the Underwriters review the due diligence performed by the Buyer. The rate is 2%-3% of the Policy Limit, including Underwriting fees and taxes. The price of R&W insurance has dropped considerably in the last several years, while the number of insurers offering this coverage has increased.
Timing is critical. If you want R&W insurance to cover your next M&A deal, there should be a provision made at the Letter of Intent stage. If it’s put in place at that time, it can always be removed.
If you’re interested in making Representations and Warranty insurance part of your next deal, contact me, Patrick Stroth, at firstname.lastname@example.org.
In recent years, as more insurers have entered the Representations and Warranty insurance market (according to a study from Harvard Law School, there are now more than 20 insurance companies writing these policies), there have been more opportunities for ever smaller M&A transactions to secure coverage, with deals as low as $15M deemed eligible.
The insurers that offer these policies understand that given the smaller transaction size, they will be asked to cover most, if not all, of the transaction value (TV) of the deal.
Insurance companies are providing flexibility for Buyers and Sellers by offering policies that provide coverage up to the purchase price, while also insuring the Non-Fundamental reps to a specified Limit – more on this below.
Sellers of small TV targets have less leverage than their counterparts, so having the ability to transfer ALL the indemnity risk can provide a productive tool for both sides.
Naturally, Underwriters in this space require the same levels of Buyer diligence as the larger deals, so eligibility for R&W should be checked before proceeding.
Here’s why this matters: most R&W policies don’t cover the entire cost of the transaction. They only have to provide Limits up to the Indemnity Cap (Cap) as outlined in the Purchase Agreement.
A Seller’s maximum exposure is equal to that Cap and no more. Therefore, there’s no need to provide more protection above that Cap. In many cases, the Cap runs 20% to 30% of the TV.
Typical R&W insurers that cover $100M+ M&A deals are reluctant to insure more than 30% of the TV. So, the maximum an insurer would be willing to cover on that $100M deal is $30M, even though that same insurer has the capacity to provide a $50M or $75M Limit. The reasoning is that Underwriters are not comfortable insuring a majority of the TV.
This position is not the case with deals in the lower middle market (sub-$30M TV space). Unlike the larger deals, it’s easier for Caps to exceed that 30% threshold. Consider a $5M Cap is 33% on a $15M deal. Buyers have significantly more leverage over targets in this sub-$30 TV space, and therefore routinely require higher Caps, particularly with regard to Fundamental reps.
Within the Purchase and Sale Agreement, there are specific categories of reps: Fundamental and Non-Fundamental.
Fundamental reps often include:
Any rep not identified as Fundamental is considered a Non-Fundamental rep.
Buyers scrutinize the Fundamental reps more closely than any of the other Seller reps, as breaches of Fundamental reps lead to larger, more serious financial damages.
Breaches of Fundamental reps are rare because they have been so closely watched, but according to the recent AIG claims report, they do happen.
R&W insurance is priced based on the amount of Policy Limits provided. Since smaller transactions traditionally don’t need higher Limits, Underwriters haven’t been able to set a price for small deals that justifies the risk.
For that reason, Underwriters developed the approach of offering to insure the entire transaction by covering the Fundamental reps at a maximum Limit, while including coverage for the smaller, Non-Fundamental reps Cap.
The per Limit rate for these purchase price policies is discounted due to the lower risk of the Fundamental reps, while enabling Underwriters to collect sufficient premium to insure the smaller deals.
Take the case of a PE firm seeking to purchase a chain of car washes for $22M.
Within the Agreement, the Buyer seeks a $4.4M (20%) Cap on Non-Fundamental reps, but no Cap on Fundamental reps.
Prior to the entry of the new R&W policies, the maximum limit of coverage for Fundamental and Non-Fundamental reps would be $6M to $7M and the parties would have to bear any risk above that Limit.
Today, policies are readily available to offer a package that provides $22M in Limits for Fundamental reps, with a Sub-Limit of $5M for Non-Fundamental reps.
Consider the pricing benefit as well.
A $22M Limit R&W policy runs $400K to $600K. However, a policy with a $22M Limit on Fundamentals and a $5M Sub-Limit for Non-Fundamentals can be as low as $220K.
It’s clear that the use of R&W insurance will continue to grow as more Buyers and Sellers come to understand its benefits and insurers are willing to cover a wider range M&A deals.
If you are considering a M&A deal on the small side but didn’t realize you could secure R&W insurance to protect yourself, let’s talk about this recent trend of insurers covering full transaction value.
You can reach me, Patrick Stroth, at email@example.com or 415-806-2356.