The COVID-19 pandemic has changed trade, commerce, and business in so many ways already… with more changes to come. The world of M&A has reacted as well. But as I noted in my previous piece, No Significant Drop in M&A Activity During This Recession, we won’t see the slowdown happening.
Instead, we’ll see a shift to a Buyer-friendly market. Also, watch for PE firms with plenty of cash to look for opportunities – and bargains… struggling companies they can turnaround.
The pandemic will impact a key part of M&A activity: the due diligence process and the use of Representations and Warranty (R&W) insurance to cover breaches of reps in the Purchase and Sale Agreement.
Just as with any insurance product, COVID-19 must be addressed with R&W policies. And expect pandemic-related questions from Underwriters in the due diligence process.
Not every company, of course, has been affected by COVID-19 in the same way. For example, a software company that already had a largely remote workforce is in much better shape than a retailer forced to close brick-and-mortar locations.
But overall, insurers are closely monitoring the impact of COVID-19 on operations of any acquisition target. This is how I expect it to impact R&W coverage moving forward:
As a worldwide pandemic affecting billions, nobody can claim that COVID-19 is an “unknown” prior to a deal being signed. And R&W policies only cover breaches that were unknown, “historical,” or related to issues that were not disclosed by the Seller.
The impact of the virus on the workforce, including layoffs and supply chain disruptions will be the focus on enhanced due diligence in particular, and not considered breaches. Claims related to a drop in revenue are right out the window. These will be excluded, but perhaps covered in another M&A related policy, such as business interruption insurance.
That being said, you can limit exclusions for specific things related to the pandemic, not just anything COVID-19 – that exclusion would be too broad. Despite its seriousness, the pandemic can’t touch every rep. So expect very careful language.
Since R&W policies are largely written for each individual transaction, a broker has the ability to identify the right Underwriters and products and make the exclusionary language in a policy as favorable/narrow as possible for the policyholder.
Take the Fraud Exclusion for example. Fraud is absolutely excluded in virtually every insurance policy because it’s a moral hazard. However, savvy Brokers and Underwriters can create wording in a policy to provide legal defense of a policyholder accused of fraud until the alleged fraudulent behavior is proven. If there is no proof of fraud, the exclusion cannot be triggered, therefore, a policyholder benefits from the protection provided by the policy. Depending on the rep in question and the amount of diligence shown to Underwriters, a Broker can negotiate wording that can lessen the scope of a COVID-19 related exclusion.
With some M&A transactions, there can be a long period between signing the Purchase and Sale Agreement and actually closing the deal, especially with large and complex deals. For example, it took months for Amazon’s acquisition of Whole Foods to win regulatory approval and close.
Imagine if a deal like this had been done recently, and COVID-19 swooped in during that interim period. Remember, to be considered a breach, the issue must be unknown and/or result from failure to disclose a harmful issue by the Seller.
But a change in the overall economic environment or the industry such as this pandemic, can’t be considered an “unknown” and therefore would not be covered.
Thankfully, this is not much of an issue with lower middle market companies because interim periods between signing and closing are rare, and if there is an interim, it is likely measured in days, not months.
One last thing to watch out for. For now, R&W coverage pricing and deductibles haven’t changed. They should be increasing as more claims are coming in in this time of crisis.
The previous trend had been for consistently falling prices and its use in ever-smaller deal sizes – down to $15 million, which was one of the factors in its growing use by middle market companies. It’s something to watch out for.
To discuss the impact of COVID-19 on R&W and other M&A-related insurance, I invite you to contact me, Patrick Stroth, at email@example.com.
In insurance parlance, if you insure a particular exposure, you’re covered. If not, you’re bare. If you’re looking for a policy that covers something that’s never been covered before, you’re… naked.
That’s the situation many privately held, small and middle market companies find themselves in when they seek to sell their business.
The Buyer asks them to secure Directors and Officers Liability insurance (D&O), specifically a “tail” policy to make sure there’s a source of insurance coverage in case the Seller is held liable for any wrongful acts against an employee or others – things like human resources issues or fraud – committed before the closing date.
Essentially, the Buyer doesn’t want to find out six months after the closing date that there is some sexual harassment lawsuit or anti-trust complaint against the former owners.
As the new owner, the Buyer doesn’t want to be on the hook for incidents that happened before they purchased the target, so they require Tail coverage that extends the target’s D&O Liability, Employment Practices Liability, and Fiduciary Liability coverage for up to six years from closing.
Tail policies provide virtually the same protection as a traditional D&O policy that has a Tail Endorsement. On the acquisition date, the Tail kicks in and covers lawsuits brought against the directors and officers of the target company. This covers any allegations that they committed a wrongful act prior to the acquisition, all the way back to the incorporation date.
This sort of coverage is standard in the M&A world. I’ve been working in this space for years. As I mentioned in a previous article, when Representations and Warranty insurance is not a fit for a deal, Naked Tail coverage is one of three alternatives.
(To put it in to perspective, the cost of D&O Tail coverage is about $20K to $50K. That’s a fraction of the cost of a R&W policy. And the deductible on a Tail policy is $25K to $50K, which is also a fraction of what it is for R&W.)
There are literally thousands of privately held companies in the $30M to $50M range that have never held D&O insurance and now need it to satisfy the terms of their acquisition. Today, this can be done quickly, easily, and broadly.
For example, a small business, run by husband and wife for 20 years. They never felt the need for D&O coverage and had gone the whole 20 years without any sort of legal claim against them. But, when they were ready to sell and enjoy a well-deserved retirement, they were forced to scramble and find coverage because the Buyer required a D&O Tail. Since the couple had never carried D&O previously, their options for finding suitable coverage were limited. That is until now.
Insurance companies didn’t look at these Naked Tails favorably in the past. Generally, they wanted to see three to four years of successful coverage under a regular D&O policy (and wanted three to four years of premiums).
What happened to people who didn’t previously have a policy and are about to sell or merge? The insurers would provide scaled down policies with multiple exclusions at rates that were substantially surcharged.
Things have changed. Now, insurers understand that the risk of anything that the Seller didn’t know about blowing up post-closing is very small. And they are willing to offer these Naked Tail policies for even small transaction size deals.
Today, Underwriters need only a statement from the Seller warranting that, as of the closing date, they know of no fact, event or circumstance that would give rise to a claim. Such warrants are hardly problematic because the Seller is already making these warrants to the Buyer on a much broader scale. Therefore, the Naked Tail is a relatively low risk for Underwriters.
There are a couple of reasons you need a D&O Tail policy when you’re going through any M&A deal, besides the fact that it is contractually required. (For those who’ve never had D&O insurance and don’t see why you need it now, pay close attention.)
D&O Tail coverage doesn’t cover fraudulent behavior, but it will give you money to defend yourself against allegations of fraud. An allegation is not proof. But if you want to keep your escrow, you must defend yourself in court, no matter how frivolous the claims. Without D&O coverage, you’ll pay your own legal costs.
D&O Tail coverage doesn’t cover fraudulent behavior, but it will give you money to defend yourself against allegations of fraud. An allegation is not proof. But if you want to keep your escrow, you must defend yourself in court, no matter how frivolous the claims. Without D&O coverage, you’ll pay your own legal costs.
As I mentioned, if you’re looking to sell your business, you’ll most likely be contractually obligated to take out a D&O Tail policy. There’s no getting out of it, so to speak. And with the legal and financial protection it offers, why wouldn’t you want a policy anyway.
I would recommend not going to your regular commercial insurance broker, even one with experience in standard D&O insurance. A Naked Tail policy is a whole other animal.
You need a broker experienced in insuring M&A transactions and Naked Tails in particular. It’s a slightly different skillset. And because this issue usually comes up close to closing, you want a pro who can get the paperwork processed in a day or two.
I’ve worked in this world for years and would love to answer any of your questions about setting up a D&O Tail policy to your deal. It’s low cost and easy to do.
You can contact me, Patrick Stroth, at firstname.lastname@example.org
Steven Epstein, founder of RedCAT Systems, and his partners and management team had slowly but surely built their company in a highly specialized niche serving top clients, including those in the Fortune 500. They were ready to sell to take the company to the next level.
But this small, Colorado-based software company involved in HR and compensation solutions for clients like LinkedIn, Uber, NYSE, and many more wasn’t interested in being acquired by just anybody.
They were looking for a partner who wouldn’t accelerate growth too fast or take on too many new clients too quickly because they wanted to ensure a slow growth strategy that would keep current clients happy and give the new ones the same high level of customized service they’re known for. In their specialization of executive compensation, which has a lot of moving parts, this counts for a lot.
After a time, they found their match – a company that understood their business culture – and were recently funded by PE firm Broadtree Partners.
“We wanted to make sure that our clients were treated well. It’s a very high-level service. There’s really nothing that we would be asked that we weren’t able to fulfill on time, on budget, and pretty much the experience was exceptional. That’s why we were able to get the type of work that we do. And we wanted someone who would share that philosophy and maintain that while at the same time doing measured growth,” says Steven, of RedCAT.
As with any M&A transaction, there were some hiccups along the way… as well as one major obstacle that could’ve derailed the whole deal, and probably would have, if this transaction was being negotiated prior to 2019.
This is an in-depth examination of this real-world M&A transaction. We first got the story from the Buyer’s perspective – you can check out that article here. Now, we’re hearing from the Seller as we explore how the deal went down so that both sides were happy. Additionally, Steven was featured on my podcast, M&A Masters. You can listen to his episode here.
Once Broadtree and RedCAT had a signed a Letter of Intent, it took roughly nine months to close the deal.
One of the things that stalled the deal moving forward was due diligence. Broadtree was more used to dealing with larger companies that had more in-depth and detailed financial records that could be combed through. It took a while for RedCAT management to get all the required information together.
“As a company, if that was your plan [to be acquired], I would just keep much more meticulous track of every single document,” says Steven. “Every little bit of every single dollar that was ever spent took a lot of effort to come up with… and then thousands of pages of contracts we had already signed. Looking at and reviewing every single thing took quite a while.”
Tech due diligence – which involved making sure no code or other IP could be claimed by another party – also took some time to get through.
But what was the major sticking point?
One of RedCAT’s partners, who had been burned in business deals in the past, wanted some protection. Specifically, he wanted to use Representations and Warranty insurance so that less money (including his) would be held in escrow and there wouldn’t be any threat of clawback.
With R&W insurance, if there are any breaches in the Seller’s reps, it’s the insurance company – not the Seller – who reimburses the Buyer and pays the financial damages. Those claims do get paid, and this coverage is reasonably priced.
Often the Seller pays for the insurance because of these benefits. But there are plenty of reasons for a Buyer to get on board, too. For one, in case of a breach, they don’t have to go after their new team members (the Sellers) who’ve joined the company after the acquisition for damages – that’s very awkward. Also, there is no need for costly or time-consuming legal action. The claim gets paid, and everybody goes about their business.
“[R&W insurance] allayed our partner’s fears, basically of the deal and the liability,” says Steven. “If something did come up, I think it would be tremendously beneficial to have it. Let’s say we didn’t have R&W, and we put in $1.5, $2 million in escrow. And then some kind of obscure thing comes out, and we disagreed with it. That would cause a serious breach. Not only of, say it’s a million or two dollars, but then we probably wouldn’t want to stay on. And the effect is most likely the failure of the new business.”
Just a short time ago, this wouldn’t have been possible because insurers were only offering R&W coverage for larger deals. But recently, we’ve seen an increase in Underwriters crafting policies for transaction sizes under $20M, which opens up this insurance to a whole other section of the M&A world, including lower middle market companies like RedCAT.
For Steven, the R&W coverage offered more than financial protection.
“The peace of mind can be priceless. Just the feeling that I don’t have to worry about this. We’re covered. It’s not a thing that will A) damage the relationship and B) just consume life energy where you’re fighting about something that is likely frivolous.”
That’s a ringing endorsement for Representations and Warranty coverage. If this case study has interested you in this specialized type of insurance, tailor-made for M&A transactions, and now available for deal sizes under $20M, contact me, Patrick Stroth, at email@example.com.
In the world of M&A, many companies, on both the buy-side and sell-side, have realized the tremendous benefits provided by Representations and Warranty insurance.
The Buyer is able to recover any losses from a breach of the Seller reps without doing so at the expense of the Seller. The Buyer simply makes a claim with the insurer. Plus, the policy cost is either discounted significantly or is free because the Seller will gladly cover the premium.
Sellers love it because they take home more at closing and the indemnification risk is transferred to a third party – the insurance company. A clean exit, and they have zero fear of future potential clawback if there is a breach.
That being said, not everyone is willing to entertain using this insurance.
This is especially true in the case of a corporate, strategic Buyer, in which one company buys another because of synergy of products… to expand to a new customer base or geographic region… or to acquire products they want.
The thing is that strategic Buyers are often much larger than the acquisition target – often hundreds of times larger. In these cases, there is no incentive for the Buyer to get R&W insurance; the protection it provides them is negligible. This is the case even if the Seller is willing to cover the cost. The other issue: the Seller has no leverage here.
So what’s a Seller to do?
As a small Seller, you don’t have to enter into an M&A deal with no protection. There are alternatives if your Buyer isn’t interested in full R&W insurance.
For tech companies, the most sensitive reps are those dealing with technology, of course. If those reps are breached, it could be very expensive as they are critical to the value of the company.
The target tech company could be confident that their IP is not infringing on anybody, but the Buyer no doubt still has a bit of worry.
If the Buyer is not willing to consider full R&W insurance, a Seller could get a limited policy that just covers IP reps. These types of policies do rely on the Buyer’s due diligence. So the Underwriters still have to engage the Buyer to get their diligence on IP. But it’s not the full report, so it’s a relatively easy ask. And the cost is still on the low end, with a premium cost at 2% – 2.5% of policy limit (subject to $100K minimum premium), with 1% transaction value retention.
The same sort of arrangement could be made for tax reps, as well.
Although the vast, vast majority of R&W insurance is on the buy-side, it is possible for Sellers to get their own policy. This could be handy if the Buyer refuses to disclose any of their due diligence and the Seller is nervous about not having any protection from risk.
To be frank, sell-side policies can be more challenging than those of the Buyer’s side. It essentially protects the Seller in the case of a third-party (which includes the Buyer) bringing action against them for a breach of their reps.
For example, McDonald’s recently bought a small AI company – the technology will be used to speed up the drive-through ordering process. A huge company buying a small one.
Hypothetically, let’s say the AI company had unknowingly breached another company’s IP. That other company will sue McDonald’s and the AI company. McDonald’s is fine – they have their own protection and legal team. But the founders of the AI company need protection because they no longer have insurance after the acquisition. A sell-side R&W policy can be a perfect option.
Owners and founders can also rely on a Directors and Officers liability policy to protect them in case of allegations of misrepresentation, unfair dealing, or fraud. At the very least, the D&O policy can pay lawyer costs to protect the policyholder.
In the vast majority of purchase and sale agreements there is a requirement that the target company have a D&O policy in place. Privately owned companies with a small number of shareholders/owners might think they don’t need this coverage because they don’t have outside shareholders. But this protection is key.
Once the Buyer acquires a company, the board is their responsibility. They don’t want to take a risk on things done before they acquired the company. It’s best to have some other source of recovery like this on their end as well.
A D&O liability policy will run you a tiny fraction of what R&W costs.
For those companies that never carried D&O insurance in the past, there’s a solution. Companies can purchase a D&O Tail policy that will provide virtually the same protection as a traditional D&O policy that has a Tail Endorsement.
In the event there is a claim against any of the directors and officers, they will be protected from legal action for up to six years post-closing if there is a D&O “tail” policy.
Even if they didn’t have insurance previously, on the acquisition date the tail kicks in and covers any lawsuits brought against the directors and officers at the target company. This covers any allegations they committed a wrongful act prior to the acquisition, all the way back to the incorporation date.
Let me wrap things up with a quick case study of a company that wanted R&W coverage in place… and a Buyer who wasn’t willing to deal… and what they did next.
A small AI company was bought by one of its clients – one 1,000 times its size, roughly, and worth $20B. The total transaction value was $17M.
The Buyer had no interest in R&W insurance, even when we offered a policy that covered the full $17M.
The Seller was really concerned because the IP reps went from general reps to fundamental reps with a longer survival period. That’s a lot of risk out there for them for years down the road if another company claims IP infringement.
We offered to insure just those IP reps, with a premium from $100K to $300K, which the Seller was ready to pay.
All that was needed to write the policy was the Buyer’s due diligence report. But they didn’t want to disclose any confidential information.
The last alternative we were able to offer the Seller was a D&O Liability Insurance policy. We got the thumbs up and did a $5M limit D&O policy for $50K.
The company was acquired on July 1, 2019. Until July 1, 2025, any lawsuit filed against the company’s board of directors for allegations prior to the acquisition date will be covered.
Of course, R&W insurance would have been preferable for the Seller. But this was the best option and does offer substantial protection.
If you’re interested in exploring your options for protecting yourself post-closing with Representations and Warranty insurance or some other type of coverage, get in touch with 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.
As more players in the world of M&A come to realize its tremendous value, there have been several big changes in the use of Representations and Warranty (R&W) insurance to protect Buyers and Sellers post-transaction. (Any financial loss resulting from a breach of the Seller’s representations in the purchase-sale agreement are paid by the insurer because they take on the indemnity obligation from the Seller.)
I’ve mentioned previously that the number of insurance companies offering this specialized type of coverage is more than 20 today, compared to just four in 2014.
There are also more policies being written than ever before. A part of that is the fact that just a few years ago insurers only felt comfortable insuring deals of $100M or more, and then only with audited financials.
Now, they are offering coverage for deals under $20M… in fact, they’ll now go as low as $15M… without requiring a strict financial audit during the due diligence process.
The reason? The R&W market has matured, so to speak. Insurance companies are more comfortable with it as they’ve had successful experiences with larger deals. Underwriters are familiar with the product and the claims process. (Only about 20% of deals result in claims.)
Now, insurers are looking to increase their bandwidth and increase the number of clients they cover. And that means they have to look at smaller clients.
The risks are smaller and can’t be mitigated as much as with larger clients. But by bringing down the rates enough, they can cover the small deals. And because the amounts involved are so low, there isn’t much financial risk.
Still, sub-$20M deals are different in a few key ways:
There are many more M&A deals on the smaller side that don’t get the press of the big-name transactions. And I think the use of R&W insurance to cover transactions at any level can only go up as it becomes more well-known, especially among PE firms and VC funds.
I’m an optimist by nature. But if there is a slowdown in the economy, you will see a lot of owners and founders running to the door to close out business – that’ll cause a spike in sub-$100M transactions.
And in order to capitalize on their return and secure more cash at closing in uncertain economic times, they’ll want an R&W policy covering the deal.
If you’re involved in an M&A deal under $20M and are interested in the protection that comes with Representations and Warranty insurance, I’d invite you call me, Patrick Stroth, at 415-806-2356 or send an email to firstname.lastname@example.org. I’m experienced in deals of all sizes and I have the contacts at the insurers to secure the coverage you need.
There is nothing venture capital funds like more than a clean exit in which they can take their money from sales of portfolio companies, distribute funds as necessary to investors, and then move on to new acquisitions with the money they earned from the sale.
But sometimes there’s an issue and a VC fund can be sued by a third party well after the sale of the portfolio companies… with the fund being on the hook for millions.
That’s not such a clean exit.
Here’s the scenario.
A VC fund has a portfolio of 10 tech companies. They were all promising startups. Some fared poorly. Some did okay. With such early stage companies, that’s just the cost of doing business. Nobody can tell for certain what startups will crash and burn.
But some of the portfolio companies did very well in growing quickly and seeing revenues soar, thanks to breakthrough tech products, not to mention guidance from the fund.
After a few years, the fund had plenty of potential Buyers come calling. The VC fund was happy to offload several of the portfolio companies, resulting in a tidy profit overall. The fund managers are happy. The investors are happy to see a return on their seed capital.
Unfortunately, that fund, a legal vehicle for having equity in those portfolio companies, is still liable for lawsuits from third parties. And the fund also retained an obligation to indemnify the Buyer for contingent liabilities they were unwilling to assume.
And because a good portion of the capital from the sale of the portfolio companies is still held in reserve for contingent and/or tax liabilities that might come up, that capital is at risk and they are unable to make a final distribution.
It’s like if you had a bank account for several vacation rental properties you owned. You’ve already sold the properties. But because you still have that bank account with the sale proceeds, you are still linked legally to the properties.
If this lawsuit from an outside party is successful, the proceeds will come – be “clawed back” – from your reserves held in escrow against potential liabilities.
But there is a way to speed-up the liquidation of the fund so that all the proceeds can be distributed to investors instead of being held in case of potential clawbacks.
Fund managers can make a final distribution to the fund’s partners or interest holders without fear.
With this “fund liquidation insurance” in place, VC funds are able to close the “liquidity gap” after the sale of their portfolio companies and get a clean exit while still meeting the reserve requirement, which is what they’re after, of course, and maximize their returns.
This coverage can also be expanded to cover heirs, assigns, estates, spouses, and domestic partners of fund managers. With this insurance in place, policyholders are covered for identified and unidentified contingent obligations that fund managers would otherwise prepare for with reserves or holdbacks.
Fund liquidation insurance unlocks the millions (in some cases tens of millions) of dollars VCs are forced to keep in escrow/reserve to cover the cost of these potential liabilities.
Some Private Equity and similar investment funds are also using fund liquidation insurance rather than holdbacks during windups to cover back-end risks and to enable the efficient distribution of a fund’s proceeds to investors.
Divestments, which can be multi-year liabilities, can be insured, with the risk of clawback transferred completely to an insurance company. This is not Representations and Warranty Insurance (R&W), although the two types of policies can work in tandem.
This policy will be set up during the final stages of the liquidation process.
Potential liabilities, which can include sell indemnity caps, escrows, and excesses, are added up to form the policy limit. Premiums for this insurance are 1.3% to 3% of that limit, with an additional premium of 3% to 5% for unknown risks. It’s a low cost, considering all the benefits.
Another benefit: this specialized type of insurance could also be a deductible expense. Consult with your tax professional.
For more information on fund liquidation insurance, contact me, Patrick Stroth, at email@example.com or 415-806-2356.
It’s a good time to be alive for Buyers and Sellers in the M&A world.
The use of Representations and Warranty (R&W) insurance, is more widespread than ever, with deals as low as $15M considered insurable. That’s down from a minimal deal size of $100M just a couple of years ago.
What makes R&W coverage so attractive?
It protects both Buyer and Seller if there is a financial loss resulting from a breach of the Seller’s representations that were outlined in a purchase-sale agreement.
The insurer covers the losses in case of a breach because they take on the indemnity obligation from the Seller.
Plus, the number of insurance companies offering this coverage has jumped from 4 in 2014 to more than 20 today.
The news comes from the latest report from one the largest insurance companies in the R&W and broader M&A insurance space, AIG. The report, their fourth in the Claims Intelligence Series report, is called Taxing Times for M&A Insurance.
When this report is released, those involved in the M&A industry and Private Equity pay close attention to the trends it highlights.
The bottom line is that more R&W policies are being written than ever before as both Buyers and Sellers come to understand the benefits such a policy will bring to their deal, such as…
Both sides of the table have a better understanding of how R&W works, not just for their negotiations, but when the time comes for actually “using” their policy.
That calls to mind another trend of note: more claims are being reported in this space. It’s not surprising as there are more insured deals out there. But never fear, insurance companies do pay claims in this space readily, unlike with some other forms of insurance. And, as of now, the trend of claims isn’t outpacing the premiums generated by R&W, so pricing and retentions will remain steady.
Plus, it’s clear that policyholders (the Buyers) are better prepared to work with the insurer to get their claims paid. The more policyholders purchase R&W, the more comfortable they’re getting as R&W impacts their negotiations as well as when a claim does happen, they are better prepared to:
A) Report a loss at a more favorable time (after the Retention level has dropped down 12 months after closing), and
B) When they do report a claim, they bring extensive supporting documents to help the insurer process the loss more efficiently and quickly. This comes from R&W claims representatives who work with policyholders directly on claims.
Note that 74% of breaches are reported to R&W Insurers within the first 18 months of closing. It’s more evidence that policyholders are more sophisticated in the use of R&W, with half of those breaches reported after 12 months when the Retention drop-down provision has been triggered.
Overall, this is a good sign that R&W insurance is steadily maturing and provides a sustainable tool for M&A.
Here are some of the raw numbers:
Buyers and Sellers interested in one of these R&W policies need a broker who specializes in R&W, works on these deals routinely, and is experienced in M&A.
I’d welcome the opportunity to speak with you further about how R&W insurance could benefit your next M&A deal. You can call me, Patrick Stroth, at 415-806-2356 or send an email to firstname.lastname@example.org, to set up a time to chat.
With any merger or acquisition, tax liability is a major concern because when you buy a company you assume its tax obligations. And you can bet the IRS is keeping close tabs on every transaction for taxable events, not to mention state tax authorities.
Not paying attention to tax treatments that apply to acquisitions could cost a Buyer significantly, and perhaps negate any advantage they had in the deal at all. For example, say a Buyer purchases because they think it has favorable tax deals, but the taxing authority disagrees. Then they’re on the hook for the tax bill.
But for a low premium, tax insurance, with policy terms generally set at six years, would protect against that disastrous event. Think of tax insurance as an “add-on” to Representations and Warranty insurance, kind of like you add earthquake or hurricane coverage to your homeowner’s policy.
That might be putting it too lightly, actually. Tax insurance protects a taxpayer (in this case, the acquiring company) if there is a failure of tax position arising from an M&A transaction, as well as reorganizations, accounting treatments, or investments.
A few examples of where tax liability insurance would be applicable (thanks to RT ProExec Transactional Risk’s recent white paper for this info and other helpful tips in this post):
Checking tax status is, of course, part of any Buyer’s due diligence. An outstanding tax bill is easy to find. But certain tax treatments the Seller insists are correct and up to standard, may not be. The Buyer, relying on its tax attorney’s specialized tax expertise, can insist those issues be taken care of pre-sale because they are exposures.
In the past, Sellers could go to the IRS and ask, “Is this an exposure?” and get a Private Letter Ruling okaying the request. But with the IRS swamped these days, they’re not really issued anymore.
When there are tax issues that come up for debate during due diligence for an M&A transaction, both sides bring in tax attorneys and each side makes the best determination in their opinion if this is a taxable transaction or not. They could take a light touch or be very conservative.
The Buyer will likely insist that a portion of any tax liability goes to the Seller, whose expert says they don’t agree with that determination. If there is a disagreement – get tax insurance.
Underwriters will get letters from tax attorneys from both sides outlining their arguments, along with supporting documents. It’s quite simple underwriting.
Underwriters want to see:
It generally takes the Underwriters about three to four days to deliver a preliminary response.
In some cases, M&A transactions can become tax-free transactions or tax-free exchanges. Of course, the IRS can always disagree and insist on back taxes and fines.
Some things to keep in mind:
When Underwriters aren’t confident about a specific tax position, they may set retention at where they think the tax authority would settle. When they are more confident, they will be okay with minimal retention by the insured or none at all.
If a tax memo convinces them that the IRS agrees that it is not a taxable event – good. If not, the IRS triggers an inspection.
The insurance will pay the legal costs to fight the IRS, as well as taxes, penalties, and fines if they lose. And, get this. If your insurance win was, let’s say, $5 million and the IRS says, “You just made $5 million in income,” the insurance will pay tax on that as well. That is known as a “gross-up.”
Tax liability insurance is more expensive than R&W (it generally costs between 3% to 6% of the limit), but it makes sense as the stakes are higher. So it should be an important part of any M&A transaction.
If you’d like to discuss how to protect yourself with tax liability insurance and how it coordinates with R&W coverage (because R&W does not include a Seller’s identified or disclosed tax risks), please call me, Patrick Stroth, at (415) 806-2356 or email me at email@example.com, to further discuss this vital insurance protection.
The typical insurance broker wants to serve all their clients’ needs, especially if it’s a large client that requires various types of insurance to cover its operations.
The motivation is to be there for the client, who you know well. And the extra commission doesn’t hurt either.
But although a broker may have the best intentions, if the insurance required is out of the broker’s area of expertise (and no broker is master of all), this practice is actually not good for clients. They’re just not going to get the best value out of their policy.
When it comes to Representations and Warranty (R&W) insurance, a highly specialized variety that covers M&A deals, this is definitely the case.
R&W insurance protects both Buyer and Seller if there is a financial loss resulting from a breach of the Seller’s representations that were outlined in a purchase-sale agreement.
If there is a breach, the insurer covers the losses because the coverage transfers the indemnity obligation from the Seller.
Buyers and Sellers entering into deals who are interested in one of these policies need a broker who specializes in R&W insurance and does it routinely. Not to mention that the broker must understand how M&A works.
In R&W insurance, it’s not what you know, it’s what you don’t know that will come back to bite you.
Here’s why: On the surface, the coverages from one R&W policy to another are very similar. It’s rare when R&W insurance policy verbiage diverges greatly and have material coverage missing, which often happens with other types of business insurance. Within various business insurance programs, many coverages considered “essential” by some are deemed “optional” by others and therefore omitted to save costs (i.e. Uninsured/Underinsured Motorists coverage).
The scope of coverage for an R&W policy is determined by two elements: The Seller’s reps and the degree to which the Buyer performed diligence on those reps.
The key difference between R&W policies comes from decisions Underwriters make as to what degree they’re willing to cover all or most of the Seller’s warranties. This decision is based on two elements: The Underwriters’ appetite for risk in a certain business sector and the amount of diligence performed by the Buyer. It’s essential for the insurance broker to determine to what extent each insurer is willing to cover the majority of warranties, and where there may be flexibility.
Unlike other instances when business insurance is considered, R&W is brought to bear in M&A transactions where 100’s of millions are at stake. That’s both exhilarating and terrifying for the parties. Often times, Buyers and Sellers haven’t used R&W before, so they have no idea what to expect from the process. They need a “steady hand” to guide them, manage their expectations and inform them as to what they can expect.
Brokers who lack experience in placing R&W will struggle to navigate the underwriting process. Ultimately, this can put their clients through unnecessary stress due to delays and “surprises” that an experienced player can anticipate and prepare for.
An example would be to prepare Buyers for the time and access Underwriters will need with the Buyer’s team to review the diligence performed and which outside parties participated. Brokers unfamiliar with R&W might fail to prepare their clients for this, which can result in a huge burden on the Buyer.
A broker’s relationships with Underwriters at different insurance companies is essential. Different insurers have different appetites for risk. A qualified broker, who are also experienced with M&A, knows who does what.
Some insurers are comfortable with healthcare deals and the added regulatory scrutiny they bring.
Some insurers are comfortable in the up-and-coming cannabis market. (Actually, there’s only one insurer in this market so far, but more will ultimately follow.)
Some insurers will cover certain deals but only with so many strings attached that the client won’t actually qualify, or the cost will be too high.
Insurance companies’ appetite for certain risks can change over time, and a savvy broker will keep track of these trends.
R&W policies cover complex business deals – and the Underwriters typically don’t know every industry well. That’s where the broker comes in to match the right Underwriter with experience – and interest – in a certain space for the deal.
A good broker/Underwriter relationship has other benefits.
First, a good broker sends information the Underwriters need without waiting for them to ask. That means coverage is obtained that much more quickly.
Just like anything in life, when you know someone, things just go smoother. This is particularly true on smaller deals, in which Underwriters have to deal with less due diligence provided by the Buyer.
Some insurers will penalize the Buyer for having less comprehensive due diligence. But a good broker can be a go-between and mediate in that case.
For example, say the financial statements were reviewed but not officially audited. The broker can explain why that was the case and why it’s okay. A trusted relationship makes it possible.
Typically, both Buyers and Sellers have their own brokers handling their respective insurance programs. When those brokers see the premium sizes (and the resulting commission) from R&W policies for big deals they say, “Sign me up.” They’re not qualified, but they’re certainly not leaving that money on the table and are willing to dabble if given the chance. This creates unnecessary friction between the parties as they argue on behalf of their “guy” or “gal”.
The best approach is to select an independent specialist who will only handle the R&W placement. There would be “zero conflict” with the incumbent brokers as R&W is a one-time deal that doesn’t touch any other policy.
That neutral broker will have a fiduciary responsibility to the Buyer (R&W policyholder) to provide the broadest level of protection, while committed to delivering a variety of options that are budget appropriate in the interests of the Seller (who often shares in the cost of R&W).
That’s why a neutral broker who knows R&W best practices and has the clients’ best interest at heart will get the ideal outcome for both sides.
There’s no shortcut for a broker who has experience and has had working relationships with Underwriters for years. With that comes mutual respect. If there are disagreements or contentious points, they are easier to work through.
In an M&A deal, Buyers and Sellers should not rely on a broker who does their other insurance to secure their R&W policy. Get a specialist.
A number of Underwriters have already “trained” me. I know the inside track. They know I’ll run the process the way they need to provide the best policy in a timely manner.
I’d be happy to discuss with you how Representations and Warranty insurance could benefit your next M&A deal, as well as the costs. Please contact me, Patrick Stroth, at firstname.lastname@example.org or 415-806-2356.