D&O Liability Coverage Versus TLPE Insurance
As I’ve written in the past, there are many founders of small- and medium-sized, privately held companies that simply don’t see the need for Directors & Officers (D&O) liability coverage.
I won’t argue the merits of D&O insurance here.
But, the reality is that when those owners try to sell their companies, that lack of coverage will come back to bite them.
Buyers, in this case, will almost certainly require a D&O “tail” policy to make sure the Seller is held liable for any wrongful acts against employees or others – things like human resources issues or fraud – committed before the closing date but that didn’t come to light until after closing.
The Buyer doesn’t want to be held liable or pursued by claimants for incidents that occurred before the purchase. So, they require coverage that extends for up to six years after closing.
Essentially the Buyer is looking for a layer of protection from any potential issues caused by the Seller.
For transactions where the Buyer is carrying Representations and Warranty (R&W) insurance, the D&O tail policy will still be required as many R&W insurance carriers will want to insulate the Buyer’s R&W policy from possibly being used to pay any Seller-related claims that incur financial damages.
A D&O claim could even represent a breach. But, the D&O tail provides protection for the Buyer’s R&W policy. The tail policy will also fit nicely into an R&W insurance deductible.
Here’s the issue:
For transactions under $20M in EV, traditional R&W coverage cannot be used. In this case, I think a new insurance product, Transaction Liability Private Enterprise, is a viable alternative to a D&O tail policy.
TLPE insurance is designed for smaller deals. Retention is only 1% of EV or $10,000, whichever is higher.
It is a Sell-side R&W policy where the Seller, rather than the Buyer, is the policyholder. TLPE policies are triggered when a Buyer submits a written demand for damages from the Seller.
Here are the reasons why I think TLPE insurance can replace a tail policy:
Most post-closing D&O claims actually come from Buyers alleging Sellers misrepresented something about the company. While a D&O tail policy can provide the Seller with some legal defense coverage, these policies specifically exclude contractual liabilities. Therefore, breaches of the purchase and sale agreement will likely be excluded. Buyers sometimes work around this by alleging fraud, which a D&O tail is compelled to defend.
TLPE policies are written specifically for Buyer claims of breaches of the sales contract, so no exclusion workaround is necessary. With TLPE insurance, there is no contractual liability exclusion. This makes TLPE insurance infinitely broader in scope than a D&O tail policy.
Depending on the amount of insurance, a TLPE policy may be less expensive than a D&O tail policy. Both policies generally run for a six-year term.
Of course, for deals above $20M, TLPE insurance isn’t available. When faced with bigger deals, D&O tail insurance, which I feel should piggyback on a traditional R&W policy, is the only option.
If you’d like to discuss TLPE coverage, I’m happy to fill you in on the benefits of this unique insurance product. Please contact me at any time at email@example.com.
The Biggest Impact of TLPE Insurance
Transactions—the major decisions in the life of a business—impact both Sellers and Buyers.
In a standard transaction, a Buyer will request that money from the purchase price be held in escrow. While I’ll admit there is a strong argument justifying these requests, there are viable alternatives.
Why do Buyers Want Holdbacks?
Often, there’s not enough data available for both parties to reach an adequate level of certainty when it comes to risk, so Buyers use escrows/holdbacks as a hedge. This way, the Buyer can immediately respond to a breach, if one occurs, and they’re holding some cash from the sale.
The amount held back is usually 10% of the purchase price. This may be reasonable to the Buyer, but it can be quite significant for Sellers of small companies looking for an exit.
Recently, Representations & Warranty insurance has emerged as the most significant risk transfer solution. With this coverage, if there is a breach of the Seller reps, the Buyer can recover any losses without going after the Seller. The Buyer simply makes a claim with the insurer.
R&W coverage is easy to purchase, claims are paid, and it works. Thus, it has become increasingly popular in the M&A world.
The Wrinkle in R&W Insurance
There is a wrinkle, however, because R&W isn’t readily available for sub- $20M EV deals.
But there is a solution:
Transaction Liability Private Enterprise Insurance (TLPE).
Unlike traditional R&W insurance, TLPE is a sell-side policy where the Seller, rather than the Buyer, is the policyholder. The policy is designed trigger when the Buyer makes a claim against the Seller. Instead of going after the Seller directly, the Buyer simply collects from the insurer. Easy.
Think of TLPE as a simplified version of R&W coverage that can be placed in days rather than weeks at a fraction of the cost.
Sellers benefit from this insurance as well, and we’ve seen the results first-hand. The lesson we’re learning after 10 months of small business placements is that TLPE is effectively reducing escrow levels from 10% to 1% of the purchase price. (TLPE is only 1% of EV or $10,000 whichever is higher.)
Some examples from recent deals include:
I regularly hear from M&A professionals who say that R&W coverage, including TLPE policies, removes a significant amount of stress from the process.
One big reason may be that Sellers are closing with significantly more money in their pockets at no cost to the Buyer. That’s a nice goodwill gesture, to be sure.
If you’re looking to reduce risk when you sell for less than $20M EV and increase your closing payment, TLPE is the best way forward.
Please contact Patrick Stroth, for more information at firstname.lastname@example.org.
If you’re a sell-side advisor… investment banker, business broker, or an insurance agent… I have some news for you:
If you aren’t at least discussing Transaction Liability Private Enterprise(TLPE) as an option to cover an M&A transaction, you are doing your SME clients a serious disservice.
In many cases, these business owners simply don’t understand the risks they face, even after the deal closes or how TLPE coverage, which is offered by London-based CFC Underwriting, could protect them. They made be very good at what they do, but they are often not sophisticated about the intricacies of M&A.
There are four main areas of concern:
TLPE eliminates the need for large Buyer Escrows/withholds. Most Buyers require 10% or more of the purchase price to be held for a year or two to ensure there’s money available to throw at costs arising from breaches. TLPE policies are designed to replace the escrows, and with their lower retention levels, there’s no need for Sellers NOT to collect at least 99% of the purchase price at closing with no risk to the Buyer. I’ve personally placed policies(more than one) that reduced Buyers’ escrows by over $1M!
Problem is that a Buyer can make a claim against a Seller up to six years later for an alleged breach of a purchase and sale agreement. You can’t run from your contractual obligations.
This can be very expensive if the Seller is found to have breached a Rep or Warranty in the sale contract. Expensive as in they’re on the hook paying the Buyer for loss incurred and legal costs. In some cases, they could be most, if not all, of the money they made from the sale of the company.
Having TLPE coverage in place provides protection.
This is when a Seller makes an untrue statement about their company. They’re not doing it maliciously or willfully, so it’s not fraud or negligence. Yet, it is not true, which is a big problem.
How could an owner not know something so important about their business? In today’s quickly evolving regulatory environment, these “blind spots” can crop up.
Again, a misrepresentation like this can result in a claim that the Seller has to pay. With TLPE insurance in place, the insurer will pay the claim.
TLPE coverage is easy to get, with no underwriting necessary. And the Seller is able to reduce their holdback. Retention with TLPE in place is only 1% of enterprise value or $10,000 whichever is higher. This helps the Seller keep most of the sale proceeds right after closing.
For example, I recently brokered TLPE coverage for a deal in which a sports apparel manufacturer bought a high-performance glove wholesaler for under $2M. The process took two days and cost just $20,000. The TLPE policy enabled the Seller to reduce the Buyer’s holdback from $140,000 to $14,000.
In another case, the owner of a $12M SaaS company was able to negotiate a $1M+ reduction on the Buyer’s escrow by securing TLPE, a savings of more than 10x the policy premium.
In short, TLPE, which was created to specifically protect small business Sellers, is ideal for SME owners.
If you have any questions or would like to explore the protection TLPE coverage could off you or your clients, please contact me, Patrick Stroth, at email@example.com.
In this era of sky-high valuations, PE firms seeking inorganic growth are increasingly looking at an alternative to acquiring fully built out platform companies.
The strategy is to buy a platform that is not fully built out yet and available for a lower price and then “add on” other small companies. Not only are these acquisitions cheaper, but they are also easier to transition into the platform, which helps accelerate growth.
This trend has also led to increasing adoption of two unique M&A insurance products that have been available for a couple of years but were not widely used until now.
More on that in a moment. But first, why are valuations so high?
Well, 2021 was a banner year in M&A, with 8,624 deals with a combined value of $1.2 trillion. That’s 50% above the previous record for deal value in a single year.
What brought about all those deals? As Pitchbook in the 2021 US PE Breakdown:
“GPs were motivated by the availability of debt, the wave of sellers coming to market to avoid anticipated tax hikes, and the urge to deploy capital quickly in order to return to the fundraising market. Many industries, if not most, experienced intense competition for deals as a result, and multiples elevated to 2019 levels or higher in 2021.”
On other words, it’s a seller’s market, with intense competition for target companies pushing prices higher.
A compelling trend has emerged out of all, says the Pitchbook report:
“The current deal climate has been particularly conducive for buy-and-build strategies, and add-ons as a proportion of the number of total US buyouts reached an all-time high of 72.8%. During the market dislocation in 2020, firms had turned to add-on dealmaking to continue deploying capital with diminished risk, because add-ons are typically smaller deals and the GP has a firm grasp on its platform.”
As I’ve written before, PE firms these days use Representations and Warranty (R&W) coverage to protect their deals as a matter of course. It’s become standard. So, it’s no surprise that they’ve sought out similar insurance products when doing add-on acquisitions.
For transactions under $20M in deal value, PE firms use Transaction Liability Private Enterprise (TLPE) insurance. For example, I recently brokered TLPE coverage for a deal in which a sports apparel manufacturer bought a high-performance glove wholesaler for under $2M. The process took two days and cost just $20,000.
By having this TLPE coverage in place, the Seller was able to reduce their holdback from $140,000 to $14,000— matching the policy retention. The standard retention level for TLPE is 1% of enterprise value or $10,000, whichever is higher. Compared to the usual escrow or holdback of 10% of purchase price, no wonder TLPE is so popular.
As this manufacturer looks at other add-ons, they will again look to be covered by TLPE insurance, which offers six-year policy periods with a limit that is 100% of enterprise value. TLPE isn’t just for Sellers. Now Buyers can be named as Loss Payee in a TLPE policy which ensures faster collection from covered losses.
What about strategies where the planned add-ons are expected to be above the $20M TLPE threshold? CFC Underwriting has created an innovative coverage called a Portfolio Policy where an initial portfolio platform is underwritten and insured by CFC consistent with a standard R&W policy. The Portfolio Policy can grow as companies are added to the platform at a discount.
Under the Portfolio Policy, R&W coverage is arranged for the PE’s platform investment. As add-ons are brought in, the Portfolio Policy is amended to add new limits for each new entity brought on board. Each new Limit is independent of the other acquired entity Limits, so there’s no dilution as companies scale.
The thinking is that the Underwriters who underwrote the original platform acquisition will be familiar enough that it will save time and money on the underwriting process (lower UW fees and discounted premium rates.)
They can see how the new add-ons fit on the platform and will understand the investment theory of the PE firm making the decision to acquire the add-on. In other words, they are already familiar with the key players and aren’t coming at this fresh.
With familiarity comes comfort and Underwriters can add new companies to a platform for a fraction of the underwriting fee because they’ve already done most of the legwork. Considering the increasing costs for R&W, a scalable product should be a welcome alternative. Another perk: processing time will be cut down as well, with the underwriting call cut in half at least.
If a PE firm is going into an acquisition and knows upfront that add-ons will be bought, the Portfolio Policy is the correct route.
Otherwise, they should go with traditional R&W insurance for the platform. For add-ons they could go with another R&W policy if the enterprise value of the add-on is above $20M. If it is lower than $20M, TLPE is the way to go.
When seeking out this specialized and relatively new M&A insurance, it’s best to reach out to an insurance broker experienced in this type of coverage
I’m happy to help. You can contact me here at firstname.lastname@example.org.
The dream of every startup is to one day be acquired by a PE or VC firm or a Strategic Buyer.
All the hard work and dedication finally pays off. And it’s only natural that these firms will announce the happy news to the world with a press release whether it’s a merger or announcement of a successful round of fundraising.
Unfortunately, these days such announcements have put a target squarely on the backs of soon-to-be or newly acquired companies in all sorts of industries, from manufacturing to tech to healthcare to consumer-oriented businesses. These days, of course, every company has a database full of sensitive data about its customers, clients, and/or own operations and systems. Just as importantly, most companies today rely on their IT systems for day to day operations. Being locked out can cause operations to grind to a halt. Who can go for a day without access to their system?
As noted in a recent article in the Wall Street Journal, hackers involved in ransomware attacks are shifting their focus away from big corporations to smaller targets, including midmarket acquisition targets. Government authorities and law enforcement have noted this trend has been heating up in the last year or so, even as bigger targets like the Colonial Pipeline grabbed the headlines last year.
These cyber criminals know that:
In one such case cited in the Journal article, a midsize manufacturer was bought the 4th quarter of 2021 by a PE firm. Two months later, a Russian ransomware group locked up its hardware systems and demanded $1.2 million to release them. The company paid.
This is typical of these attacks. And deal-makers have taken note and are seeking measures to protect themselves and their acquisitions from financial losses and loss of reputation.
Fortunately, there are some best practices that can help prevent such attacks, as well as protections that can provide financial compensation if a ransom is paid.
As noted in my previous article on cyber liability insurance, this specialized type of coverage is fast becoming a must-have in deals. Buyers are basically requiring Sellers to have a policy that will respond to any cyber claims. And Buyers are taking out their own policies as well to cover what the Seller’s policy does not.
When writing these policies, Underwriters have a common set of questions they ask to verify the cyber security and privacy measures in place. If they’re not satisfied, no policy. Or, at the very least, they will load down the policy with broad exclusions and narrow limits.
On the plus side, this has forced companies to bolster their security measures and given them clear direction on how to do so.
One of my contacts, an Underwriting Manager for Toko Marine HCC – Cyber & Professional Lines Group, provided a list of security controls they look for when writing a policy (otherwise they will not write the policy or adjust terms accordingly):
1. Multi-factor authentication (MFA) is required for all remote access to the Insured’s network.
2. MFA is required for all local and remote access to privileged user accounts.
3. A preferred Endpoint Detection and Response tool is required.
As the Underwriter noted:
“If the Insured is missing any of these three important controls the premium and deductible will increase and we will sublimit Breach Event Costs, System Failure, Dependent System Failure, and Cyber Extortion to $250k. Additionally, we will include an endorsement with a $250k ransomware sublimit/50% coinsurance for all losses/expenses related to a ransomware attack.
“If the Insured does not use MFA for all access to emails through a web browser or non-corporate device, cyber crime will be reduced to $25k. If they use MFA for email access, the maximum cyber crime limit available is $100k.”
The implementation of cyber liability insurance is more important than ever, as cyber security has become one of the most costly and largest exposures out there. As a result, Insurers are looking to exclude cyber claims from other M&A insurance products, such as Representations and Warranty coverage.
You should also note for board members of a startup that suffers from cyber security issues, that Directors and Officers insurance may not protect you from investor lawsuits if you did not take proper cyber security measures to protect the company. Failure to Affect and Maintain proper insurance is a standard exclusion clause in D&O policies.
Insurers want deal-makers to take out stand-alone cyber liability policies which are more appropriately underwritten and broader in scope to best handle these exposures. They don’t want D&O or R&W insurance to become “umbrella policies.”
When seeking out help in securing cyber liability coverage, it’s best to reach out to an IT specialist or an insurance broker who is connected with such experts.
I’m happy to help you secure cyber insurance. You can contact me here at email@example.com.
Cyber crime is a major problem in the United States and around the world.
It seems every day there is another news story about hackers and other criminals who have been able to breach company networks and get their hands on confidential data…or take companies hostage by locking them out of their networks or even shutting down a business’s operations until a ransom is paid.
Remember, the Colonial Pipeline ransomware attack in May 2021? Cyber criminals managed to access computerized equipment that operates the pipeline, which runs from Texas and New York and delivers about 36 billion gallons per year to the eastern seaboard.
The incident cost the company $25 million. And all the hackers had to get in was use one compromised password that was leaked on the dark web.
Also in May 2021, the data of more than 100 million Android users was compromised. Personal info from over 700 million LinkedIn users was found for sale online. Facebook users were hit too – 553 million of them.
It’s clear this is a serious problem. And it extends to all industries.
Every company these days, from retailers (online and brick-and-mortar) to restaurants to healthcare providers, collects confidential information, also known as personally identifiable information, or PII. This can include customer names, birth dates, Social Security numbers, driver’s license numbers, credit card numbers, bank information, medical records, and more. Everything a hacker would need to steal an identity.
It can be collected by the company directly or through a third-party, like a payment processor like PayPal.
But in any case, if there is a fault of security and that data goes out into the world, customers are going to blame the business they patronize. They’ve shared their information with the company, and the company breached their trust. That certainly doesn’t encourage repeat business. Plus, there are costs related to notifying all the people affected. There can be legal penalties and fines as well, particularly when healthcare information is involved.
Not to mention, in some cases, the affected customers have a right to claim compensation if they suffered material or non-material damage.
Enter cyber liability insurance to make these payouts on behalf of the company.
But there is another wrinkle in this issue you may not have considered, where again cyber insurance comes to the rescue.
Say you acquire a restaurant or hotel chain or a group of healthcare companies and, six months or a year post-closing, one of these breaches of confidential data is discovered. (It is very common these incidents are not discovered until six months or more after they occurred.)
As the Buyer, you are on the hook. When the deal is done that exposure has been transferred to you from the target company. That’s even if the incident occurred before the sale.
It doesn’t matter if, during the diligence process, you asked the Seller about any data breaches. To their knowledge, they had none.
Again, enter Cyber Security & Privacy Liability insurance. And here’s the best way to protect yourself as a Buyer:
1. Make sure the Seller has a robust cyber liability policy in place that will respond to these claims. There should be at least a $5M limit. That will cover the expenses associated with notifying all the customers whose data was stolen. This should be the first batch of money that is used for any expenses from a data breach.
2. Make sure you, as the Buyer, also have a cyber liability policy. This may cover what the Seller’s policy does not.
Keep in mind that a stolen personal information incident is also a breach of the Representation and Warranty policy covering the deal. So the R&W insurance will effectively sit right on top of the cyber policies.
This will help not only cover expenses but also potential loss of value of the target company. And this kind of fallout can happen.
Say there is major data breach of a hotel or retail chain. Those customers are probably going to have second thoughts about ever doing business there again.
Cyber liability can also cover the impact from ransomware that cause outages and a loss of business. For example, the computer network and payment system for a chain of sports bars is held hostage during the Super Bowl…reducing the bars to only accepting cash! A big loss.
Cyber liability insurance means extra diligence in the run up to the sale.
I’ve put together some common diligence questions asked during that process. I would recommend viewing them and keeping them handy during your next acquisition.
You can get this free download here: Sample Cyber Liability/Privacy Questions in Diligence
You can also discuss this issue with me, Patrick Stroth. You can contact me here at firstname.lastname@example.org.
As Representations and Warranty insurance matures as a product and comes into wider use, Underwriters are taking lessons learned from past claims to equip future policyholders on ways to either identify pre-closing trouble-spots, or to mitigate their impact post-closing. They’re looking for patterns or “danger areas” where breaches are more likely to occur.
Many such breaches result in losses far exceeding the R&W policy limit. So, it’s essential that Buyers take action so that they can catch any issues before a deal closes. That way they can address the issue with the Seller. (Read to the end of this article for key questions to ask in this regard during the due diligence process.)
The cynical view is that insurance companies are taking such an interest in order to exclude parts of the deal from the policies they provide so they don’t have to pay claims.
But I see it as an attempt to protect Buyers and give them the chance to go to the Seller for a remedy. That could be a lower price or having the Seller address the issue. This way the risk is transferred away and does not have an impact on the R&W policy for the deal.
All industry types are impacted by material contract breaches. But the biggest “hot spots” are manufacturing, tech, and government contractors.
Trouble Areas to Look Out For
Currently, material contracts are now the third leading cause of R&W claims overall worldwide, preceded by financial misstatements and violation of laws, and tied with tax issues. Material contracts represent 14% of reported incidents, as reported in AIG’s M&A Insurance Comes of Age report.
If a Buyer acquires a target company with bad contracts and it is not disclosed, the Buyer is left holding the bag. And that bag can be quite big. Damages in material contract claims can be sizeable.
Think a $20M material contract claim with a $10M R&W policy.
There are four leading types of material contract breaches.
1. Issues around profitability of a contract (e.g. improper accounting for expenses).
2. Target in breach of a material contract.
3. Change in a customer relationship (e.g. termination or curtailing of purchasing levels). This could involve contracts with key customers where a customer is allowed to go to another provider for lower costs, leaving the new owner without revenue they expected. This is a major issue.
4. Failure to disclose existence of a material contract or material term (e.g. undisclosed discounts)
Due Diligence Questions You Can Use
The below are questions regarding material contracts taken from actual due diligence calls with Underwriters. I would recommend you make this a standard part of due diligence in your deals.
1. Discuss the scope of your diligence of Company contracts. Was this reviewed in house by the Buyer? What diligence was memorialized in writing, if any? Have you reviewed all material customer and vendor contracts? Confirm you’ve reviewed all form agreements and material deviations therefrom.
2. Please confirm no issues were identified in the top 15 customer and service provider contracts.
3. Please confirm that you did not identify any material vendor or supplier that cannot be readily replaced.
4. Discuss any notable provisions (e.g. change in control, anti-assignment, most-favored nation, termination, preferential pricing, restrictive covenants, atypical indemnity, powers of attorney). How does Company ensure compliance?
5. Describe the indemnification provisions in the material contracts. Have there been any breaches (actual or alleged) of any contract? Any other material disputes or declines in business under any contract? Are you aware of any other planned terminations or other issues with respect to the Company’s material relationships?
6. Did you or any advisor conduct customer calls/surveys? If so, describe the results.
7. Confirm Company is not a party to any government contract. If so, describe.
8. Have any customers provided any notice of intent to terminate? Are there any concerns related to this?
9. Any other concerns related to material contracts?
Material contract breaches can be a serious issue for any M&A Buyer. But armed with knowledge, it’s a problem easily avoided before a deal closes.
I’m happy to discuss this issue with you further. You can contact me
You can contact me Patrick Stroth, at email@example.com.
When you sell your house, one of the best ways to get noticed by potential buyers is to “stage” the home. This is interior design. Nice furniture and décor. No personal items or family photos. No family photos on the wall. No crazy paint schemes on the wall.
Some sellers even hire professional decorators to arrange their homes in this way.
Similarly, in the M&A world, if you want to use Representations and Warranty (R&W) insurance, you should be prepared to stage your deal to make it more appealing to Underwriters who would be approving and writing your policy.
Doing so will get your deal noticed and your policy priced appropriately.
Why should you have to jump through hoops for a policy you pay for? Wasn’t it just a few years ago that insurers were hawking R&W coverage to anyone who would listen…?
Things have changed.
As I mentioned in my article, “Bandwidth,” the problem is that Underwriters are overwhelmed right now.
R&W coverage has become standard in many circles, including PE firms and Strategic Buyers. It’s more popular than ever as M&A players have come to understand its benefits, that claims are paid properly and on time, and that this specialized insurance can actually smooth negotiation and speed up deal-making.
Combine that with an increase in M&A activity overall and, in particular, a rise in the number of so-called mega deals of $1B+ in transaction value (TV), which get priority from Underwriters…
And the result is that the teams of Underwriters out there (who are also short-staffed as companies can’t hire enough people fast enough to meet demand) simply don’t have the capacity to research and understand all the deals and determine coverage and terms for all the Buyers and Sellers out there who want a policy.
In fact, insurers are actually declining to cover otherwise great risks because their Underwriters lack bandwidth. They’re just stretched too thin. Actually, national insurance brokers are not covering deals under $400M in transaction value in most cases.
Unfortunately, that means to secure R&W coverage for your deals, you have to be prepared to put in some legwork. And while there are some common themes, there is also industry-specific prep you must consider depending on what space your deal is in.
First, the best way to stage your deal is preparing your due diligence. The goal: to make the Underwriters life easier and make less work for them. Ninety percent of R&W policies are buy-side, which means it’s up to the Buyer to do the prep work.
In this case, that means:
1. Having all the proper due diligence done before approaching the Underwriter. Loop in your experts now, including your lawyers and accountants. Identify potential areas of concern…and have answers or solutions ready.
Have that work done upfront so the Underwriter can review quickly, have their most common concerns mollified, and write that policy. And the Buyer should also be prepared to address any new concerns or requests for new documentation that come up.
2. You know the concept of supply and demand. Demand goes up, supply goes down…costs go up. That is what is happening with R&W policies. So, plan for increases in due diligence costs, insurance costs…and higher R&W premiums. Prepare any decision-makers for these increased costs to prevent delays.
Something to note. If you have a deal under $400M TV, forget going to one of those nationwide brokers as they simply don’t have the time for you. You need to look for a boutique broker, somebody regional, somebody experienced. This goes the same for any law or accounting firms you want to work with on the due diligence process. Oh, and be sure to contact these firms ASAP and get on their calendar. They’re busy too.
Also, healthcare, technology, service businesses, restaurant industry, entertainment…every industry has its own little processes you should follow to best stage your deal.
More on that in a future article.
For now, if you’re working on a deal and are worried that R&W coverage might not be available to you, as a boutique broker with long-time experience with this insurance product, I’m happy to chat with you.
You can contact me Patrick Stroth, at firstname.lastname@example.org.
Representations and Warranty insurance transfers all the risk in an M&A deal, including the indemnity obligation, to a third party – that’s the insurer.
It’s hard to argue against a major benefit like that. Plus, R&W coverage makes negotiations smoother and faster (and cheaper when it comes to less attorney fees) because all the nitty-gritty of a deal doesn’t have to be picked over. If there’s a breach, a claim is filed, and the insurance company pays.
Easy. It’s no wonder it is more widely available and widely used than ever before.
The perception may be that R&W coverage has gone from an obscure insurance product to something that is ubiquitous in the M&A process. And if you’re Private Equity that may be the case. PE firms are the most common repeat buyers. They’ve embraced this coverage in a big way – so much, in fact, that demand has grown exponentially.
But not everybody is totally convinced of the value of this coverage.
In the case of one Strategic Buyer I interviewed recently, while he didn’t object to R&W insurance being part of the deal, there was definite reluctance on his part. Simply because it was the first time he had used it on a deal.
This reluctance to take on R&W insurance – or at least their lack of exposure to it – on the part of Strategic Buyers is no surprise. In the past, they never really needed it. Until a few years ago, it was more of a Buyer’s market… the Buyer had more leverage, especially a Strategic Acquirer like a massive corporation buying a smaller company.
So, the Buyer didn’t have to accommodate the Seller with R&W coverage. They could impose escrow requirements and essentially be unopposed. The Seller had no recourse. In many cases, Strategics have been convinced by their attorneys that there is nothing more secure than having cold hard cash sitting in an escrow account.
Also a factor: Because Strategic Acquirers have not used this insurance before, there is a fear that it would slow the deal down or alter the process in a way that would cause a delay. They didn’t want to add this new, “foreign” element they weren’t familiar with to get in the way of what had been their smooth, well-oiled machine.
Then, things changed…
Why Strategic Buyers Are Changing Their Mind on Rep and Warranty Insurance
Strategic Buyers seemingly had plenty of reason to push R&W insurance to the side. But they can’t ignore it any longer.
It’s a Seller’s market out there right now. And Sellers, even smaller companies being acquired by vastly larger companies, now have leverage. And they’re using that power to make R&W coverage standard in M&A deals.
So Strategics have been forced to make this accommodation in increasing numbers to make quality deals to buy solid companies they want.
The good news is, the process to secure this specialized coverage, even if you’re totally new to it, is straightforward. Here are some things to keep in mind:
1. A professional Strategic Buyer, when making such a big investment as acquiring a company, is going to be doing thorough and appropriate due diligence. That’s a given.
Well, that means they’ve probably done enough due diligence to qualify for R&W insurance. You simply send the diligence over to the Underwriters. It’ll probably have to be rearranged or organized in a different way, but the diligence is there.
2. Underwriters are ready to work with Strategic Buyers, so it never hurts to look at R&W coverage to see what the options are. Underwriters will provide applicants with a quote that outlines the major policy terms before committing funds for underwriting fees. Within those indications, the Underwriters will comment on what they’re concerned about with the deal, what they call “heightened areas of risk.”
They’ll put in their quote that they’ll be looking closely at Topic A, Topic B, Topic C, etc. So, if a Strategic can respond to these topics and show their diligence in these specific areas, Underwriters will be satisfied.
This eliminates a concern had by many Strategic Buyers: that they’ll pay an underwriting fee to get R&W insurance and then there will be a lot of exclusions on the policy. But it’s not true. You can go in with eyes wide open and get all the details before you spend a dollar.
3. Working with an experienced broker who knows M&A and Rep and Warranty coverage is key. A broker can convey information back and forth between the Buyer and the Underwriter. A broker knows what information is needed. They can manage expectations, provide reasonable timelines, be diligent in following up to make sure the proper due diligence and documentation – in the proper format – is flowing to the Underwriters.
Not just any broker will do. Some less experienced brokers have a tendency to be reluctant to ask a client for more documentation when requested by the Underwriter. They don’t want to be a bother or have the client ask why they didn’t request the document at the beginning of the process.
But the truth is, and an experienced broker knows this, that sometimes, in the course of the underwriting process, there are questions that come up that must be satisfied. An experienced broker can head that off somewhat because they’ll have identified those areas of heightened areas of concern and addressed those with the Buyer upfront.
Where to Go From Here
With the right help, the process to underwrite a R&W policy have this coverage in place in an M&A deal is actually quite easy. That’s even for a Strategic Buyer that has never used this insurance before.
If you’re engaged with accounting firms and law firms experienced in this area, along with an experienced broker who can work with Buyer and Underwriters alike to shepherd the policy from application to closing day, it can be a frictionless process.
And having that coverage means that between Buyer and Seller all the most sensitive issues of a deal – indemnity, escrow, etc. – are now non-issues.
Soon enough, I expect more Strategic Buyers to happily embrace R&W coverage and become converts. All it takes is facing the unknown and going through the process once.
My firm has extensive experience in Representations and Warranty insurance. If you’re looking at this coverage for the first time, or are already an enthusiastic user, you can contact me, Patrick Stroth to chat about your next deal. You can reach me at email@example.com.
If you thought M&A activity would slow in 2022 after the record year in 2021…think again.
Market watchers see current levels continuing through at least the first half of next year. As you know, an increase in M&A activity equals more demand for R&W insurance.
And that means you should expect to see many of the same trends driving the use of Representations & Warranty (R&W) and other M&A-related coverage continue as well—if not become even more widespread.
Here’s a breakdown of what you should be looking out for in the coming year:
1. The “extra” frees being charged on smaller deals are creeping into all
For a while now, many insurance brokers have been quietly adding fees onto what are considered small deals (under $50M TV). They typically add fees when they don’t charge commission. Now they are trying to do so on all the deals they cover.
Premium ranges that used to be standard at 2.5% to 3% of the amount of the policy, so $250,000 to $300,000 for a $10M policy, are now at or above 5%.
There could be some pushback on this from policyholders as premiums go up. However, many brokers will still be able to “sneak in” fees like this because the overall cost of an M&A transaction is expensive and those fees can get lost in the shuffle, so to speak.
This is fair warning to keep an eye out.
2. Increased scarcity for a home for sub-$50M TV deals.
As I wrote in my article, “Limited Bandwidth for R&W Insurance in 2021”, there are fewer and fewer Underwriters who want to work on deals under $50M in Transaction Value. Simply because there are so many deals above $500M+ out there. With limited time and resources, insurers, of course, will focus on those deals generating higher revenues..
As Woodruff Sawyer put it in their Private Equity and M&A Looking Ahead to 2022 report:
“We expect RWI options for deals less than $50 million in enterprise value to be scarce leading into the end of the year. As bandwidth reaches capacity, underwriters will pick and choose only deals they deem highly profitable to pursue. We believe there will be limited to no capacity for small deals or deals with financial issues or a lack of underwriting.”
But if you don’t hit that desirable threshold, all hope is not lost.
What you need is a clean deal and solid due diligence. With a simple package like this that Underwriters could process quickly, there could be a receptive audience. You should also find a smaller, boutique firm that specializes in smaller deals and will give you their full attention.
With an approach like this coverage is scarce but not impossible.
Why would Underwriters turn away business from smaller deals?
If the due diligence is lacking, that leads to unanswered questions. As a result, Underwriters have to put exclusions in the policy or limit the coverage. And they don’t like to do that because it makes them look like the “bad guys”—they get the blame when policyholders get upset.
This type of situation often happens because the insurance broker did not adequately manage expectations.
Sometimes, Underwriters just need clarification in these types of cases where they might otherwise decline to cover a deal.
For example, in the case of one company that was buying a film and TV library. The Buyer had not done extensive diligence on who owned all that content, which made the Underwriters very nervous. They were expecting thorough legal diligence on the intellectual property.
Then the Buyer made several good points. Since they were simply distributors, they were not subject to intellectual property infringement laws —those who produced and planned the use of the content would be on the hook. And not only were they not exposed in that way, but all their contracts had indemnification language, so they were further insulated from IP complaints. On top of that, they had insurance to respond to IP related issues.
That was shared with the Underwriters and the rest of the underwriting process went smoothly, was completed ahead of schedule and with no limitation on IP.
It’s the perfect illustration of how packaging makes all the difference.
3. Rates will continue to be high well into Q1 2022…and beyond
Premium rates went up from 2020 to 2021…and I see them continuing to rise into 2022, at least into the first half of the year. Demand for R&W insurance is just too high to compel a decrease. And, as I said at the beginning M&A activity is on a tear and will continue.
4. Watch out for the impact of the shake-up at R&W insurers.
R&W insurance companies have an Underwriter problem. First, new insurers are entering this lucrative market and poaching whole teams of Underwriters from established carriers. This interruption in talent and staff could slow down processing.
Also, in some cases one of the larger national brokers is losing experienced brokers, and executives in the wake of a failed merger which would have made them redundant. They’ve seen the writing on the wall and decided to leave and start their own firms, including some Underwriters who want to get in on the brokerage side.
They have the contacts. They have repeat clients they can bring over. It’s the perfect opportunity.
5. Expect increased scrutiny from Underwriters with regard to insurance that the target is carrying and cybersecurity.
R&W insurers and Underwriters are looking to pull other policies in to recover losses to be paid in the event of a breach. The thinking being those losses are actually insured by a company’s traditional commercial insurance policies.
There is also a focus on cybersecurity. Underwriters want to see that companies have adequate IT and cybersecurity measure in place to protect data.
As Woodruff Sawyer puts it on their report: “If a deal team does not perform diligence in these key areas, they should expect additional questions and/or exclusionary language related to things like Management Liability, Cyber Liability, and Professional/E&O Liability.”
6. Claims are steady.
More R&W insurance claims are being paid these days. But it stands to reason as more claims are being reported…because there are more policies out there. No big concern here. “Roughly 20% of policies result in claims, and about 25% of submitted claims result in a limit loss,” as they mention in the Woodruff Sawyer report, and that is a similar rate to 2020.
The rate of claims being paid has not changed.
7. Expect more deals with no indemnity.
There is an interesting phenomenon that has been occurring.
The accepted wisdom in M&A Insurance circles for a long time was that R&W policies with no Seller indemnity would be more risky and have more claims. As a result, Underwriters used to favor deals where the Seller indemnity clause was present, and deductible was shared by the parties. They wanted to see both sides have “skin in the game.”
However, in practice this has not been the case. There is no discernible difference between the two types of deals. So, expect to see more deals be covered with no indemnity needed.
Here’s how it used to be:
In the Purchase and Sale Agreement there would be an indemnification clause that the Seller must pay the Buyer’s loss if there was a breach. If there was a R&W policy in place, the policy stepped into the Seller’s shoes to take care of that and pay the loss. Although the Seller would still be on the hook for at least a share of the deductible.
Today, however, now Sellers want no indemnity and negotiate that the reps and warranties do not survive past closing. They want to sell “as is” – kind of like a used car. To be clear, in these types of “as is/non-indemnity agreement”, the Seller is liable to the Buyer for nothing…ever…nothing is held back. However, the risk is hedged for the Buyer because they have R&W insurance in place.
8. Concern about COVID is waning.
As the pandemic winds down, insurers are less concerned about pandemic-related claims. Although they will continue to ask about COVID in their diligence process.
9. Prices for targets are not going down.
From attendees of a recent McGuire Woods Independent Sponsor Conference, the word is that prices for targets are not going down any time soon—despite any pandemic effects. Many vulnerable companies pulled themselves off the market. And they are strengthening. The multiples and competition for these targets is going up, not down. So, if you’re waiting for a dip in evaluations…it’s not happening.
It’s clear that it’s going to be an interesting year in 2022. And I’m happy to help with your M&A insurance needs.
You can contact me Patrick Stroth, at firstname.lastname@example.org.