Insights

  • The Rise of the Independent Sponsors
    POSTED 4.27.21 M&A

    You have PE firms… you have Strategic Buyers… you have VCs…

    You have Independent Sponsors.

    These are individuals looking for a deal. They have money and experience, and they’re looking to buy a company.

    They differ from other M&A players in key ways.

    A PE firm reaches out to investors, builds up a nest egg and then, with that pool of money, buys a series of companies… They might buy at $20M, put $10M into the company and then sell for $150M to $200M – a nice return for the fund and the investors.

    They’re buying to build a portfolio for the benefit of their investors.

    But Independent Sponsors often don’t worry as much about portfolios or building a fund…

    In fact, they used to be called Fund-less Sponsors.

    A common perception in the M&A world is that anyone without a fund behind them doesn’t have the money to do deals.

    But Independent Sponsors do, although they are often not the sole source of capital…

    They find a target, put it through their vetting process, and then they go to PE firms or other sources of money as potential investors.

    The Independent Sponsor’s point is that a PE firm has cash it needs to put to work – why not with me? The Independent Sponsor has done the legwork and found a viable target.

    Typically, PE firms and other investors struggle to find good deals in today’s environment. They cold call owners/founders, go through their referral network, or work with investment banks to find targets. It’s not a terribly efficient system.

    Simply put: Independent Sponsors find deals but might need capital. PE firms and other investors have capital and are looking for deals.

    So it’s a win-win.

    Jon Finger, a partner with McGuireWoods whose practice focuses on private equity and corporate transactional matters, is a big believer in Independent Sponsors. As he puts it, we learned that going to trade shows, calling on companies, and the like is very time consuming. The lightbulb moment for us was that the Independent Sponsor in our network can be doing a lot of that spadework if you will, for us and our network. So if we spent more time nurturing our Independent Sponsor relationships, and really finding opportunities that they had, which we could then introduce to our capital partner network, it really made what we were doing much more efficient.”

    The match made in heaven with Independent Sponsors is made even more powerful when you consider the potential advantages Independent Sponsors may have with target companies.

    • Independent Sponsors can have more flexibility to take their time in harvesting opportunities and closing deals.
    • This extra time, says Finger, “allows the Independent Sponsor to really identify the capital partner that makes the most sense for each opportunity and each situation.”
    • An Independent Sponsor may be able to effect a more personal approach that target companies find appealing. The Independent Sponsor is often a former CEO in the industry. There is a rapport… relationship building… a spirit of collaboration.
    • Independent Sponsors may have a variety of structures that other investors may not have access to by virtue of requisite investment criteria or regulations that constrain how they are able to invest.

    Who Are Independent Sponsors?

    Independent Sponsors are so diverse… coming from many different backgrounds and points of view.

    Often, they are former CEOs or top executives. They know the industry they are investing in. They have contacts… they know the landscape. That makes them ideal “judges of characters” for what targets to invest in.

    Finger works extensively with Independent Sponsors. He explains what makes them so effective:

    “A lot of our clients in the Independent Sponsor world spun out of blue chip, private equity firms. They have that pedigree of doing deals, and now they’re doing deals as Independent Sponsors.

     “[Many] are entrepreneurs who founded and sold a business. And now they want to go out and do it again. And frankly, a lot of our Independent Sponsor clients are true CEO level talent, that may have made a lot of money for investors in the past. And they have a Rolodex within a market or within a segment to say, I want to go out and do a roll up in this space. And that allows them, with that domain expertise, to really be a powerful and successful Independent Sponsor.”

    The Drawbacks to Being an Independent Sponsor

    Independent Sponsors face a serious issue. They cannot afford to have a deal go south. If they spend $100,000 on due diligence and other expenses, they are out that money if there is no sale… because negotiations fell apart, for example.

    A PE firm with a $150M fund can more easily pursue deals that don’t pan out. They can bat .700 or .800. But an Independent Sponsor must bat 1.000.

    There is a way Independent Sponsors can mitigate that risk.

    Representations and Warranty (R&W) insurance can actually reduce the friction in the negotiations of Reps. This specialized type of insurance covers any financial loss from a breach in Reps. That gives peace of mind to the Buyer. And the policy can replace 90% of an escrow. So less money from the purchase price is being set aside and goes right to the Seller’s pocket. Good to get more cash at closing, even better to get the peace of mind

    Another benefit is that the post-closing integration process is more successful because there is no mistrust and animosity in the leadership of the acquired company. They feel they were treated fairly in the deal, and they have cash on hand.

    Both parties can move forward together, which is key to a successful and profitable acquisition.

    R&W coverage helps close deals and integrate the companies.

    These days it’s more widely available than ever, even for sub-$20M deals.

    And thanks to competition, eligibility standards for R&W insurance have never been simpler. The cost has never been lower. And the claims have not overwhelmed the industry, so we can see these lower rates continuing for a very long time.

    As a broker specializing in Representations & Warranty insurance, I’d be glad to discuss the benefits of coverage for your specific deal. Please contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • Dealing With the “Emotional” Side of Strategic Acquisitions
    POSTED 4.13.21 M&A

    It’s a tragic story seen time and time again in the M&A world, specifically in strategic acquisitions…

    On one side, you have a Seller.

    A relatively small company. An owner/founder who has worked hard to build the business to what it is. They are elated to have caught the eye of a larger company seeking to acquire them, whether they will take on an executive role post-sale or will take the sale proceeds and invest in a new venture or sail off into the sunset for a much-deserved retirement.

    On the other side, you have a Strategic Buyer.

    Usually, the company is 50… 100… times the size of their target… maybe even bigger. They’ve found a small company that offers a technology they need… or access to a new market… or whatever else.

    Sounds like a match made in heaven. A win-win for both sides. It should be easy enough to hammer out a deal that makes everybody happy.

    However, all too often it doesn’t turn out that way due to fear, distrust, greed… in other words, human emotion.

    Fortunately, there is a way to overcome that element and get these deals done quickly, in a way that is amenable to both sides. But first…

    How Deals Fall Apart

    In these types of lower middle market acquisitions, a Strategic Buyer (or even a PE firm) is experienced in the process of acquisition. They do it all the time. To them, this is just another transaction.

    But the Seller, the original owner and founder of the business, while good at what they do and very accomplished in their industry (which is why the Buyer has an eye on them) … is inexperienced in M&A.

    This is probably the only deal they’ll be involved in in their life. They might even be intimidated by the process.

    Two very different perspectives.

    And this can create a lot of friction that can hamper the negotiations and delay the deal… or even cause it to fall apart all together. And we’re not even talking about disagreements on the sale price, stock options for the executives to be newly onboarded after the acquisition, or anything like that.

    It comes down to the process, and there are several elements at play.

    1. The acquisition itself can be a distraction to the Seller. They’re spending their time looking at contracts, talking with lawyers, pulling together financial and other records for due diligence, and other tasks. This takes time away from actually running the business, which can be impacted negatively as a result. This is very frustrating to the Seller.
    2. Speaking of due diligence, this process can be difficult. First, as a smaller company, they might have had all their records organized in a way that are not easy to pull together. They’re having to dig deep to find the information the Buyer wants. And, not accustomed to what is required for thorough due diligence, it feels invasive to the Seller. They get tired of answering all these questions. (Again, remember that the Buyer does this all the time – they don’t “get” why the Seller might feel this way.)
    3. This is a big one… indemnification. The Buyer says to the Seller: “We went through all this due diligence. We’ve gone through your records with a fine-toothed comb. We know you found the process frustrating, and we appreciate your efforts.”

    “But… in case we missed anything and any of the Representations in the Purchase-Sale Agreement are inaccurate, we need to hold money in escrow from the sale price for a year or two. Just a few million dollars. Oh… and we’ll take that money if there is a breach to cover our financial damages. But that almost never happens, so it’s no problem.”

    This is the last straw. The Seller feels like the Buyer has looked at every single file they have. They’ve been upfront and honest about everything related to their company’s finances, contracts, intellectual property, tax situation, and everything else.

    This indemnity provision feels like an insult. They feel like they shouldn’t be held responsible for something they didn’t know about that the Buyer missed. Not only that, but the owner/founder can be personally liable for breaches as well. That dream retirement could be at risk.

    At the very least, they will not get the full proceeds from the sale for years down the line. They won’t have that money to invest in a new venture, for example.

    From the Buyer’s point of view, they’re making a multi-million-dollar investment and they need to protect themselves. It’s part of doing business.

    But the Seller takes it personally. They feel distrust. They’re confused, stressed out, and upset. They feel taken advantage of by this “big company” swooping in. The air goes out of the room. Human emotion comes into play.

    It turns what was a smoothly running collaborative process into a tense, confrontational one. Everything could potentially be sabotaged.

    And if it’s not, it can still create an acrimonious relationship between the incoming management team from the Seller’s side and their new employer. They might be able to forgive the process, but they’ll never forget what went down. This can be huge as that first year after an acquisition is critical in integrating the acquired company.

    How to Avoid All This Drama

    There is a simple way to sidestep these issues that will make both sides happy and maintain a strong relationship going forward.

    The Seller will avoid the indemnity obligation and potential clawback.

    The Buyer will still remove risk.

    And when included early in the negotiations, it will smooth out negotiations and make the deal-making process easier.

    It’s a specialized insurance product called Representations and Warranty (R&W) insurance. I feel strongly that any Buyer today who doesn’t offer this option to the Seller in a lower middle market deal is not acting in good faith.

    With a R&W policy, the indemnity obligation is transferred away from the Seller to the insurer. And the Buyer has certainty they will be made whole if there is a breach. They simply file a claim with the insurance company – and these claims do get paid.

    It’s a no-brainer, especially when you consider that:

    • This coverage in recent years has been made available for lower middle market deals, including those with transaction values as low as $10M.
    • The cost has been decreasing as more insurance companies enter this market. And when you deal with a “boutique” broker that specializes in this type of coverage (instead of the big companies that offer R&W among hundreds of other products), the cost for commissions and fees is even lower because they have much less overhead. The starting cost for a LMM R&W policy today is just under $200K (including fees and taxes).
    • And especially noteworthy for the Buyer, when offered this coverage, most Sellers will happily pay for the policy once they realize the advantages it offers them. It’s a small price to pay for the peace of mind knowing they won’t be on the hook in case of a breach… and can take home more cash at closing.

    Still, some Buyers are hesitant. They want to limit the time and effort they spend on the deal, especially on some of the extra due diligence R&W policy Underwriters might ask for. They might feel like using some of that leverage as the bigger company and simply leave the Seller on the hook.

    That’s very true. However, let me stress again that I feel that is borderline bad faith on the part of the Buyer not to at least offer this coverage. And it’s in their best interest to do so, as it’s a strategic way to show good faith and will reap rewards in the form of smoother deal-making and a good relationship going forward.

    The Seller no longer feels “bullied”… they feel like the Buyer has their back. And that is priceless.

    Next Steps

    Even experienced Strategic Buyers might not be very familiar with Representations and Warranty insurance. They might have heard of it, but only know what it used to be several years ago, when it was only offered for larger deals and the costs were higher.

    A lot has changed with this specialized insurance product in recent years. It’s more affordable and more widely available.

    I’d be happy to get you up to speed and share how this coverage could specifically benefit your next deal.

    For details, please contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • Why Buyers Should Embrace R&W Insurance to Remove Seller Fear
    POSTED 2.2.21 M&A

    For lower middle market companies looking to be acquired, these owner/founders, often of businesses they have built from the ground up, are looking for a once-in-a-lifetime liquidity event.

    They are ready to sail off into the sunset, perhaps into retirement or perhaps another business venture that will require as much capital as possible. They want to truly cash in from the sale and walk away without further obligation or liability.

    At the same time, while they are experts in whatever their business does and passionate about their company, they are not well-versed in the world of M&A. You might consider them “unsophisticated” Sellers.

    This creates an atmosphere of fear in these Sellers that can make them reluctant to move forward, especially when they realize they are personally liable to the Buyer if any losses are incurred post-closing from a breach of the Seller reps. But, as you’ll see in a moment, Buyers who take the right approach can remove that fear in one fell swoop.

    What are these Sellers afraid of?

    There could be issues with ESG (environmental, social, and governance) that could come back to bite them years down the line if a lawsuit is looming. Unfortunately, often these companies have not taken out Directors and Officers Liability insurance, which would protect them and pay legal costs and any claims due.

    Any number of issues not uncovered in due diligence, such as IP infringement, tax problems, or others, that are no fault of their own, could crop up. In these cases, the money from the sale held-back in escrow could be at risk. This chips away at the major cash payout they were expecting. Money beyond escrow could even be clawed-back in some cases.

    Not to mention, there is a lot of uncertainty in the new U.S. government administration.

    They feel their future wealth is in danger – in more danger than ever before.

    What a Buyer Can Do

    Buyers can take away that fear by hedging the Seller’s risk with Representations and Warranty (R&W) insurance. This specialized type of coverage transfers virtually all the risk away from the Seller over to an insurer.

    This insurance removes the need for indemnification provisions in the Purchase and Sale Agreement and for a major part (typically 8% to 10%, sometimes more in cases where the Buyer believes there is more risk) of the sale price to be held back in escrow, which makes the Seller happy. If there is a breach in any of the Seller Representations and Warranties, the Buyer simply makes a claim with the insurer. And there is no chance of claw-back.

    And claims do get paid consistently, Buyers should understand.

    This process also eliminates the need for such extensive negotiation in the lead up to the sale because there isn’t so much back and forth between lawyers for the Buyer and Seller. (Which can have the added benefit of saving both parties on legal fees.) In many cases, a Seller will be okay with a more Buyer-friendly agreement because R&W coverage has so effectively limited their risk.

    As you know, Buyers want broad indemnification provisions to cover any potential loss, while a Seller’s goal is to narrow what breaches are covered and the survival period. With R&W in place, and a third party (the insurance company) paying for losses, no need to argue. In fact, some industry watchers maintain that deals with R&W in place are eight times more likely to close.

    Previously, R&W coverage was the province of major deals – hundreds of millions or billions in deal size. But in recent years, Underwriters at many major insurance companies are taking on transactions as low as $15M.

    And it’s very affordable. Right now, you’re looking at a rate that is 2% – 2.5% of limit, including underwriting fees and taxes, which is a significant drop in what it cost just a couple of years ago. The rising popularity of R&W insurance among savvy PE firms, as well as some Strategic Buyers, means more policies being written. And there are more insurance companies than ever offering this coverage. That has brought the cost down.

    Better yet for Buyers, because of the removal of risk and peace of mind, Sellers are more than happy to pay for R&W coverage. Given the choice between accepting risk and the escrow that goes with it, Sellers will eagerly cover the costs, making R&W essentially “free” for Buyers!

    It’s clear that for Buyers in the lower middle market space, the advantages of R&W insurance far outweigh any minimal additional cost and additional due diligence required by the Underwriters (which probably should have been done anyway and doesn’t necessarily add significant time to the process).

    One important thing to note is that large Strategic Buyers – we’re talking the Apples and Googles of the world – have more than enough leverage that even if a Seller wants it, they are not likely to agree to R&W coverage. For them, any losses from something going wrong when acquiring a lower middle market company are just a drop in the bucket.

    Lower middle market deals are right in the sweet spot for R&W. For smaller Buyers who understand that the fastest way to grow inorganically is with key acquisitions, it’s the perfect vehicle to bring Sellers to the table. As more Buyers focus on this space, it’s essential for them to have R&W to be competitive.

    Buyers should bring up the concept of using R&W insurance early on, with a provision made at the Letter of Intent stage. It’s a gesture of goodwill of sorts that soothes concerns the Seller may have. Of course, knowing that any losses post-sale will be covered gives the Buyer peace of mind as well.

    As mentioned, with this coverage in place at the beginning, negotiations are much smoother and go more quickly.

    In the current climate, lower middle market Sellers are running scared. Buyers bringing R&W insurance into the equation will go a long way to gaining trust, making them feel secure and ready to go forward with the transaction.

    It’s important to deal with an insurance broker well-versed with Representations and Warranty insurance and its role in M&A. While some of the bigger providers do offer this coverage, they focus the majority of their time and energy on bigger deals.

    I specialize in securing this coverage for lower middle market deals, and I welcome your questions. If you’re a Buyer or Seller interested in finding out more, please contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • ESG Investing in the World of M&A
    POSTED 1.19.21 M&A

    The concept of environmental, social, and (corporate) governance – popularly known as ESG – has been gaining traction among many investors in recent years. Institutional investors, individuals, Strategic Buyers, and PE firms are all getting on board. It’s become a serious factor in deal-making in the M&A world.

    The idea is that the societal impact or sustainability of a company, how it does business, and the products it produces must be considered before investing. In some cases, these so-called “non-financial” factors (which actually have a lot of financial relevance) are given just as much, or more, weight than potential returns.

    ESG could cover how the company is reacting to climate change, their use of natural resources, their production of hazardous waste and how they dispose of it, or how they treat their workers and manage their supply chains.

    It also includes issues around the running of the company, like transparent accounting practices, the diversity of the board of directors, engaging in illegal or unethical business practices, inappropriate political lobbying, and that shareholders are involved in making decisions.

    People today, especially younger investors, care about the pollution a company produces, the sustainability of its products, its use of renewable energy, and labor practices.

    They’re increasingly investing not just with a return in mind but based on their values. And the returns often follow because companies seen as rating poorly in ESG (say if they mistreat workers or regularly spill pollutants into the environment) in the minds of investors – not to mention consumers – can see their financial performance suffer.

    It’s estimated that ESG investing represents about a quarter of all professionally managed assets globally. It’s increasingly seen as vital to assessing corporate risks, strategies, and operational performance.

    In fact, a 2014 study by George Serafeim, Bob Eccles and Ioannis Ioannou (professors from Harvard Business School and London Business School) found that sustainable companies’ stock tends to outperform that of companies with low sustainability ratings.

    ESG had its origins in a report by Ivo Knoepfel called “Who Cares Wins.”

    Knoepfel, who coined the term and is founder and managing director of onValues Investment Strategies and Research, asserted that considering ESG factors when investing isn’t just the “right” thing to do for society, it actually leads to more sustainable markets. These criteria can also help investors avoid companies that are facing financial risk due to their environmental or other practices.

    According to a report from Winston & Strawn LLP, how companies have responded to the threat of the COVID-19 pandemic has recently become a key ESG criteria. As they put it:

    “COVID-19 has highlighted that companies face much more than just financial market risks, and the failure to take due consideration of such non-financial risks and related ESG factors could spell disaster.”

    The Winston & Strawn report highlighted five ESG considerations public companies must address:

    • More robust disclosures and transparency with stakeholders (customers, suppliers, employees, shareholders) regarding contingency planning and crisis management.
    • Use of ESG rating systems to see how companies are performing on these indicators and how they compare to competitors.
    • Sustainability planning and reporting, including whether there is a long-term strategy to account for marketing disruptions like climate change, pandemics, and other “market shocks.”
    • More diverse supply chains, including the increasing use of more local suppliers and redundancies so that resources don’t dry up in times of crisis. (Think of the lack of face masks early in the pandemic.)
    • The ability to support their workforce in times of crisis, including work-at-home programs, good medical coverage, and other support programs.

    You’ve seen ESG in action. Whole Foods, for example, strives to drive global change in food by seeking suppliers that use organic items.

    But ESG investing is not without its issues. An investment fund could maintain they are only making socially-aware investments, which is all fine and good until they discover that their most profitable investment is doing business with a rogue country or involved in the destruction of the environment.

    What should their next move be? Divest their top performing holding?

    Take CalPERS, California’s pension system for government employees, which has more than $400 billion in assets. It’s under pressure from activists to divest from fossil fuel companies, which are top performers.

    Take away those investments and how will this massive fund pay out to all those ex-employees, their spouses, their kids, and others? It might not be financially possible.

    Besides, the rules are always changing. What is environmentally friendly today might not be tomorrow.

    So, it’s clear that ESG investing is not without its challenges. But going forward, PE firms, Strategic Buyers, and other deal-makers must keep it in mind when eying potential acquisitions. And not just because it “looks good” – it can have a real impact on the long-term success of a company.

  • How Business Development Has Changed in Private Equity 
    POSTED 11.10.20 M&A

    As with so many areas of our lives, COVID-19 has had a huge impact on business development among Private Equity firms. The “old ways” of finding and connecting with potential acquisitions and deals are disappearing, a trend that was already happening but was sped up by the travel and other restrictions brought about by coronavirus.

    As Mark Gartner, head of investment development at lower middle market-focused Private Equity firm ClearLight Partners LLC, put it in a recent article, “Creative Destruction: How Private Equity BD May Change Forever”:

    “The pandemic is stress testing everything, and COVID-19 may finally kill several BD strategies already in decline.”

    “I believe that the best originators in the lower middle market will start to approach the private equity game through the lens of a lead generator with the content and lead capture techniques to match.”

    Gone are the days of constantly traveling for in-person meetings with investment bankers, M&A advisors, and other reps for target companies. To be honest, all the information you glean from these meetings could be handled in a phone call.

    An inability to travel, says Gartner, has hastened the decline of what he calls “high volume, low value city visits.” But that doesn’t mean all travel is out, says Gartner, who still sees a need for visits that emphasize quality over quantity and activities that produce real relationship development.

    Also, out the window: BD pros collecting as many CIMs (confidential information memorandums) as possible to fill their PE firm’s funnel. The idea is that the more “books” they have, the more winning deals will come out of it.

    Gartner recommends PE firms instead have their BD team analyze potential deals based on what he calls an “angle matrix” and concentrate on deals that they have a higher probability of closing because they have the right angle, which could be “process dynamics, executive resources to bring to the table, prior experience/investments in a related space, a previously developed investment thesis, and geographic proximity.”

    What other changes are on the horizon? A PE firm has a great story… the trick is now to get the word out through different channels.

    There are several more strategies that have been building for some time that are now experiencing faster adoption due to the pandemic, says Gartner.

    Specialization

    Generalist PE firms may think that casting a wider net will result in catching more deals. A better strategy is to pick a small group of sectors to get really good at. Soon, you’ll build a brand – and reputation – associated with those industries and, as Gartner says, “relevant deal flow will start to find you.”

    If you’re worried that concentrating on a limited number of industries could backfire if those sectors go into decline, Gartner recommends this strategy:

    “Pick sectors that are specific enough to be memorable, but that are broad enough to offer room for pivots if need be.”

    Thesis Development

    An investment thesis is, of course, a PE firm’s plan to make an acquired business more valuable within a few years. It essentially lays out the reasons to do a deal.

    Gartner maintains that today this tool is more important than ever. As he puts it:

    “Investors that put in the work to get off of their heels and proactively call their shots by developing investment theses have advantages over more reactive investors. I’m always amazed by how much incremental deal flow arrives when I market very specific sectors of interest to intermediaries and other deal referral sources.”

    This strategy goes along with the move from being generalist to specialist.

    Digital Marketing for Lead Generation

    It’s amazing how difficult some PE firms make it for business owners and dealmakers to contact them. And how little they take advantage of the online tools that are available for reaching out to potential targets and their reps… and turning them into leads.

    Creating valuable content written for business owners is key to creating engagement. This could be articles and blog posts… even a podcast… to get the word out about a PE firm and what makes it different than others out there.

    Also, says Gartner, make sure the firm’s website is clear and easy to navigate, with contact information clearly visible. For website design, he recommends looking at management consulting websites.

    Own Your Local Market

    In the time of COVID, Gartner says there’s never been a better time to leverage the geographic proximity of a PE firm to potential acquisitions. Staying local means no travel and, whether or not it is true, feels safer.

    To market locally does require a different approach. These are some avenues Gartner recommends:

    “Membership in YPO or Vistage, providing regular content / interviews for the local business journal, sending personalized invitations to business owners to luncheons / events, and partnering with law / accounting firms to deliver value-added in-person content.”

    Where We Go From Here

    Business development for PE firms is changing forever. But by being nimble and quick to adapt to the new reality, savvy firms can differentiate themselves from competitors and nab the better deals.

    For more on this and other topics from Mark Gartner of ClearLight Partners LLC, be sure to listen to my interview with him from my podcast, M&A Masters.

  • Why Representations and Warranty Insurance Is the Perfect Tool for Bankruptcy Sales
    POSTED 9.29.20 M&A

    I know of a company that was on the verge of being bought for $100M. Then COVID-19 came in, the deal fell through, and now the business, forced to go through bankruptcy, is selling its assets for $20M.

    This will not be a unique case. In the coming weeks and months, expect a growing list of companies looking at bankruptcy as their way out due to the ongoing economic effects from the pandemic.

    Unlike past downturn-related bankruptcy sales, there is a very valuable M&A tool that can be brought into the transaction that greatly benefits both Buyers and Sellers (also known in these cases as debtors):

    Representations and Warranty insurance.
    As Bryan O’Keefe, Gena Usenheimer, and James Sowka, partners at Seyfarth Shaw, put it in their recent article, “How An M&A Tool Can Benefit Bankruptcy Sales”:

    “When properly utilized, reps and warranties insurance can increase the value of the distressed asset while simultaneously providing the asset purchaser with a backstop on the promises made in the purchase agreement.”

    R&W coverage transfers the indemnity risk away from the Seller to a third party – the insurer. And the Buyer simply goes to the insurer with a claim for damages from any breaches post-closing. It’s a win-win for both sides of the transaction.

    In bankruptcy deals covered by R&W insurance, the Seller’s company and/or its assets are more valuable, which gives them more cash to cover their debts. The simple reason why is that an asset backed up by an insurance company is more valuable to a Buyer than an asset that is bought as is. They can sell for more, simply put.

    For Buyers, this coverage gives them protection and peace of mind that if something goes south and there are unknown breaches of the reps and warranties of the Purchase and Sale Agreement, they won’t have to go after the debtor (which doesn’t have funds to cover the damages because of their financial situation) for relief because the insurance company is ready to go.

    This is vastly different than how business is usually done with these 363 sales. In the past, the mode was “as is, where is.”

    It’s kind of the like buying a used car “as is”—it’s up to the purchaser to have a mechanic check out the vehicle to make sure it’s in good running order and there are no hidden issues. When a car warranty is added to the deal, not only does it cover repairs if something breaks down unexpectedly, but the owner can also actually increase the selling price.

    With a 363 sale, the burden of conducting due diligence of the target asset is on the Buyer, and they often have a shortened timeline to conduct it. Things can be overlooked. R&W coverage acts like the car warranty.
    As Bryan, James, and Gena say in their article:

    “Most 363 sales are ‘as is, where is’ – a bankruptcy term of art meaning that the asset purchase agreement has no indemnities and the debtor is not standing behind the usually limited reps and warranties contained in the agreement.”

    “While the bankruptcy court’s 363 sale order wipes out third-party claims against the assets, it does nothing for so-called ‘first party claims’ – that is, the reps and warranties made between the debtor and buyer around the overall state of the assets.”

    R&W coverage is more affordable than ever. It causes no friction or change in dynamics in the deal; in fact, it makes negotiations smoother. And it’s now available for middle market companies. This has meant its widespread adoption in some M&A circles.

    PE firms have been on board with R&W insurance for several years now. And SPACs are warming up to R&W as well. Now it’s time for bankruptcy sales to join in.

    Why haven’t bankruptcy attorneys already been using this unique insurance product? They simply were not familiar with it.

    You should know that insurance companies have departments that specialize in R&W coverage exclusively for 363 sales, which means not only are they experts in the field but also are coming in with aggressive pricing for the policy, which is a relief of companies in trouble, who face higher legal and other fees in general.

    As bankruptcy attorneys realize these and all the other benefits of R&W coverage, watch for its use to increase as the coming wave of bankruptcies crests in the near future.

    To find out how this specialized type of insurance can be a game-changer in your 363 sale or more straightforward deal, contact me, Patrick Stroth, at pstroth@rubiconins.com for all the details.

  • Intellectual Property in M&A – and How Representations and Warranty Insurance Fits In
    POSTED 9.1.20 M&A

    Representations and Warranty (R&W) insurance is a specialized coverage that transfers all the indemnity risk to a third-party – the insurer. If there are any breaches of reps and warranties post-closing, the Buyer simply files a claim and gets paid damages.

    In many cases, it’s a much more affordable alternative to traditional indemnification – the holdback of funds in escrow to pay out any possible damages that come up from breaches. Because they take home more cash at closing, R&W insurance is especially appealing to Sellers.

    Due to the protection it provides, R&W coverage is becoming an increasingly common feature of transactions in just about every industry. And because it’s now available for deal sizes under $20M, it’s been embraced by Buyers and Sellers of lower and middle market companies, including PE firms and strategics.

    Despite its many advantages, R&W insurance went over like a lead balloon in Silicon Valley for many years.

    Why? Early R&W policies would exclude intellectual property. It was considered uninsurable. And because IP is such a central part of deals with tech companies, what would the point be of seeking a policy that didn’t protect for breaches in that area?

    These days, breaches of IP-related reps and warranties, in which the Seller states that there is no litigation or claims related to IP infringement, they are the sole and exclusive owner of the IP, and they have the right to transfer the IP, are insurable.

    This doesn’t have ramifications just for mergers and acquisitions among Silicon Valley tech companies.

    Today, every company is a technology company, not just those that have hardware and software as their central offering.

    Consider McDonald’s. In 2019, the fast-food giant made three key acquisitions of innovative tech companies: Dynamic Yield, which offers personalization and logic technology, Apprente, known for its voice-based conversational technology, and Plexure, which creates mobile apps.

    The goal was to incorporate tech from these companies to install more efficient and personalized ordering through mobile devices, self-order kiosks, and drive-thrus at McDonald’s locations.

    When companies like McDonald’s make acquisitions, they want to ensure the IP they’re buying is free of encumbrances that could cost them months or even years down the line, such as code that comes from another source.

    The Best Ways for Buyers to Get Ahold of IP They Need

    During my recent interview with veteran M&A lawyer Louis Lehot, formerly of DLA Piper and founder of his own boutique law firm, L2 Counsel, he highlighted three different ways a Buyer might get access to IP they need:

    • Mergers are the easiest way to sell a company because it does not require all shareholders to agree to sell all their shares. You simply need a majority of outstanding shares of capital stock to approve it. This type of deal also has tax advantages for the Seller.
    • For Buyers who simply want access to technology, they could simply license it. This way, the Buyer doesn’t have to worry at all about any breaches and liabilities. However, they aren’t the only company able to take advantage of this tech. There could be other license holders.
    • However, for Buyers who want to be able to “build on” IP, developing it to further monetize it, an asset acquisition is the way to go. They are able to only secure the part of the company they need and avoid any liabilities the entity might have. They can also “cherry pick” team members from the target business they want to bring on. This also gives them “exclusivity.”

    Typical Breaches of IP Reps

    We don’t know if R&W insurance was used in these acquisitions by McDonald’s. However, in deals like this, where the technology and the intellectual property is so important, it’s a good idea for Buyers because of the many risks that might prevent it from fully making use of the IP it has acquired:

    1. Open source code being used. “Open source code is code that’s already been developed,” explains Louis. “And the condition to using that open source is that if your code contains the open source code, then you have automatically granted a license to everyone in the community.”
    2. A failure to secure consent from third parties (such as former employees or founders) who have a claim to the IP for the deal.
    3. Claims from third parties that the IP infringes on their patents or IP rights. For example, former employees from another company are accused of using tech they brought over from their ex-employer.
    4. A failure to properly register the IP with the government.
    5. Lack of evidence that employees or contractors who helped create the IP gave away their rights to the Seller.
    6. The product or service uses or licenses technology from a third party, and the Seller does not have the right to transfer the IP without consent.
    7. If the tech involves sensitive customer data, and there is no privacy policy with customers that allows the company to transfer and disclose this data.

    A nightmare scenario: A Buyer acquires a cutting-edge startup with the technology it needs to keep up with their competition. However, post-closing it is discovered – when a lawsuit comes their way – that a bit of critical code backing up this IP was actually from another company. The programmer was simply trying to take a shortcut, and nobody noticed.

    1. One of Louis Lehot’s tools for avoiding situations like this is a questionnaire that covers IP issues. It includes questions like:
    2. How did the IP first come to the company? A red flag here, says Louis, is former employment of founders. If they worked previously at a company and then start a new company doing the same thing in the same way – that’s a huge problem.

    Did each founder assign his or her IP to the company? “I’m always shocked to find the number of defective assignments of IP at formation,” says Louis. “And so that’s an easy fix, as long as the founder that contributed that IP is still around. But if you have a co-founder that was really key to the development of the IP, that formation has departed, and you have no leverage to get that person to sign in as assignment later on, that can be sticky.”

    R&W Insurance Protects Buyers and Sellers in Case of IP Issues

    During the interview, Louis also explained that R&W insurance has revolutionized how deals are done in recent years. Not only does it provide protection but also helps create a less potentially contentious relationship between Buyers and Sellers down the road. As he put it:

    “I think it’s in the interest of Buyers and Sellers to externalize the risk of breaches of reps and warranties with insurance. And it really takes the sting out of the friction of an ongoing relationship between a Buyer and the Buyer’s new employees, who are helping the Buyer monetize the IP.”

    “Really, going back to those employees and dinging them for indemnification claims is really the last thing you want to be doing and the easiest way to disincentivize them and demotivate them from doing what they need to do.”

    The addition of IP protection to Representations and Warranty insurance, as well as its recent price drop and availability for deals involving lower and middle market companies, has made it a game-changer in the M&A world. As a broker, I’ve been fortunate to have had years of hands-on experience with R&W coverage. I’m ready to discuss how it might benefit your next deal. You can contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • AI and Machine Learning’s Impact on the M&A Process 
    POSTED 8.18.20 M&A

    Artificial intelligence and machine learning have radically changed the way business is done in countless industries. And the M&A world is no different.

    This cutting-edge technology has the potential to cut the average time to get an M&A deal done by 66% – if not more – within the next five years.

    It’s the biggest advancement going on right now in M&A, with the greatest impact felt in the due diligence process, which will be cut from three months to one month or less when AI and machine learning are used to review and analyze the data in virtual data rooms.

    In this report from Datasite (formerly Merrill Corp.), The New State of M&A 2020 – 2025, M&A practitioners from around the globe were surveyed on this issue.

    48% felt that due diligence could be enhanced by technology the most; so there is clear demand for its implementation.

    35% said that combining that technology with virtual data rooms would help accelerate due diligence the most.

    30% believed that AI and machine learning will have the most transformational impact on M&A in the next five years.

    Faster due diligence means more deals getting done because this element is the most important success factor in M&A and also the most time consuming – the Datasite report notes that 66% of those surveyed felt due diligence was the most time-intensive part of an M&A deal.

    AI and machine learning will make due diligence more secure, more complete, faster, and more cost-effective.

    And contrary to popular belief, technology will enhance the process, not replace the people.

    Software can’t replace deal-makers or those guiding investment and acquisition strategy. We will always need people to negotiate prices and terms, and we will always rely on experience and expertise. And, not even due diligence can be automated completely.

    How It Works

    During the typical due diligence process, there are hundreds and thousands of pages of disclosures, financial statements, contracts, and other data about the target company. It’s all electronic these days, placed in various “folders.”

    It’s organized. But trying to locate a specific piece of information among all those documents is very difficult and time consuming, requiring Buyers to read through pages and pages to get the data they need. Hence the usual delays to the process.

    When you upload the documents to a virtual data room and have AI and machine learning software scan all of them, you now have a very effective search tool to help you pinpoint, accurately and quickly, the specific document you need to get the answers you’re looking for.

    Importantly, machine learning and AI can also search documents, identifying important sections and highlighting potential risks based on parameters set by the person conducting the diligence, helping them better assess the opportunity.

    It’s an appealing picture. And it must be why 65% of those surveyed by Datasite said that “new technologies should enable greater analytical capability in the due diligence process.”

    Barriers to Adoption

    As with any change in the way things are done, you might expect some resistance to the widespread adoption of using AI and machine learning to essentially create a searchable virtual data room. In fact, only 26% of M&A practitioners surveyed for the Datasite report believe this technology will help accelerate due diligence.

    Some of their concerns? The financial constraints and data security and privacy issues.

    But, I think that the benefits sell themselves, and more people will come around as the technology progresses and costs come down. Savvy Buyers and Sellers know that the quicker the due diligence process is over… the quicker the deal gets done.

    According to the Datasite report, 56% of those in M&A believe due diligence time will be cut to a month or less in five years’ time – so there is clearly confidence this technology will progress to where it needs to be for widespread adoption by then.

    And besides, with the pandemic, everybody has become more comfortable with technology like Zoom… and that will translate to being more open to tech like AI and machine learning.

    It’s like when years ago, the idea of the paperless office started floating around. It was slow going at first. But once there were effective digital scanning and storage solutions, like cloud storage, and the costs came down, the paperless office became a reality.

    Or, think about virtual data rooms themselves. Twenty years ago they didn’t exist. Today, you can’t do a deal without one.

    Another example: Representations and Warranty (R&W) insurance.

    For years, many felt it was only for big deals or too cost prohibitive. But as more insurers have started offering this product and more Buyers and Sellers are insisting on this coverage, the price has come down. Plus, deal sizes of under $20 million are now routinely accepted.

    Implementing AI and machine learning into the due diligence process for your next deal may not be feasible yet. But you can still enjoy the protection of R&W insurance coverage.

    As a broker with years of hands-on experience with this unique product, I’m standing by to answer your questions. You can contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • The Importance of Data Security in M&A – and How Insurance Fits In
    POSTED 7.28.20 M&A

    The nature of risk in M&A deals has changed, and it’s made specialized insurance coverage more important than ever.

    Data security is now, more than ever, one of the biggest concerns for those involved in M&A. And for good reason. It’s creating more risk in deals, especially those involving tech companies.

    These days, businesses need to be aware of how the businesses they acquire collect data, secure data, and use data. There are several factors at play here.

    Increased data privacy regulations in the European Union, known as GDPR, as well as the California Privacy Act (with similar policies sure to be put in place in other jurisdictions across the country), can put Buyers at severe risk, particularly when they acquire companies with less than effective data security.

    And Buyers are taking notice.

    In fact, according to Deloitte’s annual The State of the Deal: M&A Trends 2020, 70% of respondents (from Strategic Buyers and PE firms) stated that protection of data in a company they were acquiring was more of a concern than it was a year ago.

    Andy Wilson, a partner in the M&A Services division of Deloitte & Touche, put it nicely:

    “Data privacy can be a diligence issue. A target company may bring a cybersecurity weakness into the organization, or a transaction that involves layoffs or other workforce changes may create data security risks.

    At the same time, data protection and management can be an integration issue, with a newly combined organization perhaps reaching into new geographies where regulations differ for the handling of data.”

    Regulations Today Call for Strong Penalties

    GDPR (General Data Protection Regulation) was instituted in 2018 in the European Union and outlines strict guidelines for the collection, organization, storage, use, and destruction of personal data. Fines for violations, based on annual revenue, can run into the millions. For example, Marriott International in the U.K. was fined £99 million in July 2019 for a data breach of 339 million guest records.

    Investigators believe the incident goes back to 2016, when Marriott acquired Starwood hotels group. The group had its systems compromised in 2014, but it was only discovered in 2018. Regulators faulted Marriott for not conducting proper due diligence prior to the acquisition or doing enough to secure its systems.

    Elizabeth Denham, with the Information Commissioner’s Office, which administers these regulations, said this about the case:

    “The GDPR makes it clear that organizations must be accountable for the personal data they hold. This can include carrying out proper due diligence when making a corporate acquisition and putting in place proper accountability measures to assess not only what personal data has been acquired, but also how it is protected.

    Personal data has a real value so organizations have a legal duty to ensure its security, just like they would do with any other asset. If that doesn’t happen, we will not hesitate to take strong action when necessary to protect the rights of the public.”

    As you can see, they’re taking it seriously, targeting businesses of every size in every industry. These days, every company has sensitive customer data. It’s not just tech or financial industries like banks or credit card companies that have to worry. Any business that touches the internet is vulnerable.

    Plus, not only can you run afoul of regulators due to a privacy breach or data leak, but you can also introduce vulnerabilities to your own secure system by blending it with the newly acquired company’s system.

    How to Protect Yourself

    1. There are solutions, or at least things you can do to mitigate potential problems.
    2. Enhanced due diligence.
    3. A laser focus on post-acquisition integration of systems to make sure they and each company’s security practices line up. This goes from the IT side all the way down to prohibiting employees from putting their password on a Post-it on their computer monitor.

    Purchase the right Cyber insurance.

    Cyber Liability coverage is a must-have for virtually every M&A deal in today’s climate, due not only to regulatory penalties but also the financial damages from a data security breach. There are measures to take to protect data, of course, on the tech systems side. But hackers are ever more sophisticated and can get around even the most sophisticated protections.

    The need for Cyber Liability coverage may sound obvious, but be aware that not all Cyber policies are alike. Avoid the cheaper versions that only cover data breaches. The top policies now offer coverage for malware attacks (which happen 5x more often than loss of data), electronic theft and ransomware attacks – all of which can seriously damage a company’s value if left unprotected. The difference in cost for a more comprehensive Cyber policy is negligible.

    Due to the heightened exposures businesses face from cyber-related losses, most R&W policies will require a Cyber Liability policy be in place for the target company, and will impose exclusions for Cyber-related losses if no such coverage is in place.

    In the case of both Cyber Liability and R&W coverage being in place, here’s how it works:

    In the event of a breach, the insurance companies will let the Cyber Liability claim be paid first and then the R&W policy will cover any damages not covered. Keep in mind, the deductible on a Cyber policy is a fraction of a R&W policy retention, so Cyber provides a cost-effective first line of defense.

    It’s comprehensive protection that’s very necessary today.

    As a broker with extensive experience with both Cyber Liability and R&W insurance, I’d be happy to discuss coverage for your next M&A deal.

    Please contact me, Patrick Stroth, at pstroth@rubiconins.com.

  • Let’s Talk Exclusions 
    POSTED 7.21.20 M&A

    When it comes to insurance – in any realm – most people aren’t as concerned about what the policy covers as much as what is excluded.

    That’s the number one factor in whether or not they get the policy.

    Why would something be excluded?

    There are three principal reasons:

    1. Something is flat out uninsurable. An example of this would be a moral hazard, which is a situation in which one party engages in risky behavior because they know it is protected… and the other party (in this case, the insurance company) will pay the price. You can’t intentionally misbehave to trigger a policy and get paid – that would be like suing yourself. If you could, there’d be no incentive to be on good behavior.

    2. Underwriters want more information on a specific point before they are willing to insure an exposure in the Purchase-Sale Agreement, so they put in an exclusion until they are satisfied with the extra information provided. Once they have that information, they’ll make a value judgement about whether or not to remove the exclusion and what, if any, additional premium charge is applicable. For example, if the standard policy costs $120K, the Underwriter might say we will remove a particular exclusion… for another $30K.

    3. An exclusion might be included because the exposure is simply better covered on a separate policy. Environmental Liability is routinely excluded in R&W policies because the risk is best insured by a broader (and less expensive) Pollution Liability policy.

    All that being said, here are some of the most common exclusions we see today.

    (Disclaimer: This is subject to any specific terms in a deal, due diligence performed or not performed, and each particular Underwriter – whose opinion can vary.)

    

Top 10 Representations and Warranty Insurance Policy Exclusions

    1. Actual Knowledge

    This is when you want to buy a policy, but during diligence you discover the financials aren’t accurate… and you buy the policy anyway. In this case, any damages related to issues you knew about won’t be covered. If you notice anything unusual about a target, which would trigger a breach, you can’t suppress it until after closing. If you do, this is known as “sand bagging” and is excluded.

    2. Interim Breaches Between Signing and Closing

    If there are any breaches between the time of signing the deal and closing it – and the parties knew about it – it’s not covered. For smaller deals, signing and closing are usually on the same day, so there’s no problem. But for bigger deals with regulatory or funding issues (like the bank offering financing won’t sign off until signing) to sort out, this comes into play. For example, when Amazon bought Whole Foods, they had to wait six months for regulators to okay the deal as far as potential anti-trust issues.

    3. Full Disclosure Representations and Rule 10b-5

    These are catch-all Reps that go way beyond standard Reps and Warranties. They are excluded– because you can’t cover everything out there, especially something with unknown potential financial impact. As a result of this “universal exclusion” the 10b-5 reps are being removed from agreements.

    4. Purchase Price Working Capital Adjustments

    Sellers have complete control in calculating and providing sufficient cash in the company’s accounts to cover operating expenses for a period post-closing. Since it’s in the Seller’s interest to have as little cash left behind as possible, a moral hazard exists. R&W Insurers therefore exclude any failure by the Seller to accurately estimate and adequately fund the company’s accounts. If, for some reason, the Buyer discovers they’ve been “shortchanged” after closing, the Buyer has to go after the Seller directly.

    5. Fines and Penalties

    Any misbehavior that results in government action may be excluded where deemed uninsurable by law (i.e. punitive damages in CA are uninsurable).

    6. Deduction of Tax Benefits from Recovery Amount

    If you have losses and related expenses after closing, that breach often nets you a tax break. If the insurance company pays the claim for your damages, they’ll deduct the amount of the tax break accordingly.

    7. Wage and Hours Laws Violations

    Misclassification of employees versus independent contractors is common, especially in the tech sector in places like California. With contractors, companies don’t offer benefits or pay employment taxes. But often the line between contractors and actual employees is blurred and companies can be sued. With that much exposure, insurers won’t cover it, without extensive information and at a higher premium.

    8. Major Environmental Issues

    Say you buy a company that owns a building which had a major fire or chemical spill in its past. These are hazards that a R&W policy won’t pick up because it should be covered by a 
Pollution Liability policy you can buy elsewhere.

    9. Forward-Looking Reps

    With R&W coverage, you’re insuring Reps of what you know up until the close. Any projections or forward-looking statements are simply uninsurable. For example, if you’re projecting $14M in revenue in the quarter following the acquisition, up from $10M in the quarter before the deal, the insurance company can’t protect that estimate. Projected revenue or growth is not covered.

    10. Consequential/Multiplied Damages

    In the past, R&W insurers considered consequential damages/multiplied damages uninsurable; however, competition and favorable claims experience has changed this position. Today, insurers are willing to either cover these broader damages outright (mirroring the Purchase -Sale Agreement) or will agree to remove any specific exclusion language (be “silent”) on consequential/multiplied damages if the Purchase-Sale Agreement concurrently omits “consequential/multiplied damages” in its definition of “damages”.

    A savvy Buyer will insist on consequential damages being included in the Agreement. It’s therefore essential for R&W Brokers to address this point with all Insurers to ensure proper coverage is either provided or limitations disclosed to the prospective policyholder.

    Next Steps

    As you can see, R&W insurance is not a catch-all that will pay claims on any sort of issue post-closing. What’s covered is narrowly defined by necessity. It’s also essential to note that exclusions can be flexible where Underwriters are provided the right information. This highlights the importance of Engaging an experienced R&W Broker to negotiate with Underwriters on a Buyer’s behalf.
    Still, when you consider all that these policies do cover and the other benefits, including transferring the indemnification risk to a third party, speedier negotiations, and more, it’s well worth pursuing this coverage for most M&A deals – for both Buyers and Sellers.

    It would be my pleasure to discuss potential exclusions and other coverage details with you. Please contact me, Patrick Stroth, at pstroth@rubiconins.com.