M&A experts worldwide are using an insurance policy known as a Representation and Warranty (R&W) to transfer risk from the parties in a transaction to an insurance company. R&W policies are designed to, “step in the shoes” of a seller to pay indemnification claims made by the buyer for inaccuracies of the representations and warranties outlined in the purchase/sale agreement. Due to the low cost of R&W insurance, sellers are driving the demand for these policies rather than accept large, lengthy escrow or withhold terms. Buyers are discovering how R&W insurance can enhance their bid without having to raise their offer.
Limit Capacity – Up to $100M on a single policy. Excess capacity up to an additional $400M available as needed.
Retentions – commonly 1% to 3% of the purchase price. Reduces over time
Premium – 3% to 4.5% of the limits purchased (including taxes and fees). Minimum premium is $300,000
Underwriting Fee – From $25,000 to $35,000 in addition to the premium. Covers the cost of Insurer’s attorney’s fees and due diligence costs to review and manuscript a policy. Non-refundable.
Terms – designed to match the survival period. Post survival extensions available upon request.
We are entering into a serious recession due to the ongoing worldwide pandemic. The economy has taken a big hit, and it’s not over yet. But I see opportunity out there, especially in the M&A world.
Let’s put this in context first. Think back to the last recession – The Great Recession of 2008/2009.
There were lots of opportunities for businesses back then too, but there was no money. This time around, thanks to conditions prior to the downturn, there is plenty of dry powder available, not to mention very favorable lending terms.
Will there be opportunities to invest and acquire? We expect and hope, but we’ll see for sure soon enough.
It’s true that currently the pace of deals has fallen off a cliff. Deals are not simply being delayed… but actually cancelled. That’s bad, of course, and it has people worried. But conditions are already shifting.
We’re moving from a Seller-friendly market to a Buyer-friendly market. Like everything else in the near term, prices will be coming down.
As a Seller, you may have had a potential deal in the works. But, due to recent events, the Buyer is reluctant to move forward. Understandable, given it’s a time of uncertainty. And, many Buyers are reevaluating and focusing on other priorities. On the upside, if the price comes down low enough, Sellers in a bind will have other suitors. It’s a Buyer-friendly market, after all.
In this environment, PE firms have the advantage. PE firms may have been more aggressive price-wise in the recent past, while Strategic Buyers were spending more freely. Now the tables have turned. Strategics will be less aggressive while looking at takeover targets because in the near term they’re trying to protect as much cash as possible.
This opens the door for PE firms and other financial Buyers to make lower offers and pick up those targets themselves (and then sell them later for a premium).
This is all set against a backdrop of declining valuations.
Some of these target companies have had recent valuations of seven to 10 times EBITDA. Just a short time ago, they were valued at 10 to 15 times EBITDA. A company with $10M EBITDA was being targeted at $100M to $150M. Now that the price tag has dropped below $100M, there are a lot more interested Buyers. That’s one of the reasons this looming recession is still a good environment for M&A. And, as I mentioned, it’s a Buyer-friendly market… especially for financial Buyers.
Despite this pause in our economy, let’s look at the underlying forces that support robust M&A activity:
There is a lot of dry powder among buyers, specifically financial buyers.
Sellers were demanding record high valuations – and getting what they wanted. Those valuations will be coming down because we are seeing fewer Buyers. This gives remaining Buyers more leverage.
Financing costs continue to be low.
The dynamic of aging owners and founders that want to exit.
Continued digital transformation and tech disruption in every industry. Companies have to upgrade their tech at some point with regards to IT security, cloud computing, and more. Those lifecycles and disruptions will continue.
These market conditions are out there, no matter what… despite COVID-19.
That’s why I think that once we have falling metrics regarding the spread and impact of the coronavirus and a stable stock market for three weeks, we’ll be right back in business, and M&A activity resuscitated. Spring has come.
Another factor to consider is that there are a lot of distressed businesses out there in industries like transportation, restaurants, hotels, retail, etc. There are a lot of capital raises out there now – funds set up to go after good – but currently distressed – acquisition targets.
Under these current conditions, I see Representations and Warranty insurance as being a very favorable benefit because it factors into a few areas:
If a Buyer has more leverage in a deal, they will impose broader Reps and Warranties and other conditions. If a R&W policy is covering the deal, the Seller doesn’t really need to worry about more Buyer-favorable terms because it’ll be insured anyways. (A caveat: Underwriters are still conducting normal due diligence in these cases. They are not lowering the bar or loosening eligibility standards.)
Cash is still king. Getting R&W insurance means Sellers get more cash at closing and don’t have to worry about money being tied up in escrow for a year when they have to satisfy creditors or wish to invest elsewhere.
In distressed acquisitions, M&A Buyers need R&W coverage because often they don’t buy whole companies, just the assets. And the Seller may not have a choice. Having R&W is kind of like having protection for those assets if the Buyer has done diligence, but they are later compromised unexpectedly.
Without R&W coverage, the Buyer has no recourse to go after the Seller because they already took the funds to pay creditors. R&W insurance is the backup. Whatever dollar amount it cost for the policy… it’s more than worth it in those cases.
The longer a deal sits and doesn’t get closed, the greater the chance it will fall through completely. R&W insurance will accelerate negotiations all the way to closing.
It remains to be seen for sure, how this pandemic will impact the economy as a whole, and M&A activity in particular. But I feel confident that we’re shifting to a Buyer-friendly market and smart Buyers will take advantage of this opportunity.
In that case, it’s more important than ever to get Representations and Warranty insurance to cover deals for the protection of both Buyer and Seller.
If you’d like to discuss coverage, please contact me, Patrick Stroth, at pstroth@rubiconins.com.
Since last year, trade tension between the U.S. and China, as well as other countries, has been at a high-level. After the signing of the so-called Phase 1 trade deal with China earlier this year, that feeling has slackened somewhat, although the full, final deal is still being negotiated.
As part of this deal, China has agreed to buy more American agricultural goods, as well as oil and gas, pharmaceuticals, and other manufactured goods. Yet U.S. companies are still looking for alternate supply chains and manufacturing hubs. For example, Apple has been seriously looking at moving at least some operations to South Korea.
This is not the only impact.
Many companies are signaling that ongoing global trade disputes like this one – and the uncertainty they bring – will continue to influence their M&A strategy going forward. (The impact of the coronavirus pandemic remains to be seen.)
In a survey conducted by Deloitte and highlighted in their The State of the Deal: M&A Trends 2020 report, 40% of respondents (which include Strategic Buyers, as well as PE firms) said trade disputes would not change their M&A strategy. But it’s important to note that 30% of those surveyed said they would focus more on domestic deals instead of going overseas for acquisitions.
PE investors in particular are worried that tariffs will have a significant and harmful effect. 70% of those surveyed in the Deloitte report said that “tariff negotiations are having a negative impact on their portfolio companies’ cash flow.” The same percentage felt tariff troubles were harming portfolio companies’ operations, too. That’s compared to 55% and 58%, respectively, in 2018.
This decline in M&A deals abroad is not new and not tied to the coronavirus impact on the economy. As I wrote in March 2019:
“Cross-border activity decreased in 2018, hitting the lowest level in four years, continuing a trend that started in 2017. There were only 2,192 cross-border transactions worth $655.6 billion in 2018, compared to 2,983 in 2015. There are a few factors at play here:
All of these factors are still at play.
As we reported earlier this year, M&A activity is expected to hold strong in 2020. But U.S. companies and PE firms will be looking at domestic acquisitions more than cross-border deals. This was true before the coronavirus and now is even more so as the pandemic spreads across the globe. You can’t ignore the impact from interruptions to manufacturing, trade, and economic activity from interruptions like this.
This negative impact also creates even more uncertainty surrounding emerging markets, where U.S. companies are increasingly hesitant to invest.
The other problem is that already emerging markets were already more risky investments than they had been in the past, with companies earning less and less returns.
There is a caveat here.
Look for increased M&A activity where U.S. companies invest in European Union acquisitions, excluding Germany and France. It will be Italy and Spain instead, because they have smaller companies, i.e. small targets. European companies are being adversely affected by Brexit and that will make them ideal value opportunities for U.S. acquirers.
With smaller deals happening domestically and internationally, insurers have responded by offering Representations and Warranty insurance for those under $15M to $20M in transaction value.
For more information on this specialized type of insurance with a host benefits for Buyers and Sellers, you can contact me, Patrick Stroth, at pstroth@rubiconins.com.
While attending a recent M&A conference, I was surprised to hear so many of the participants – including PE firms, M&A attorneys, and bankers – still hold the mistaken belief that Representations and Warranty (R&W) insurance is too expensive.
In fact, the floor for R&W coverage has actually come down drastically in the past year to the point that a $5M policy can easily be found and it will cost less than $200K, including underwriting fees and taxes. (This figure doesn’t include broker fees, which the big firms are adding to maintain income levels. More on that below.)
Why the disconnect? These folks haven’t checked in on R&W insurance for a while, and people assume what was true a couple of years ago is still valid. They tend to get their information and updates from conferences. I was happy to spread the good news while I was there, and I got positive response. These folks did not see value in a policy if the cost was $225K, $350K. But if they could get a policy for under $200K, they were interested.
This significant drop in costs reminds me of Moore’s law. Quite appropriate considering how many M&A deals are done in the tech space. This maxim holds that every 18 months we can expect the speed and capability of our computers to double, while we pay less.
There are several reasons why the cost of R&W coverage has dropped:
I expect this trend to hold steady as the increase in R&W policies written has not yet translated into a corresponding increase in paid losses by Underwriters. Due to the simple fact that more policies are out there, reported losses are up. However, most of these cases fall within the policy retentions, so insurers are not having to write many R&W checks to cover damages. Plus, just because they’re writing smaller deals doesn’t mean Underwriters are getting sloppy and accepting just anything. They expect the same due diligence, making the smaller deals just as safe for them as bigger deals.
It should be noted that unlike other discounted insurance products, these low-priced R&W policies provide coverage just as comprehensive as the higher priced alternatives (depending on the complexity of the deal and diligence completed, of course). You’re not getting lower quality coverage or added restrictions just because it’s cheaper.
A sub-$200K priced R&W policy is good for M&A for the following reasons:
1. Lower costs make the value proposition on smaller deals more “palatable” – especially for Sellers where $1M or $2M less in escrow makes a material difference. These folks can’t take a $1M to $2M hit if there is a breach. R&W coverage is a lifesaver for them.
2. Lower priced policies more easily enable Buyers and Sellers to share the costs.
Many Buyers are saying that Sellers want R&W coverage on the deal but don’t want to pay for it. And Buyers are chagrined by that. But if costs are split and it’s under $100K for each side, it’s more favorable, and both sides benefit from having the policy in place.
As you know, this specialized insurance makes negotiations smoother, lets the Seller keep more cash at closing, and ensures that the Buyer doesn’t have to take legal action against the Seller if there is a breach, which is awkward if the Seller’s management team is on board with the new entity.
3. The lower price point makes R&W an affordable tool for add-ons, which are expected to increase as PE firms and Strategics look to enhance the value of their portfolio companies.
With PE firms in particular, thanks to lower cost policy and premium, they won’t just reserve R&W coverage for deals above $100M in transaction value. This lower price justifies using R&W on deals at $30M, which they are doing more of because it’s a lot easier to spend $30M to $50M than $100M. PE firms will transact two to three times more add-ons per year than one big acquisition.
I saw this first-hand recently with a policy I provided here in Silicon Valley. The company brought in a $90M add-on to an existing portfolio company. The $5M limit R&W policy cost just $175K (including underwriting fees and taxes).
Overall, with the lower price for an R&W policy, cost is no longer an objection for either party to consider a policy.
If R&W continues its stellar performance, expect to see even fewer exclusions and possibly lower retention levels.
But how much lower can the price go? Not much further if R&W insurance is to be sustainable. If the product gets too cheap insurers will not be able to collect enough in premiums to pay claims.
We’d caution prospective users to be wary of policies coming in under $100K.
One observation from this drop in premium rates is that the major insurance brokers offering R&W coverage have reacted to this price drop (which they’ve had to go along with to stay competitive) by adding broker fees of as much as $25K. These big firms have big overheads and want to protect their profit margin.
That’s where a boutique firm like Rubicon Insurance Services shines. In this segment of small market M&A deals, we take a back seat to nobody. We can broker policies more cost effectively and more efficiently because we don’t have the overhead. We won’t charge those broker fees.
I’m happy to provide you with more information on R&W insurance and provide you with a quote. Please contact me, Patrick Stroth, at pstroth@rubiconins.com.
We’re not yet to the end of the first quarter, and we already have a solid idea of where M&A activity is headed in 2020.
Deloitte put out a report, The State of the Deal: M&A Trends 2020, based on a survey of 1,000 corporate executives and PE firms that looks back at what happened in 2019 and their views and plans for 2020. And the outlook is good for M&A, although there will be some key changes to keep in mind.
As noted in the report, M&A activity will continue to be very solid this year. Only 4% of those surveyed anticipate a decline in the number of deals. Sixty-three percent forecast an increase in transaction activity. That’s down from 79% last year.
There will probably not be as big an increase compared to the last seven years, a boom time that has seen more than $10 trillion in domestic deals alone since 2013. But that’s to be expected as this level of growth in transactions is hard to sustain.
As Russell Thomson, national managing partner of M&A services for Deloitte & Touche LLP put it in the report:
“We’re fairly long into this M&A boom cycle, so it’s not surprising to see a drop in expectations for larger deals. What we’re seeing in the marketplace is more interest in deals in the sweet spot between $100 million and $500 million. Deals aren’t going away; companies are just being a little more careful about those larger deals.”
So the boom is tapering off a bit, but it’s still a rising trend due to several factors, including…
But this is the biggest change we can expect in 2020:
The number of deals over $500M in transaction value will likely come down and be replaced by deals in the $100M – $500M range… and as low as $20M. This is for a variety of reasons.
When they add on new acquisitions, the firms can expect to sell those portfolio companies at a much higher multiple than before. This is why they are getting better returns with smaller targets.
Based on this Deloitte survey, it’s clear that M&A activity has slowed a bit but is still going strong, continuing a trend of an unprecedented level of deal-making that started back in 2013.
Also, on the rise: the use of Representations and Warranty (R&W) insurance to transfer indemnity risk away from the Seller to a third party – the insurer. With this coverage now available to sub-$20M deals, look for this insurance to be a part of an increasing number of deals in 2020.
Whether Buyer or Seller, R&W insurance coverage can offer many benefits including smoother negotiations, more cash at closing, and less risk. But it is important to have a broker with extensive experience with R&W insurance and how it can impact a M&A deal. If you’d like to discuss coverage for your next deal, please contact me, Patrick Stroth, at pstroth@rubiconins.com.
