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.
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.
“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:
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.
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.
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:
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.
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.
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.”
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.
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.
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.”
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.
