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.
Will there be an economic downturn in 2020? Aside from the current turbulence created by the coronavirus, which represents only a temporary setback, I don’t see any indication that we’re headed for a recession in the near future. As I’ve outlined previously:
“The ongoing “trade wars” are no issue. The GDP is solid. Consumer spending is stable, if not going up. Consumer savings is up. Debt ratios are lower than they have been in years.”
Of course, there are some out there who do forecast problems. And companies are making strategic plans in case of an economic downturn or recession. It’s always smart to be prepared, of course.
But even if the market shifts from bull to bear after an impressive 10-year expansion, I don’t see too much impact on M&A activity. And many of those making deals on a regular basis agree with me.
As noted in the recent report from Deloitte, The State of the Deal: M&A Trends 2020, 42% of respondents to their survey (which include PE funds and Corporate Strategic Buyers) said “an economic downturn may actually boost deal activity.” 19% said it would have no impact, and only 23% see a potential decrease in M&A activity.
Seems counterintuitive. But, as Jason Langan, partner, M&A Services, with Deloitte & Touche LLP, put it:
“If the economy slows, let alone dips into a recession, companies aren’t going to ignore M&A—they are just going to be even more deliberate in the deals they look to do.”
Here’s how it will play out and why even in the wake of an economic downtown M&A activity will remain solid:
If the economy goes south, expect companies to divest nonperforming, non-core assets. This allows them to generate more cash, be more nimble, and put resources elsewhere. In fact, 75% of corporate strategics expect to have divestitures in 2020. That’s the second-highest level in the last four years and compares to 77% last year, so only slightly lower.
Why divest? According to the Deloitte report, those surveyed cited a change in strategy, financing needs, and a desire to shed technology that no longer fits with the business model.
Even in a struggling economy, perhaps especially in a struggling economy, companies can’t sit back and decide to save cash by not making deals. They’ll be left behind by their competitors who continue engaging in M&A activity.
What will change, most likely, are the size of the deals and how many are done. Strategics will also take time to make sure the deals they do make are beneficial; they’re less likely to take risks.
Why wait for a company to slowly grow on its own when you can make a key acquisition to get the technology, customer base, or whatever else you need to take the company to next level quickly? That’s why Corporate Strategics will continue to make smart acquisitions.
If a downtown occurs… what happens to the prices of target companies? They go down. For PE funds, which have a lot of ready cash, that is a signal to start bargain hunting. So we will start to see a trend of smaller deals in case of recession.
There are also other factors impacting M&A activity in 2020, including…
Nobody wants a recession. And based on my analysis of current market conditions, I don’t think there will be one.
But should one happen, I don’t think M&A activity will slow significantly. Any slowdown will be the natural result of seven straight years of $1T+ in annual deal value. It’s hard to maintain that level of activity over such a long period.
However, we will see smaller deals… and less risky ones. But overall look for both Strategic Buyers and PE firms to take advantage of the opportunity to make smart deals, both divestitures and acquisitions to maximize profit margin and spur growth.
Whatever size deal, whether it involves Strategic Buyers or PE funds, the use of Representations and Warranty (R&W) insurance should be a given. It offers protection to both Buyer and Seller and helps get deals to closing much faster.
But an experienced broker who knows M&A is needed to integrate this coverage. If you have any questions about R&W insurance – or have your own take on a looming recession and its impact on M&A activity – please 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.
In the last few years, there’s been a game-changer slowly but surely transforming the M&A world.
The use of Representations and Warranty insurance is increasing across the board as Buyers and Sellers, PE firms, VC funds, and strategic buyers all recognize that this coverage makes negotiations less contentious and more cost-effective. Because the indemnity risk is transferred to a third-party, this insurance also gives a sense of security.
R&W insurance is changing how deals are structured.
We covered why – and some of the foundational details in the first part of this article, which you should read here first.
Now, we’re to going to get into the weeds, so to speak. Taking a look at some of the specific ways deal terms are being rethought when R&W coverage is part of the deal.
If there is a breach of a Representation or Warranty in a Purchase and Sale Agreement, Sellers seeking to limit their exposure, prefer wording in the agreement that requires breaches to be “material” in order for the Buyer to be able to claim the breach for indemnification purposes. Depending on the deal size, “material” generally being more than $100,000 to $250,000.
Naturally, a Buyer will want to remove this qualifier by applying a Materiality Scrape (i.e. to literally scrape “material” as a determinant for breaches), giving them the ability to determine a breach and thus reduce their risk.
If R&W insurance is in place, most Sellers will agree to Materiality Scrapes because the policy coverage will mirror the Materiality Scrapes in the agreement, eliminating risk on both sides of the table. According to SRS Acquiom, 2/3 of deals with R&W include even Double Materiality Scrapes (where Buyers determine both the breach and the calculation of resulting damages).
Buyers like having pro-sandbagging language in Purchase and Sale Agreements.
Say a Buyer is performing their diligence and they find a problem. They see that a Seller’s representation has been breached… but the Seller hasn’t recognized the issue.
Without R&W coverage, what happens next is…
The Buyer is under no obligation to tell the Seller what they found. They can go through the deal and then bring up the breach post-closing. That blindsides the Seller, who is left wondering why the Buyer didn’t inform them sooner to avoid having to pay damages. Making a claim against the Seller like this is referred to as “sandbagging.”
An R&W policy will have a warranty statement – a pro-sandbagging provision – that says the Buyer certifies they have no knowledge of any breaches. If it turns out they do have knowledge and don’t inform the Seller before the deal closes, that breach will be excluded.
As you can imagine, this is great motivation for the Buyer to be forthcoming if any issues show up in their due diligence efforts. They will tell the Seller as soon as possible because otherwise they won’t get the benefit of the insurance later.
This also enables the parties to address “known” issues before closing rather than the having a future “surprise” sprung on an unsuspecting Seller.
Before R&W Insurance emerged, the prevailing belief of Buyers was that large escrow accounts provided both security and a more “honest” Seller. As R&W began replacing escrows, Buyers and their advisors argued that having cash on hand was safer than hoping an insurance company would pay claims.
After a successful period where R&W policies have incurred and promptly paid claims, confidence in R&W has only increased, while escrow amounts have decreased. So much so, that according to SRS Acquiom, the average escrow amount has fallen from 10% of transaction value on uninsured deals to 1% of transaction value on insured deals.
There are certain Buyer-friendly “catch-all” reps out there, officially known as 10b-5 representations, or full-disclosure representations. Among all the other specific representations in a Purchase and Sale Agreement, this catch-all states that the Seller doesn’t know of any potential breaches or other issues. Therefore, any future unexpected event could potentially trigger these reps, greatly exposing Sellers.
These open-ended reps can’t be underwritten, so they are routinely excluded by R&W policies.
In response to the insurers’ position, Buyers and Sellers have agreed to remove these 10b-5 reps entirely so the corresponding exclusion is eliminated. SRS Acquiom reports that some 90% of deals with R&W no longer contain 10b-5 reps as compared with 62% in uninsured deals.
In a recent report on M&A trends from SRS Acquiom, the company noted that they are seeing more non-reliance provisions, which are very Seller-favorable, in Purchase and Sale Agreements.
With this provision, the Seller is telling the Buyer that the Buyer cannot rely on information provided by the Seller, like a tax report or financial statements. The Buyer must perform their own diligence and use those findings to make any determinations.
This protects the Seller if the Buyer claims that they were provided inaccurate financial statements or similar diligence reports. This shifts risk in the direction of the Buyer. But if R&W insurance is in place, the Buyer is not worried because the coverage would cover and pay the claim for any breach.
In the event of loss, there are deductibles due before a claim is paid. In the past, there was a tipping basket. For example, if there was a deductible of $500,000, the Buyer had to eat the first $250,000. However, the minute it goes over $500,000, the Seller is responsible for the entire deductible.
With R&W coverage in place, the two sides are now agreeing to split the deductible 50/50, simplifying the deductible issue.
On a side note, it’s amazing how many claims of breaches are reported at least one year post-closing. Most policies have a deductible dropdown. If after one year there have been no claims, the deductible goes from 1% of transaction value to ½%.
It’s clear that Representations and Warranty insurance is taking the M&A world by storm. I see it becoming standard in the next few years. You can get ahead of the curve by learning about this specialized type of insurance and how it could change the terms of your next M&A deal – whether Buyer or Seller. Just contact me, Patrick Stroth, at pstroth@rubiconins.com for all the details.
