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.
You’ve no doubt heard of the best-selling book from author Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable.
In it, Taleb denotes “black swan” events as those that are unexpected or unpredictable. Examples include the 9/11 terrorist attacks, World War I, the rise of the internet, and the fall of the Soviet Union.
However, despite the worldwide, devastating impact on society, economies, entire industries, healthcare infrastructure, and more, the COVID-19 pandemic is not a black swan.
Taleb himself says so, noting that many experts, including Bill Gates, who has closely studied and funded epidemic research, have long said a global pandemic like this happening was a matter of when, not if. Taleb says this is actually a “white swan.”
This is not a black swan, despite the tumultuous times we’ve had in the face of this crisis, including economic downturns, widespread unemployment, travel bans, and more. We won’t go into the details here as to how this might have been prevented or who holds the blame, if anyone.
We’re concerned with the results and what happens moving forward.
As far as COVID-19, as countries see decreasing cases and are exiting government-mandated lockdowns, we can now see we are at the beginning of the end.
Economic activity is set to return, as people go back to work and those businesses that survived, large and small, start up again.
As I wrote previously, expect M&A activity to resume, but in a different form due to impacts of this crisis. We’ll see:
This strong M&A market is also a result of previously existing conditions, such as:
This is a recipe for PE firms to come in and find low-cost but high-quality gems to invest in and turn a profit, in many cases, faster than pre-COVID-19. Private Equity has the capital, resources, and expertise to take on the challenge of many struggling companies out there right now.
This is not to say that the economy will not experience a downturn due to the pandemic. Its impact will be felt in many sectors for a long time, including companies, investors, and consumers.
But there is opportunity. And this is very different than the 2008 Crash, at which time M&A activity slowed considerably for the most part.
As Sander Zagzebski, partner with Greenspoon Marder LLP, put it in a recent article for C-Suite Quarterly:
“Shrewd dealmakers will sense opportunities by purchasing discounted debt and providing debtor-in-possession financing packages. Smaller debtors may seek to take advantage of the new Subchapter V Small Business Debtor Reorganization provisions, which as drafted provide a more streamlined process for debtors with less than $2.725M in debt. As part of the recently passed CARES Act, that limit was increased to $7.5M for the next year.”
Sander likens this opportunity to that which a select few savvy investors took advantage of in the 2008 crisis.
“While capital market and traditional M&A transactions slowed significantly during the financial crisis, distressed investors became presented with numerous attractive options. Howard Marks and Bruce Karsh at Oaktree Capital were later lauded by The New York Times for their timely $6B bet on corporate debt during the height of the financial crisis, as was Leonard Green & Partners for its timely $425M minority investment in Whole Foods.”
“Overshadowed in the media by high-profile, pre-crisis bets on the overheated real estate market by the investors profiled in Michael Lewis’ 2010 book The Big Short and others, these blood-in-the-streets bets at the bottom of the market later proved to be enormously profitable.”
There are similar prospective valuable deals out there now… for those that can recognize them.
As Sander writes:
“Many investors are starting to view the world today as Karsh viewed it in 2008 and are seeking those unique buying opportunities.”
Still, there is plenty of uncertainty surrounding deal-making, as future impacts of the ongoing pandemic are unknown. Watch for Representations and Warranty (R&W) Insurance, which had already been enjoying a renaissance amongst lower middle market deals, to be a strong presence in deals going forward.
To discuss R&W coverage with a broker with hands-on experience with this product, I invite you to contact me, Patrick Stroth, at pstroth@rubiconins.com.
The COVID-19 pandemic has changed trade, commerce, and business in so many ways already… with more changes to come. The world of M&A has reacted as well. But as I noted in my previous piece, No Significant Drop in M&A Activity During This Recession, we won’t see the slowdown happening.
Instead, we’ll see a shift to a Buyer-friendly market. Also, watch for PE firms with plenty of cash to look for opportunities – and bargains… struggling companies they can turnaround.
The pandemic will impact a key part of M&A activity: the due diligence process and the use of Representations and Warranty (R&W) insurance to cover breaches of reps in the Purchase and Sale Agreement.
Just as with any insurance product, COVID-19 must be addressed with R&W policies. And expect pandemic-related questions from Underwriters in the due diligence process.
Not every company, of course, has been affected by COVID-19 in the same way. For example, a software company that already had a largely remote workforce is in much better shape than a retailer forced to close brick-and-mortar locations.
But overall, insurers are closely monitoring the impact of COVID-19 on operations of any acquisition target. This is how I expect it to impact R&W coverage moving forward:
As a worldwide pandemic affecting billions, nobody can claim that COVID-19 is an “unknown” prior to a deal being signed. And R&W policies only cover breaches that were unknown, “historical,” or related to issues that were not disclosed by the Seller.
The impact of the virus on the workforce, including layoffs and supply chain disruptions will be the focus on enhanced due diligence in particular, and not considered breaches. Claims related to a drop in revenue are right out the window. These will be excluded, but perhaps covered in another M&A related policy, such as business interruption insurance.
That being said, you can limit exclusions for specific things related to the pandemic, not just anything COVID-19 – that exclusion would be too broad. Despite its seriousness, the pandemic can’t touch every rep. So expect very careful language.
Since R&W policies are largely written for each individual transaction, a broker has the ability to identify the right Underwriters and products and make the exclusionary language in a policy as favorable/narrow as possible for the policyholder.
Take the Fraud Exclusion for example. Fraud is absolutely excluded in virtually every insurance policy because it’s a moral hazard. However, savvy Brokers and Underwriters can create wording in a policy to provide legal defense of a policyholder accused of fraud until the alleged fraudulent behavior is proven. If there is no proof of fraud, the exclusion cannot be triggered, therefore, a policyholder benefits from the protection provided by the policy. Depending on the rep in question and the amount of diligence shown to Underwriters, a Broker can negotiate wording that can lessen the scope of a COVID-19 related exclusion.
With some M&A transactions, there can be a long period between signing the Purchase and Sale Agreement and actually closing the deal, especially with large and complex deals. For example, it took months for Amazon’s acquisition of Whole Foods to win regulatory approval and close.
Imagine if a deal like this had been done recently, and COVID-19 swooped in during that interim period. Remember, to be considered a breach, the issue must be unknown and/or result from failure to disclose a harmful issue by the Seller.
But a change in the overall economic environment or the industry such as this pandemic, can’t be considered an “unknown” and therefore would not be covered.
Thankfully, this is not much of an issue with lower middle market companies because interim periods between signing and closing are rare, and if there is an interim, it is likely measured in days, not months.
One last thing to watch out for. For now, R&W coverage pricing and deductibles haven’t changed. They should be increasing as more claims are coming in in this time of crisis.
The previous trend had been for consistently falling prices and its use in ever-smaller deal sizes – down to $15 million, which was one of the factors in its growing use by middle market companies. It’s something to watch out for.
To discuss the impact of COVID-19 on R&W and other M&A-related insurance, I invite you to contact me, Patrick Stroth, at pstroth@rubiconins.com.
Many people are concerned about the state of M&A when we get on the other side of the COVID-19 pandemic. Understandable. But as I pointed out in my previous article, “No Significant Drop in M&A Activity During This Recession,” I don’t believe M&A activity will be going south, post-crisis due to:
Now, a new report from Deloitte has shed some new light on the situation and reconfirmed my insights.
In “Opportunities for Private Equity Post-COVID-19” they discuss how in these uncertain times and ongoing economic crisis, the organizations ideally positioned to help out the economy and business, and even countries get back on their feet, are PE firms.
Why?
They have plenty of cash, and they are willing to go the Island of Misfit Toys, so to speak, and find gems to invest in. They have the patience to get in at a low cost and turn a company around.
PE firms are unlike other investors in that right now, they have the capital, resources, and occupational experience to turn struggling companies into high flyers. That’s simply what PE firms do in good times… and have a unique advantage in these bad times to keep working their magic.
A lot has been said in the poplar press about how PE firms swoop in on broken down companies then turn around and sell them for 10 times more. The perception is that they pulled a fast one or took advantage.
I think this misconception goes back to the movie Pretty Woman and other depictions in pop culture. In that movie, Richard Gere plays an investment banker who buys companies and sells them off in parts after loading them with debt… in the process ruining peoples’ lives.
Contrary to popular opinion, that’s NOT what PE’s do. They’re closer to house-flippers. They’re turnaround specialists. They do the good work of creating value where there was none before.
In this crisis, I believe PE firms will be the heroes and instrumental to a broader economic turnaround. They do good work, and it’s needed now more than ever. And nobody else is going to do it, with Strategic Buyers biding their time and holding on to their cash.
Companies struggling right now, and there are a lot of them, should not expect a government bailout. Most companies, even if they secure some of those funds, will not get what they need to move forward.
Another issue is that employees are getting laid off and collecting more in unemployment and other benefits… and that employers are concerned they won’t be able to get their experienced people back.
These are certainly uncertain times, and I think the attitude you should have moving forward is one espoused by Warren Buffett:
“Be fearful when others are greedy and greedy when others are fearful.”
We can also base this assumption of the rise in M&A activity tied to PE firms by looking to the past, specifically to the economic crisis of 2007 and 2008.
Back then, PE firms, along with other investors, sat on the sidelines. There were many opportunities that were not taken advantage of.
They’ve learned their lesson, and this time they will be aggressive in going after the low hanging fruit. PE firms are generally well ahead of public opinion on these sorts of things. The smart money gets in early, which, in this case, gives them a nice window in the next two years to get some great deals.
Lower middle market companies, those most at risk and vulnerable in this downturn, in particular will see lots of activity. These smaller businesses are easiest to make a quick investment in, without many other suitors.
For investors buying distressed assets, Representations and Warranty (R&W) insurance becomes more important than ever. This coverage makes deals clear, smoother, and more affordable.
For Sellers, not having the burden of a large escrow is a key benefit when they need cash to do other things.
For Buyers, R&W insurance is a “back stop” for risk. If they are buying assets, they won’t get a remedy otherwise if there is an issue post-closing and the escrow is not enough to cover the loss. With R&W coverage you get certainty of collection if there is a breach.
The great news is that R&W policies are now at the most favorable pricing they’ve ever been, and deal sizes as low as $15 million are eligible.
If you’d like to discuss coverage, pricing, or market conditions, please contact me, Patrick Stroth, at pstroth@rubiconins.com.
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.
