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.
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.
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.
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.
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:
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:
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.
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.”
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.
