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.
D&O Liability Coverage Versus TLPE Insurance
As I’ve written in the past, there are many founders of small- and medium-sized, privately held companies that simply don’t see the need for Directors & Officers (D&O) liability coverage.
I won’t argue the merits of D&O insurance here.
But, the reality is that when those owners try to sell their companies, that lack of coverage will come back to bite them.
Buyers, in this case, will almost certainly require a D&O “tail” policy to make sure the Seller is held liable for any wrongful acts against employees or others – things like human resources issues or fraud – committed before the closing date but that didn’t come to light until after closing.
The Buyer doesn’t want to be held liable or pursued by claimants for incidents that occurred before the purchase. So, they require coverage that extends for up to six years after closing.
Essentially the Buyer is looking for a layer of protection from any potential issues caused by the Seller.
For transactions where the Buyer is carrying Representations and Warranty (R&W) insurance, the D&O tail policy will still be required as many R&W insurance carriers will want to insulate the Buyer’s R&W policy from possibly being used to pay any Seller-related claims that incur financial damages.
A D&O claim could even represent a breach. But, the D&O tail provides protection for the Buyer’s R&W policy. The tail policy will also fit nicely into an R&W insurance deductible.
Here’s the issue:
For transactions under $20M in EV, traditional R&W coverage cannot be used. In this case, I think a new insurance product, Transaction Liability Private Enterprise, is a viable alternative to a D&O tail policy.
TLPE insurance is designed for smaller deals. Retention is only 1% of EV or $10,000, whichever is higher.
It is a Sell-side R&W policy where the Seller, rather than the Buyer, is the policyholder. TLPE policies are triggered when a Buyer submits a written demand for damages from the Seller.
Here are the reasons why I think TLPE insurance can replace a tail policy:
Most post-closing D&O claims actually come from Buyers alleging Sellers misrepresented something about the company. While a D&O tail policy can provide the Seller with some legal defense coverage, these policies specifically exclude contractual liabilities. Therefore, breaches of the purchase and sale agreement will likely be excluded. Buyers sometimes work around this by alleging fraud, which a D&O tail is compelled to defend.
TLPE policies are written specifically for Buyer claims of breaches of the sales contract, so no exclusion workaround is necessary. With TLPE insurance, there is no contractual liability exclusion. This makes TLPE insurance infinitely broader in scope than a D&O tail policy.
Depending on the amount of insurance, a TLPE policy may be less expensive than a D&O tail policy. Both policies generally run for a six-year term.
Of course, for deals above $20M, TLPE insurance isn’t available. When faced with bigger deals, D&O tail insurance, which I feel should piggyback on a traditional R&W policy, is the only option.
If you’d like to discuss TLPE coverage, I’m happy to fill you in on the benefits of this unique insurance product. Please contact me at any time at pstroth@rubiconins.com.
The Biggest Impact of TLPE Insurance
Transactions—the major decisions in the life of a business—impact both Sellers and Buyers.
In a standard transaction, a Buyer will request that money from the purchase price be held in escrow. While I’ll admit there is a strong argument justifying these requests, there are viable alternatives.
Why do Buyers Want Holdbacks?
Often, there’s not enough data available for both parties to reach an adequate level of certainty when it comes to risk, so Buyers use escrows/holdbacks as a hedge. This way, the Buyer can immediately respond to a breach, if one occurs, and they’re holding some cash from the sale.
The amount held back is usually 10% of the purchase price. This may be reasonable to the Buyer, but it can be quite significant for Sellers of small companies looking for an exit.
Recently, Representations & Warranty insurance has emerged as the most significant risk transfer solution. With this coverage, if there is a breach of the Seller reps, the Buyer can recover any losses without going after the Seller. The Buyer simply makes a claim with the insurer.
R&W coverage is easy to purchase, claims are paid, and it works. Thus, it has become increasingly popular in the M&A world.
The Wrinkle in R&W Insurance
There is a wrinkle, however, because R&W isn’t readily available for sub- $20M EV deals.
But there is a solution:
Transaction Liability Private Enterprise Insurance (TLPE).
Unlike traditional R&W insurance, TLPE is a sell-side policy where the Seller, rather than the Buyer, is the policyholder. The policy is designed trigger when the Buyer makes a claim against the Seller. Instead of going after the Seller directly, the Buyer simply collects from the insurer. Easy.
Think of TLPE as a simplified version of R&W coverage that can be placed in days rather than weeks at a fraction of the cost.
Sellers benefit from this insurance as well, and we’ve seen the results first-hand. The lesson we’re learning after 10 months of small business placements is that TLPE is effectively reducing escrow levels from 10% to 1% of the purchase price. (TLPE is only 1% of EV or $10,000 whichever is higher.)
Some examples from recent deals include:
I regularly hear from M&A professionals who say that R&W coverage, including TLPE policies, removes a significant amount of stress from the process.
One big reason may be that Sellers are closing with significantly more money in their pockets at no cost to the Buyer. That’s a nice goodwill gesture, to be sure.
If you’re looking to reduce risk when you sell for less than $20M EV and increase your closing payment, TLPE is the best way forward.
Please contact Patrick Stroth, for more information at pstroth@rubiconins.com.
If you’re a sell-side advisor… investment banker, business broker, or an insurance agent… I have some news for you:
If you aren’t at least discussing Transaction Liability Private Enterprise(TLPE) as an option to cover an M&A transaction, you are doing your SME clients a serious disservice.
In many cases, these business owners simply don’t understand the risks they face, even after the deal closes or how TLPE coverage, which is offered by London-based CFC Underwriting, could protect them. They made be very good at what they do, but they are often not sophisticated about the intricacies of M&A.
There are four main areas of concern:
TLPE eliminates the need for large Buyer Escrows/withholds. Most Buyers require 10% or more of the purchase price to be held for a year or two to ensure there’s money available to throw at costs arising from breaches. TLPE policies are designed to replace the escrows, and with their lower retention levels, there’s no need for Sellers NOT to collect at least 99% of the purchase price at closing with no risk to the Buyer. I’ve personally placed policies(more than one) that reduced Buyers’ escrows by over $1M!
Problem is that a Buyer can make a claim against a Seller up to six years later for an alleged breach of a purchase and sale agreement. You can’t run from your contractual obligations.
This can be very expensive if the Seller is found to have breached a Rep or Warranty in the sale contract. Expensive as in they’re on the hook paying the Buyer for loss incurred and legal costs. In some cases, they could be most, if not all, of the money they made from the sale of the company.
Having TLPE coverage in place provides protection.
This is when a Seller makes an untrue statement about their company. They’re not doing it maliciously or willfully, so it’s not fraud or negligence. Yet, it is not true, which is a big problem.
How could an owner not know something so important about their business? In today’s quickly evolving regulatory environment, these “blind spots” can crop up.
Again, a misrepresentation like this can result in a claim that the Seller has to pay. With TLPE insurance in place, the insurer will pay the claim.
TLPE coverage is easy to get, with no underwriting necessary. And the Seller is able to reduce their holdback. Retention with TLPE in place is only 1% of enterprise value or $10,000 whichever is higher. This helps the Seller keep most of the sale proceeds right after closing.
For example, I recently brokered TLPE coverage for a deal in which a sports apparel manufacturer bought a high-performance glove wholesaler for under $2M. The process took two days and cost just $20,000. The TLPE policy enabled the Seller to reduce the Buyer’s holdback from $140,000 to $14,000.
In another case, the owner of a $12M SaaS company was able to negotiate a $1M+ reduction on the Buyer’s escrow by securing TLPE, a savings of more than 10x the policy premium.
In short, TLPE, which was created to specifically protect small business Sellers, is ideal for SME owners.
If you have any questions or would like to explore the protection TLPE coverage could off you or your clients, please contact me, Patrick Stroth, at pstroth@rubiconins.com.
In this era of sky-high valuations, PE firms seeking inorganic growth are increasingly looking at an alternative to acquiring fully built out platform companies.
The strategy is to buy a platform that is not fully built out yet and available for a lower price and then “add on” other small companies. Not only are these acquisitions cheaper, but they are also easier to transition into the platform, which helps accelerate growth.
This trend has also led to increasing adoption of two unique M&A insurance products that have been available for a couple of years but were not widely used until now.
More on that in a moment. But first, why are valuations so high?
Well, 2021 was a banner year in M&A, with 8,624 deals with a combined value of $1.2 trillion. That’s 50% above the previous record for deal value in a single year.
What brought about all those deals? As Pitchbook in the 2021 US PE Breakdown:
“GPs were motivated by the availability of debt, the wave of sellers coming to market to avoid anticipated tax hikes, and the urge to deploy capital quickly in order to return to the fundraising market. Many industries, if not most, experienced intense competition for deals as a result, and multiples elevated to 2019 levels or higher in 2021.”
On other words, it’s a seller’s market, with intense competition for target companies pushing prices higher.
A compelling trend has emerged out of all, says the Pitchbook report:
“The current deal climate has been particularly conducive for buy-and-build strategies, and add-ons as a proportion of the number of total US buyouts reached an all-time high of 72.8%. During the market dislocation in 2020, firms had turned to add-on dealmaking to continue deploying capital with diminished risk, because add-ons are typically smaller deals and the GP has a firm grasp on its platform.”
As I’ve written before, PE firms these days use Representations and Warranty (R&W) coverage to protect their deals as a matter of course. It’s become standard. So, it’s no surprise that they’ve sought out similar insurance products when doing add-on acquisitions.
Add-On Insurance
For transactions under $20M in deal value, PE firms use Transaction Liability Private Enterprise (TLPE) insurance. For example, I recently brokered TLPE coverage for a deal in which a sports apparel manufacturer bought a high-performance glove wholesaler for under $2M. The process took two days and cost just $20,000.
By having this TLPE coverage in place, the Seller was able to reduce their holdback from $140,000 to $14,000— matching the policy retention. The standard retention level for TLPE is 1% of enterprise value or $10,000, whichever is higher. Compared to the usual escrow or holdback of 10% of purchase price, no wonder TLPE is so popular.
As this manufacturer looks at other add-ons, they will again look to be covered by TLPE insurance, which offers six-year policy periods with a limit that is 100% of enterprise value. TLPE isn’t just for Sellers. Now Buyers can be named as Loss Payee in a TLPE policy which ensures faster collection from covered losses.
What about strategies where the planned add-ons are expected to be above the $20M TLPE threshold? CFC Underwriting has created an innovative coverage called a Portfolio Policy where an initial portfolio platform is underwritten and insured by CFC consistent with a standard R&W policy. The Portfolio Policy can grow as companies are added to the platform at a discount.
Under the Portfolio Policy, R&W coverage is arranged for the PE’s platform investment. As add-ons are brought in, the Portfolio Policy is amended to add new limits for each new entity brought on board. Each new Limit is independent of the other acquired entity Limits, so there’s no dilution as companies scale.
The thinking is that the Underwriters who underwrote the original platform acquisition will be familiar enough that it will save time and money on the underwriting process (lower UW fees and discounted premium rates.)
They can see how the new add-ons fit on the platform and will understand the investment theory of the PE firm making the decision to acquire the add-on. In other words, they are already familiar with the key players and aren’t coming at this fresh.
With familiarity comes comfort and Underwriters can add new companies to a platform for a fraction of the underwriting fee because they’ve already done most of the legwork. Considering the increasing costs for R&W, a scalable product should be a welcome alternative. Another perk: processing time will be cut down as well, with the underwriting call cut in half at least.
If a PE firm is going into an acquisition and knows upfront that add-ons will be bought, the Portfolio Policy is the correct route.
Otherwise, they should go with traditional R&W insurance for the platform. For add-ons they could go with another R&W policy if the enterprise value of the add-on is above $20M. If it is lower than $20M, TLPE is the way to go.
When seeking out this specialized and relatively new M&A insurance, it’s best to reach out to an insurance broker experienced in this type of coverage
I’m happy to help. You can contact me here at pstroth@rubiconins.com.
