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.
We’re well into the second half of 2021 now…and Representations and Warranty insurance is more popular than ever. Given the protection it provides both Buyers and Sellers in an M&A deal that should be a good thing.
However, that popularity, based on the trust both sides of the table have placed on this coverage, has also brought about an unintended consequence that has resulted in PE firms and Strategic Buyers scrambling to get their deals covered.
Here’s the deal: insurance companies are declining to cover otherwise great risks due to bandwidth. In other words, they don’t have the teams of Underwriters they need to research and understand the deals and then determine coverage and terms for all those parties wanting coverage.
As a result, if your deal is under $400M in transaction value (TV), you can’t go to one of the major nationwide insurance brokers. They’re just stretched thin and are concentrating on the deals that will bring in the most substantial fees. They’re no longer looking at $100M or even $200M deals.
So, at this point, if you come under that threshold and are interested in R&W insurance, you must find a boutique firm to secure your coverage.
Why is this happening… and why now?
There are a few factors:
More M&A activity = more demand for R&W insurance.
Who Is Behind This Trend?
M&A activity is at record levels right now, across the board. Driving demand are:
3 Steps to Take Now in Light of This Trend
Despite these trends, all hope is not lost to secure R&W coverage this year, even if you’re deal is under $400M in TV. But you do have act quickly and put in some extra effort to make an insured deal happen. (And you should still prepare yourself for waiting until 2022.)
Here’s what you should do now:
1. Line up all your diligence experts right now, e.g. lawyers and accountants.
R&W policies right now are being placed on $400M TV deals and up. If your deal is smaller than that, look for boutique broker. Go to solid, experienced regional boutique firms in law, accounting, and insurance to get response you need. If you need a Quality of Earnings report, the big 5 nationwide accounting firms won’t touch you at this point.
Contact these smaller firms and get on their calendar now.
2. Engage with an experienced, boutique regional R&W insurance broker now. The sooner you get your engagement lined up, the better, even if you are at the Letter of Intent stage.
In both cases you want to avoid the backlog at bigger, national/international players.
3. Expect and plan for increases in diligence costs, insurance costs, and R&W premiums. The sooner you act, the better as costs continue to rise. It’s simple supply and demand.
To give you an idea, the total cost for a $5M Limit R&W policy was under $200,000, now it’s running $225,000 to $240,000.
But also remember that the protection and peace of mind these policies offer is well worth even the increased costs… and all things considered this coverage is cheap.
As you can see, there is real urgency here.
If you’ve got a deal in the pipeline and are thinking of using R&W insurance to cover it, we should talk now so I can help guide you through the process.
You can contact me Patrick Stroth, at pstroth@rubiconins.com.
An innovative new product, very similar to Representations and Warranty (R&W) insurance, is available now and will provide coverage for small, or “micro,” M&A deals.
Transaction Liability Private Enterprise (TLPE) insurance is available for deals with a Transaction Value of $250,000 to $10M.
London-based insurer CFC Underwriting is the company behind this innovative new insurance product, and with 230,000 deals in that range of TV, they decided to go after this underserved market.
While similar to more traditional R&W insurance, TLPE coverage differs in key ways, and not just in that R&W is intended for much larger deals.
One of the most noteworthy differences is that TLPE policies are sell-side only, which means they are triggered only when the Buyer brings a claim against the Seller because of a loss caused by a breach of the Seller representations in the Purchase and Sale Agreement.
Also, deals can be insured for up to 100% of enterprise value.
This is a very new product. Not many people have heard of it. But it definitely reaches an underserved market, and many Buyers and Sellers involved in micro-deals will get a lot of value out of it.
(If you haven’t already, I’d recommend you read my first article on TLPE insurance to get more of the basics about this unique coverage.)
Why Is TLPE Insurance a Good Idea?
Securing TLPE coverage is a no-brainer if you’re involved in a deal under $10M. TLPE insurance is new, it’s just launched. It’s meeting a big need out there.
And while this may be controversial… I’d say it’s as good as R&W coverage, if not better in some cases.
It’s better for Sellers, that’s for sure. Here’s why:
1, Availability
In professional sports, the greatest “ability” is “availability”. You may be the best athlete, but if you don’t show up on game day, your talents are useless to your team.
By the same token, R&W insurance is an invaluable tool. But it’s simply not available at any cost to the lower middle market transactions.
2. The Cost
The cost of a sell-side TLPE policy is less than a similar sized R&W policy, by as much as one-third. There are several reasons for this.
3. No Underwriting Fee
In addition to lower premiums, there is no underwriting fee for TLPE. These policies are underwritten by the Seller completing an application (just like any other insurance policy). Underwriters then use that application as a basis for evaluating risk. This method reduces the overall cost for the program by $35,000 to $50,000 per deal.
4. The Deductible Is Less
To further reduce costs, the retention, or deductible, for TLPE policies is significantly less than a traditional R&W policy. TLPE will feature deductibles as low as $10,000, all the way up to $100,000 for a $10M limit – that’s 1%. Compare that to R&W with a minimum retention of $250,000 to $300,000.
5. Lower Escrows and More Cash at Closing
The lower deductible enables Sellers to negotiate lower escrows, or withholds, with Buyers. This further increases the amount of cash Sellers get at closing.
6. Sellers Are Not Beholden to Buyers
With TLPE insurance, Sellers are not forced to ask permission of Buyers for protection from breaches of Reps and Warranties. In a traditional R&W policy, no matter how much the Seller wants it or thinks they need it for peace of mind, if the Buyer doesn’t agree to include coverage in the deal, it doesn’t happen.
The alternative in the past was a traditional sell-side R&W policy. However, the Underwriters on sell-side policies in these cases would not be able to rely on an application as they do with TLPE.
In fact, they would conduct even more stringent due diligence. This costs more and can even limit coverage because Underwriters are not equipped to underwrite R&W on that side. (In buy-side policies, they rely on the Buyer’s diligence.)
Sellers don’t need the Buyer’s input at all for underwriting a TLPE policy as everything hinges on the Seller’s input, not the Buyer’s. Seller’s seeking peace of mind can acquire it entirely independent of an uncooperative buyer.
7. The Short Timeframe
The underwriting time in TLPE is in most cases a matter of days, definitely less than a week. Compare this to the minimum timetable for traditional R&W insurance underwriting of two to three weeks from beginning to end.
8. Peace of Mind
The Seller has control of policy placement and coverage terms, which means they feel better knowing that whatever proceeds they’re supposed to get from the transaction… they are going to keep.
9. Legal Defense Costs Covered
A sell-side TLPE policy provides legal defense to help the Seller against Buyer claims. The lawyer for the policyholder (Seller), who will protect them and try to negotiate a lower settlement, is at the cost of the insurer, not the Seller. It’s built into the policy.
With traditional R&W insurance, even if there is a claim brought by the Buyer, the Seller would have to engage an attorney to respond to make sure they aren’t taken advantage of. In fact, the Seller usually isn’t involved – the Buyer is taking action against the insurer to get their claim paid.
But if the Seller has a $1M to $3M escrow they still need their own attorney for that piece of it.
Where to Go Next
If you have an upcoming deal under $10M, it’s clear that if you’re the Seller, TLPE is a must-have.
If R&W is Wall Street, then TLPE is Main Street. Insurers in this space want to insure mom & pop retail stores, franchise restaurants, small tech companies, or maybe a small manufacturer.
The cost is super low thanks to the three ways TLPE saves you money (lower deductible, no underwriting fee, more cash at closing), the process is quick and easy, and this new type of insurance offers a lot of protection to make sure you take home the proceeds you deserve from your sale.
All this being said, there is a key similarity between TLPE and R&W coverage:
The claims paying ability is no different between the two. You can count on great claims services with TLPE, just as you’ve heard about R&W.
I’m happy to speak with you about both TLPE and R&W insurance, whichever is most appropriate for your deal. It is important to work with a broker experienced in TLPE insurance when trying to secure this coverage as there are key conditions and limitations.
And one last thing about TLPE:
10. TLPE Policies Can Be Placed Post-Closing
This means if you did not get protection for a previous deal, and it is in that $250,000 to $10M range, it can actually be revisited if you’re interested.
To get more details on how TLPE might fit your specific deal, be sure to contact me, Patrick Stroth, at pstroth@rubiconins.com.
In recent years, Representations and Warranty (R&W) insurance has become available to smaller and smaller deals.
The eligible deal size dropped to under $20M… then under $15M. This is already quite a feat when you consider that the average transaction value (TV) for deals with R&W coverage in place is $500M. And to be honest, most insurers won’t go lower than $100M—Underwriters are already backed up on processing policies and insurance companies don’t always want to take the time to work on smaller deals that won’t generate large amounts of fees.
Now, for the first time ever, this unique type of coverage is available for deals with a TV of $250,000 to $10M. This opens up R&W coverage to a whole new universe of deals.
How did this breakthrough come about? As with many business ideas, someone saw a gap in the market and decided to fill it with what is officially called Transaction Liability Private Enterprise (TLPE) insurance.
According to CFC Underwriting, the London-based insurer that innovated this new insurance product, there were 230,000 deals in which the TV was between $250,000 and $10M. They decided to create a product for this vast unserved market and came up with TLPE insurance as the first to market solution.
Here are the basics on this coverage, which is available worldwide:
Covered industries include professional services, technology service and product businesses, transportation and aviation, and insurance brokers. CFC generally declines deals involving businesses in healthcare, financial services, oil and gas, mining, pharmaceuticals and regulated industries (such as telecommunications).
How It Works
Similar to standard R&W insurance, TLPE covers innocent misrepresentations made by the Seller to the Buyer.
This provides the Sellers peace of mind because they know they won’t have to risk some or all of their proceeds from the deal in the event of a breach. On the other side, Buyers enjoy a feeling of confidence because there is a guaranteed source of funds available to cover their loss.
Unlike the vast majority of R&W policies, TLPE is strictly a sell-side product. The policy is “triggered” only by a claim brought by the Buyer against the Seller for a loss caused by a breach of the Seller’s representations in the Purchase and Sale Agreement.
As part of this coverage, the Seller is entitled to have their legal defense to contest the Buyer’s claim paid for by the insurer. Underwriters have full authority on the selection of the Seller’s defense counsel, which enables them to control claims costs. The insurance company will also cover any damages or settlement amounts.
Something not in a standard Buyer-side R&W policy is the exclusion for Seller fraud.
While no insurance policy will cover known fraudulent acts, TLPE will pay the legal fees to defend the Seller against allegations of fraud. However, they will cease providing defense costs if actual fraud is established in court.
Important: if the Buyer sues the Seller for something not related to a breach, the insurer does not provide legal defense.
Quick and Easy
TLPE offers streamlined and cost-effective underwriting:
This quick and easy process is possible because the Underwriters are not viewing the reps. They’re not looking at the due diligence collected. They are simply underwriting the application that the Seller provided.
TLPE in Action
TrenData is a Dallas-based SaaS company that offers various human resources services. A larger human resources technology firm was planning to acquire them. The TV was about $5M.
What held up the deal was the Buyer insisted that in the event of a breach of the intellectual property (IP) rep, that the target company would be responsible for any legal expenses or loss. At the same time, the Buyer would retain the sole authority for selecting their own legal counsel and determining the legal strategy.
As the target company noted, this is like essentially writing a blank check. The Buyer could easily hire high-priced attorneys and/or drag the case on and on. They would not go for it.
Neither side would budge on this issue, and it seemed like the deal was lost.
However, less than a week later, the Seller reached out to my firm, Rubicon Insurance Services. We discussed TLPE coverage and how it could work in this deal. The Seller contacted the Buyer, and once they found out that the Seller would pay for the policy, that legal costs would be covered in the event of a loss, and that the deal could be insured up to the full $5M in TV…the gap between the two sides was bridged and the deal closed within a week.
What to Do If You’re Interested in Coverage
TLPE seems simple enough. However, there are key conditions and limitations with this new product. So it’s essential you have an insurance broker experienced in M&A handle the process of securing this coverage.
Something to keep in mind: TLPE policies can be placed post-closing, so if you were unable to get protection for a previous deal, it can actually be revisited.
If you’re interested in seeing if TLPE coverage could be a fit for an upcoming – or past – deal, you can contact me, Patrick Stroth, at pstroth@rubiconins.com.
Our guest for this week’s episode of M&A Masters is Scott Hendon of BDO. Scott has been with BDO for 20 years and currently serves as the National & Global Practice Leader for Private Equity. A true icon in M&A, he brings a unique perspective as he knows both the investment side and the service side.
Today we sit down with him to talk about the recently released Spring 2021 BDO Private Capital Pulse Survey Report. The survey polled 100 private equity and 100 venture capital middle-market fund managers across the United States.
On the show, Scott talks about the key takeaways from the report and offers his insights into:
Patrick Stroth: Hello there, I’m Patrick Stroth, President of Rubicon M&A Insurance Services, and trusted authority for transactional liability. Welcome to M&A Masters where I speak with the leading experts in mergers and acquisitions. And we’re all about one thing here, that’s a clean exit for owners, founders and their investors. I’ve got to say just on a personal note, real quick. When you’re doing these interviews, your big dream is to have a monster guest who’s breaking some news out there.
So I no pressure to my guest, Scott here. But this is something I’m very, very excited about today, because we’ve got a true icon in mergers and acquisitions in America right now. Today, I’m joined by Scott Hendon. national and global practice leader for private equity for BDO. BDO is the fifth largest accounting firm in the world that generates over $10 billion in annual revenues, has 191,000 employees working in 167 countries. So it’s a special treat to have Scott here because today we’re going to talk about the newly released BDO private capital pulse survey report, which was just released. Scott it’s a pleasure to have you. Welcome to the podcast.
Scott Hendon: Thank you, Patrick. Maybe just a little bit about myself. Well, as you said, Scott Hendon here and I just to cover a little bit about my background. I’m, originally from Lubbock, Texas, I moved to Dallas, Texas about 35 years ago. Went to Texas Tech University. I got an MS in taxation, I started my career at Arthur Andersen. And I’ve been with BDO for 20 years. I learned early on in my career that I wanted to get into private equity. So it didn’t take a brain surgeon to figure out that there’s a lot of money in motion, a lot of action. So I really wanted to get into the private equity side.
And once again, I realized that there’s a lot of services, and a lot of value that you could add to private equity. So as you said, once again, I’m a partner at BDO and I currently I’m the national and global leader of the private equity practice. I’m also on the board of directors for BDO USA. And I’m also on the board of directors of BDO capital, which is our wholly owned Investment Bank of BDO USA. Besides actively coordinating services and resources for private equity clients globally, I’m also an active investor. So I also invest in private equity and invest in pre spac deals, PIPEs and CRONs so I have a unique perspective. And I know both the service side to the private equity funds, as well as being an investor in there.
Patrick: So you’ve been on both ends of the table, probably, you know, there are four, four sides to a table. You’ve been on all four of them.
Scott: That’s right. And it’s been very good to me on all sides, there, Patrick.
Patrick: Outstanding. So let’s talk about the private capital pulse report. How did this come about? What is it about? And give me some comments before we get into details.
Scott: Sure, so first of all, the we’ve been doing the private equity survey for over a decade, I will say that it used to be a lengthy report that we did every 12 months, and we track year over year, what the trends were. And once again, we interviewed 200 private equity firms, or I’m sorry, funds, 100 private equity and 100 venture capital funds. So that had been working great. And we’ve been doing it for over a decade, we had a big following. It’s covered by the press very well. Then we came into to 2020. And we did back then we’re doing one survey a year. So we did our questions in late February, early March.
And then we published in early April. So as you can imagine, the change that happened between February to April in 2020. The, it was really you know, once again, a lot of the data, a lot of stuff that we’re tracking, and it just wasn’t relevant, right? Because obviously COVID was the thing of the hour. So we pivoted on that and we went to more concise reports. It’s our current pulse survey. And we’re doing that two times a year. So we do a spring and a fall. So we just released our spring, and we’ve done a release for Fall of 2020.
And I think it’s a lot better. It’s more concise. It covers a lot of the major issues out there. But more importantly by doing it every six months, it allows us to have a better beat on fund managers. You know, it’s more frequent. It’s, we can tell what emerging trends are doing, you know, real time sense of what’s going on. So, once again, that’s kind of the history of that and once again, we get a lot of following out there, it’s when we get a lot of coverage globally in regards to what’s coming out of the survey.
Patrick: Well, that’s a good clever name having a private capital pulse. Because if you’re doing this a little bit more, as real time as you can, you are on the pulse of thing. So yeah, you know, kudos to your marketing department to come up with with with that good title there. We can go in a lot directions with this on this because it is a big report. But why don’t we just get get a little macro first? All right. What’s the marketplace like for deals for private equity, you know, specific to mergers and acquisitions?
Scott: Sure. So first of all, at a high level, and then I’m going to dig down a little bit into to the survey. But as we sit today, the activity is incredible. So q1 of 2021, it’s one of the best quarters that the BDO private equity practice has ever seen. So that’s kind of where we’re at today. Now, if you roll back to 2020, not to look back, always looking forward. But you roll back to 2020. Yeah, there was two and a half trillion dollars of dry powder sitting there on the sidelines, deals were frothy.
This same from January to March, everything was going great. You know, pricing was good. Then COVID hits in March. And then from March, yeah, exactly. From March to June, the deals basically all got pulled back, everything came to a screeching halt. The banks weren’t loaning the private equity funds, we’re just trying to hunker down and figure out, you know, how to how to thrive and how to be resilient during the COVID crisis. So anyway, so there’s little activity from March to June. And starting in June, I think the private equity funds we’re getting a lot more comfortable and how to do due diligence, how to mitigate the risk.
Patrick: Learn how to work Zoom.
Scott: Absolutely. So anyway, some of the deals started coming back and banks started loaning again. So then you roll forward to the q4 of 2020. And, you know, private equity is very resilient, they figured out how to adapt. And so the deal flow, all the old deals, were coming back on the market that were pulled. A lot of new deals, a lot of people because of pricings good. I think a lot were saying, hey, are we going to have another wave of COVID or some we’re anticipating potential capital gains increases.
So we just had this tremendous amount of deals come out plus SPACs, were really getting the momentum going out, they’d raise a lot of capital. So q4 was really hot. And then we roll into q1. And just like I said, not to be redundant. But you know, it’s been q1 of 2021, has been extremely, extremely hot in a good time for certainly from the deal market and a lot of activity going on there.
Patrick: Is it safe to say, you know, because we’re still in the pandemic, but I’m going to call this post pandemic right now, for purposes. But would you say that activity and financial strength in this period right now, post pandemic has surpassed the pre pandemic levels? Is that safe?
Scott: You know, I would say it’s right there. I will say just the I think one thing that came in is all the deals that got pulled and put back on plus all the deals coming out. So it has, you know, it certainly is right there. The as far as the banks, the lending, you know, everything’s come back with a vengeance. It’s, it is amazing how resilient and resourceful that private equity has been. And I’ll go into maybe a little bit later on some of the things we’re saying the survey, but certain things have changed out there. You know, the what tailwind companies and certainly there’s young, there’s new industries, you know, a lot of digitalization other things, but man, the the market is, is really good. I’d say it’s as good or even better than pre pandemic.
Patrick: I would say, I would want to ask, as you get in just you could take whatever direction you want, but you had a section on there for key competitors. And one of the things I find this very encouraging about mergers and acquisitions, just the American economy, in general is just how it is constantly expanding is constantly evolving. And you just look at the number of private equity firms out there five years ago, you know, there were maybe 1000 private equity firms, or just over 1000 there are 4000 plus private equity firms now, yeah, I think it’s closer to 5000 just in the US. So, you know, let’s draw from that. Let’s talk about competitors in this landscape now.
Scott: You bet. So I’m gonna in that I’m looking at my survey here too Patrick but yeah, so the competition now once again, we did I’m going to do a comparative analysis from the fall survey today so what what’s the we pulling the you know what I’m personally seeing I think it’s consistent what what the fund managers feedback they gave us now, the number one competitor for deals, it’s generally strategics and private equity are kind of one one and two. That’s what we generally see. Of no surprise, strategic buyers came in as what the fund managers thought in the next six months would be the major competitor for deals.
So that came in about 52%. It’s up three and a half percent over the fall survey. One thing that’s really surprising is is that hedge funds and mutual funds. And what the fund managers said in the survey, they said it was it came in the number two spot at 51% said that they would be a major competitor for deals, and that’s up 12 and a half percent since the fall survey. So I was really surprised on that sovereign wealth funds were in at 40.5%, it was up about 4%. And then, PE and VC funds had fallen down usually once again to one or two for what they the fund managers themselves were saying. They said that they thought the most competition, you know, what would be coming out in private equity and VC firms were coming in at the four spot or fifth spot at 35%.
So they dropped eight and a half percent. So a little bit surprised about that. Now, we also just added SPACs, because I think if you look at the the SPAC cycle, you know, if you go back a few years, you know, they were kind of downstream, they were a major player, obviously, today, you know, the major banks, and they’re raising a lot of capital now, they only 23 and a half of them said that they saw the SPACs as a major competitor. So once again, that was a little bit lower than I thought, and we don’t have a comparative analysis. But we’ll we will start tracking that for future service.
Patrick: Yeah, let’s let’s let’s just, you know, focus on the SPACs real quick, because the one thing about the SPAC is, you know, for for us that are in the transaction world, you know, the a and SPAC is acquisition. And so there’s no vehicle that’s more ideally suited for mergers and acquisitions. And for the the insurance in that area, then the SPACs, and while there’s been legislation proposed and rule changes proposed as really cut off the SPAC IPO activity, you still have over 400 SPACs out there looking for an acquisition the next two years. And so, you know, I agree with you, their presence just showed up overnight. And you know, it’s still early in the game. But I mean, what are your feelings of these of these SPACs out there in the marketplace?
Scott: Yeah, so first of all, I think just what we’re seeing on the survey, I think it’s just the the magnitude of the site, you know, there’s so much capital out there. I don’t, I think SPACs, you said that it had slowed down somewhat, you know, SPACs, you’re right, there’s over 430 SPACs, looking for acquisitions, I think maybe 100 have been identified, but they’ve raised a lot of capital, and they’re, they’re coming out with really good prices. And if they don’t get their acquisition within a 24 month period, they have to give the capital back. So certainly, you have SPACs that are out there. And I see this long term too, it’ll continue out there that you’re talking about, the SEC came out with basically just an interpretation of how warrants should be accounted for.
So you had that out there cut, there’s a quite a few restatements that are going to be done. But you know, the SPAC market slowed down quite a bit in the pipes have kind of slowed down as well. But I don’t I don’t see that as a long term effect. I think the main thing is that there’s so many out there looking for deals, I think that, you know, some of the IBs, you know, once again, or slowing it down, maybe some are trying to get some people to pivot IPOs. But they’re a great vehicle an option to go public, as you said, there. You know, there’s a lot of advantages on there. If I were to have enough time on on this podcast to go through, but I like it out there, I think it’ll continue will continue to be a competitor out there.
I just think the 23.5% I think the only reason it’s that low is just because the magnitude of all the other players out there, but I can see SPACs still being, you know, a viable option going public, it’s really, you know, it’s a lot easier to do an acquisition related than roadshow, there’s, you can get 50% your capital back. And anyway, that, you know, there’s a lot it generally it’s faster to market than a typical IPO. So there’s a lot of benefits out there. And I will say even though they’re a competitor to private equity, there also have been a really good exit strategy for private equity.
So a lot of PE backed companies, we’re seeing a lot of the funds that are wanting to ensure that their portfolio companies are ready to to SPAC or get into de SPAC transaction. So they’re definitely, you know, competitor on one side, but a great opportunity on the other. And then we’ve also seen some of the private equity funds do their own SPAC raise for certain verticals out there just because once again, it’s a good vehicle to raise capital and go.
Patrick: And you know, there’s got to be exits for somebody in and as, as these portfolio companies are getting bigger and bigger, you need a bigger fish to eat this whale that you develop, you know, from a guppy and so I think is great for the M&A ecosphere, that there’s another place for these bigger exits to go.
Scott: Absolutely. And I will say one thing, I don’t think it had a huge impact on this. But some of the funds, you know, we had a certain number that were under, you know, 2 billion or, you know, of assets or management. The SPAC market, obviously, is the bigger deals out there, too. So that might have had a little bit of impact. But I think, overall, the reasons it’s at 23 and a half percent is just because the size of you know, yeah, the 2.2 $2.9 trillion of dry powder that’s sitting out there.
Patrick: Exactly. You mentioned the reports and key drivers for M&A. Why don’t we touch on those real quick? That’s more of a macro issue as well.
Scott: Sure. Yeah. So great question, Patrick. Now, what we saw in the survey for the drivers of deal flow, or what the fund managers thought would be driving it over the next six months, first of all, the private company sales and capital raises. So that’s it’s at 50% said that would be the major driver. It’s exactly the same as the the fall survey. So those are exactly the same as what I’d expect to see there. One thing that was a little bit surprising was succession planning.
So I think a lot of them think that some of the the generational companies that typically send it on to the next generation, they’re going ahead to exit out maybe it’s COVID, who knows. But anyway, for whatever reason, they they thought that succession planning would be one of the major drivers of deal flow coming up in the next six months. And it dropped from our fall, it was at 37, it went all the way up to 48%. So there’s big a big jump there, as far as the next one down would have been trades to other financial buyers or strategics. That came in at 46.5%. No surprises there, investing in distressed assets was next.
And that actually, we’ve we’ve been expecting, you know, distress assets to come to the market, right, because you kind of wait for the other shoe to drop. But anyway, there, it actually dropped the anticipation on that 2%. But once again, for whatever reason, the banks have been, you know, trying to work out and in a way we’ve seen, you know, there’s maybe stimulus money and other things. We haven’t seen the distressed assets on the market yet, but that they listed that is number four out there.
Patrick: That was a surprise. Yeah, we were, the industry was preparing for a lot more distressed.
Scott: Yeah. And you would expect eventually that’d be the case. But I think that’s what based on what the fund managers are saying or what, you know, anyway, that that was their anticipation of the market. Also on public to private transaction or taking private transactions. They 41% said they felt that would be driving deal activity. So they’re looking for any public companies, even though I would say the public markets have been pretty frothy, as well, anyway, they’re still looking for, you know, key deals out there.
And that was up 2%. Corporate divestitures is, it’s up six and a half percent day. And that’s it proximately 38.5. And with that, in that that makes perfect sense. And because a lot of the company big companies out there trying to shed non strategic businesses lean and mean, lean and mean, get back to their, you know, what they do best and, and jettison out wood and have a clear focus. So whether they’re anticipating to see a lot of investor transactions and a lot of ones that can come out, take, build it, and, yeah, build it out and flip it.
Patrick: Yeah, we’ll see. And the comment I had on is the observation is, is from a conversation you and I had earlier because we’re both old enough to have gone through multiple cycles between whether it’s 9-11. You got the .com implosion, you had the financial crisis. And then now you got the pandemic and in business owners that have gone through that cycle. At some point, I’m sure they’re putting up their hands. And they’re just saying enough. In addition to that, you guys situation is one thing about that didn’t change in the pandemic is time didn’t stop. Everybody’s getting a little bit old.
Scott: Yep. And I think that has a lot to do with where they go back to succession planning, private company sales, for exactly what you said, Patrick, so I agree. 100% on that.
Patrick: One of the other things I found that was that was surprising. This is just one of those being from California. It’s a nice sounding thing. But it’s now in the nomenclature in the boardrooms. And that’s ESG the environmental, social and governance, prerogatives and the issue about that, as its, you know, its ambitious and as aspirational as really good stuff out there. And everybody’s got great intents, but the rules for ESG are still fluid. And if you fall short of those rules that can have catastrophic implications. And you mentioned this, but I didn’t realize this is organizations likeBDO have a solution to that to keep companies abreast of that. Let’s talk about ESG and then what BDO does.
Scott: Absolutely. So first of all, in our survey, Patrick, we added, this is the first time that we added an ESG questions. And what came back on that or survey showed that 94% of the fund managers said that incorporating ESG investment criteria into their investment strategies was a priority to their LPs, and only two and a half percent said it wasn’t important. So I don’t know that I’m surprised about that. But once again, it was a really large number and a very small number that said that it wasn’t important to that to their LPs.
And I think what’s happening out there, no one is going to help out on exits, I think that everybody’s looking at private capital fund managers are feeling the pressure from LPs and other stakeholders to think within sustainable investment framework. So ESG is about your framing decisions to include the consideration of these risk factors. And, you know, they don’t necessarily affect the financial statements directly. But it’s material to the sustainable operation of the company.
And then I know, many are working to incorporate sustainable investment thinking into their business models, or there’s also regulatory issues, metrics that the SEC has gotten, and they’re starting to look at, you know, certainly for public companies, but on the private equity and private capital markets, they’re starting to look at the disclosures that are being made out there. And there’s accountability. And then if you go overseas, certainly the regulators in the EU and some of the other places, you know, they have pretty pretty stringent disclosure requirements they have to do out there. As far as the services that we’re working with the funds to look at how they get system set up to track benchmark and see how they’re doing.
And they’re certain metrics like RPI is or whatever that they track, and they give themselves grades, and then they’re tracking hey, how well are we doing on the various SCG components. And that’s important, both, you know, for them from a business perspective, to report back to the LPS. And I think that there’ll be a premium to the extent you have a company that, you know, following ESG principles that you know, that I think the return on investment will be there as well. And certainly, you know, I think you’ll get a premium on that.
Patrick: Yeah, I think it’s along the book title, you know, the infinite game, you got a long game, a short game, and then the infinite game. And this, you know, dovetails right into that, and it’s just, you know, implementation and, and establishing systems and you know, who better than BDO to come in and monitor and help help firms adjust? So it’s not one rule for everybody, but it’s customized. So I think that’s a, that’s a tremendous value add that you have, right, we can’t have a survey like this without addressing COVID. Okay, and so, and I don’t want to steal your thunder, if you want, you had to send your report has the sentence of this whole event. And and I’ll leave it to you. But talk to me about, you know, how COVID impacted things now going forward?
Scott: You bet. So first of all, it was in our big what you’re referring to, we had that everything’s changed, but nothing’s different.
Patrick: Yeah, everything’s changed, but nothing’s different.
Scott: Let me explain that. First of all, I’m going to go through what the fund’s told us about, you know, how things have long term impacts of COVID-19, especially specifically on deal making. So specifically said digital capabilities of acquisition targets, you know, once again, a key variable in the deals, importance of a robust risk management and acquisition targets. Hire long, long term ongoing valuations for certain industries, clear robust supply chain strategies, because obviously, we saw some of the weaknesses and what can happen when the supply chain breaks down, fewer in person meetings throughout the process, lower long term ongoing valuations for certain industries, and a shorter, shorter due diligence process.
So those are the main points that came out from the survey itself just on long term impacts of COVID. But what do we mean by everything is changed, but nothing’s different. And I’m going to throw out an analogy to you, Patrick. So if you kind of think through think of the forest versus the trees, so if you look at the trees, yeah, there’s new species that pop up, and maybe some grow faster than others. So if you throw that over to what’s going on right now, you know, some industries are faring much better, they actually thrived and grew and grew out of COVID-19.
So you have those, you have certain ways that how we work is changed. So you have a lot of these new industries. And so, you know, from the tree perspective, we’ve got, you know, new species or you know, once again, companies are growing, you know, there’s been a significant change out there. On the flip side, you know, if you look at the forest, I don’t think anything, the overall picture has really changed. So you still need to kick the tires, you still need to connect with leadership, do due diligence, you got to return, get generate return on investment in, you know, the the, the major theses is if you, you know, tend to or properly, you know, build out these portfolio companies, you’ll get superior yields.
And, you know, basically, that’s, you know, the big thing is to find quality deals, basically do smart things do add ons, hopefully you don’t overpay for it. And once again, it’s all about return on investment. I think, fundamentally, that’s what it’s all about. So hence, everything’s changed. And that a lot of the industries and how things are done is change. But nothing’s really different in regards to private equity, and how they invest and what the process is for making their investment.
Patrick: Sound business practices, or sound business practices. And that’s how I got. Okay, so absolutely. Tactics might but not overall strategy.
Scott: Absolutely. Absolutely.
Patrick: Well, now, Scott, this wasn’t in the report. But I do want to ask you just about because you’re with private equity and throughout M&A, what COVID has taught also in recent experience right now is having insurance on M&A transactions, specifically reps and warranties, insurance, and then directors and officers tail insurance and tax policies and so forth. The early returns that we’re getting on all the servers for 2021 rep and warranty is only getting stronger, it’s only getting better, people are buying it more often and bigger policies.
And it’s because the track record has been just outstanding throughout this and private equity, if something doesn’t work, they cut it off immediately. But, you know, don’t take my word for it, you know, as the head, you know, both national and global with, you know, private equity, and they’re in the business of mergers and acquisitions. What’s your perspective on rep and warranty insurance? Good, bad or indifferent?
Scott: Absolutely. Great question, Patrick. And, first of all, the others besides rep and warranty, all all important, but rep and warranty insurance. If you roll back four or five years, you know, wouldn’t it as common and you know, it’s not on some of the bigger deals. I’d say today, almost all the deals about the buy and sell side has rep and warranty insurance. And I think that’s gonna continue and the major reason that they’re getting reps and warranty insurances, you know, first of all from the buyer side. You know, just to start out we’re generally a lot of the you want to negotiate what the major terms of the deals are price and other things.
And usually the indemnification escrow that’s always a non productive negotiation anyway. So we’re you have a seller that’s offering say a 5% indemnity escrow, but the buyer wants, you know, what market is about 10%. So instead of having, you know, negotiations, probably non productive on that, bring in indemnification, or I’m sorry, reps and warranty coverage. And it allows you to basically drop it down, you can drop it down to 1%, which makes the deal the package more attractive to the seller.
And then also, you can negotiate, you know, better better coverage, and you get out of the typical indemnification escrow. Also, it’s generally a longer period where you get a three year coverage period versus a one year so. And then lastly, which I think is really important in you know, a lot of times there’s going to be disputes, right. And it’s a lot better if you have especially a middle market companies, if you have the prior owners that have the sellers are still coming in, they still have some, you know, some rollover equity, but a real important to the business.
The last thing you want to do is being you know, having a pissing match or not sorry for the words, but you know, basically suits or whatever the case is with prior ownership over the indemnity versus if you have the insurance company in there. Once again, it’s not the same same issues, right, you can just negotiate with the insurance company about, you know, settling up on whatever the you know, reps and warranties were. As far as the seller, well, it’s easy, because once again, they just want to get it closed as fast as possible. Reps and warranty insurance allows it to that.
And if you can negotiate a 1% versus a 10%. That means that they get more of the indemnification escrow to them instead of being tied up in a low returning escrow account so they can get more of their money and get it to work. So it’s really a win win. And it’s, it’s, you know, it would be almost uncommon not to see it in most deals these days.
Patrick: Yeah, I would if it’s if it’s done properly for the buyer, if you present the terms to the seller where you either go uninsured with a big escrow and you’re at risk for a major clawback or we’re gonna get this policy for you and your escrow goes from five or 10% transaction value down to 1%. And you can keep the rest of the money because we’re not gonna claw it back. 99 times out of 100, that seller, not only will go that direction, but they’ll happily pay all the cost. So if you’re a buyer, okay, you’ve got all the benefits, you take all the tension out of the room, you get rid of that uncomfortable post closing conversation saying, yeah, that escrow you want to get, we have to, you know, we lost it, sorry, that’s all gone.
Combined that that is free, because the cell is going to pay for virtually bad faith on the buyers part not to bring this up at least be open to bring it up. What’s great is rep and warranty is now available for the add ons where you’re looking at sub $50 million transactions. And those you just pump those out. I mean, and we really appreciate it just in our industry, because the the claims history, and the satisfaction rate on this product has never been higher. And I’m comparing that to any other insurance product out there. So we’re very, very proud of it is great to hear that. Yeah, it’s been embraced by private equity, which does not like spending a lot of money on insurance.
Scott: Yeah, but once again, for all the benefits that you just relayed. And what I did, once again, it just makes sense. It gets deals done. And also it’s just a better way to get it done and get good deals done, get money back to the seller and in also have proper coverage.
Patrick: I’m curious Scott, I know, we didn’t cover this earlier. But was there anything in the report that surprised you?
Scott: Some of the things that I guess that surprised me the most. Well it was just I think we’ve already covered it. But you know, when you had the the mutual funds and hedge funds jumping so far, that I was really surprised about that? I don’t know exactly, you know, we don’t go back and separately interview the 200 poll participants, but that was one I just wasn’t expecting. I know that they do, you know, go out and do direct deals and some of the VC deals, but for them to be in the number two spot, that was really surprising for me.
Patrick: Now, again, you go, the purposes of this is not only to take a quick snapshot back, but then using that data, you know, looking forward, what are some of the trends based on this? And we can find what are the trends you see going forward? You know, at macro micro, whichever you like?
Scott: You bet. So some of the key takeaways from there, we already talked about ESG. So obviously, I think ESG is going to continue to be more important, what we asked the funds on what they thought about asset prices, and 91% expected asset prices to rise in the next six months. So almost virtually everybody thought it would raise and there was about 50%. 50% expected to raise between 10 and 24%.
Patrick: Wow.
Scott: And then you had five and a half that that actually started would rise more than 25%. And we’re talking about a six month period. So what that was, anyway, so I think the key takeaway there, the way things are going, you know, with all the dry powder, the spax out there, prices are gonna continue to go up. So it’s key to kick a lot of tires and make sure you do quality deals.
Patrick: Just like real estate in California. My goodness.
Scott: Hopefully, yeah. So what what happens in the, you know, in 2022, I guess yeah, we’ll see on that. But anyway, that was one of the big things out there. Also, the on taxation of digital services of product. So it actually came in higher than the concern about the rise in capital, capital gains rates.
Patrick: Could you clarify that taxation on digital services? So you are paying tax on Saas kind of services?
Scott: That’s correct. So it’s digital products and services. And I think the reason it’s going to be rising, probably twofold. That one, there’s a lot of, obviously a lot of stimulus money, a lot of expenses that both foreign governments as well as state governments are going to have to cover. And also I think there’s concerns with all the digitalization of products and services that, you know, how do you keep from losing your tax base, because a lot of it, you know, has been hit typically on you know, you have people or you have a physical presence and location.
So there anyway, there’s a lot of activity going out there. From the foreign side, there’s there’s an oecds, kind of a, they’re looking at a framework of how to tax digital services and products, they should have something coming out in the summer. That’ll give some guidance out there. Once again, all this a lot of the states are changing their policies on how to tax digital services and products. And then lastly, I’ll just mention Mexico is another key example.
They just implemented a 16% VAT on digital, electronic or digital services for b2b and b2c. So I think it’s a real it’s a big issue. Once again, I think the countries and states are gonna have to continue to, you know, figure out how they get their tax revenue and how they cover some of the costs. And just with the big changes in a digital environment, you know, it’s real important for to understand what kind of impact that will have on the business, especially in technology businesses.
Patrick: The innovation doesn’t stop at the at the tax level, that’s for sure. So they’re gonna, they’re gonna keep that going. We mentioned Scott that there are now 5000 plus private equity firms out there, they can’t all be BDO clients. So, you know, for our members, the audience out there if they wanted to get you know, not only copy the report, which we will have in our show notes to link up to but how can our audience members find you and get access to the BDO private equity services?
Scott: Well, first of all, Patrick, I would like to thank you for having me on your podcast, but anybody everybody’s free to contact me directly. My email address is Shendon@BDO.com or s h e n d o n@BDO.com. Or you can go to our website at www.bdo.com. Click on our industry, private equity. And there you’ll find contact information. We also there we do have copies of the current as well as prior surveys. We have thought leadership’s and we also have podcasts out there. You can also sign up for to be notified of future surveys, thought leadership or podcasts that are coming out as well.
Patrick: Well, Scott Hendon from BDO, your private equity capital pulse report for 2021. Thank you so much. It’s been a real pleasure having you here.
Scott: My pleasure. Thanks a lot, Patrick.
