If you’re involved in lower middle market M&A deals, you should know that Representations and Warranty (R&W) insurance is now available to cover transactions as low as $10M, offering tremendous benefits to both Buyers and Sellers.
This isn’t common knowledge in M&A circles, even though it’s been more than two years since insurers started entertaining sub-$100M transactions.
The pandemic has disrupted the normal route that this sort of news gets out: M&A conferences, where insurance companies share details on product development and product changes.
If I wasn’t sharing this with you now, chances are, you wouldn’t know about it.
That’s why I’m compelled to share that R&W policies created for lower middle market deals are available, and, although costs are rising because of the immense number of deals seeking this coverage, they are cheap – costing $225,000 to $240,000 for a $5M Limit R&W policy.
This makes R&W coverage perfect for add-ons, which have been an increasing focus of PE firms in order to add value to existing portfolio companies.
According to a recent report from Axial, the online platform that connects Buyers and Sellers, “Add-on acquisition activity in the United States has experienced a steady, near linear growth since the early 2000s.”
Axial reports that 90% of acquirers are looking for add-ons right now—it’s a very robust market.
Also noted in the report: add-ons represented 43.2% of buyout activity in 2002 and that had risen to 71.7% by 2020.
Add-ons are often a smaller investment with potential for greater returns.
The benefits to Sellers in an add-on deal are:
Overall, this type of deal allows Sellers to strengthen a “weakness” keeping them from the next level. And the outlook for add-ons keeps getting better and better because Buyers in these deals are focusing on blending company cultures more than ever before. Add-ons are being done more “thoughtfully,” with conscious attention brought to successful integration—it’s not just “buy and forget.”
The greatest benefit of an add-on is that it’s a “second bite at the apple.” Sellers retain a portion of the new entity, giving them potential for additional money when the new entity is eventually sold.
For example, the owner of a $20M company agrees to sell for $15M cash and roll-over $5M (25%) in shares of the new firm. Later, when the new firm is sold for $100M, that 25% is now worth $25M, 5-times the original $5M roll-over figure and $5M more than the value of the original company.
There’s a catch. Add-ons are smaller and less experienced in M&A than their counter parties. Once a LOI is signed, Buyers with huge leverage can exert great pressure in negotiations, which creates tremendous stress on the Seller.
The acquired company might feel cornered and bullied into agreeing to take a lot of risk and liability away from the Buyer – like take on a sizable escrow. Traditionally, the Seller could be at risk of losing 10% to 30% of proceeds if there is a serious breach. And they have to swallow the fact that they’ll only get a portion of their money at closing.
Sellers have to wait a year or more – and the money sitting in escrow can be exhausted in the event of a breach that the Seller had no control over.
That’s where Rep and Warranty comes in.
Removing Risk With R&W Insurance
One way to remove some of the contentious issues in a deal is through R&W, which enables Sellers and Buyers to transfer their M&A risk to an insurance company. This specialized type of insurance is helping add-ons be successful.
Until recently, this powerful tool was not available to smaller (sub-$50M deals) due to cost and target companies not having thorough financial documents or Buyers developing key diligence reports.
As detailed in my previous piece “Moore’s Law Comes to R&W Insurance” greater competition among M&A insurance companies has driven down premium levels and simplified prior eligibility criteria. To read the Moore’s Law piece, go to: https://www.rubiconins.com/moores-law-comes-to-rw-insurance/
Insurers no longer require audited financials (a deal-breaker for lower middle market companies). Thanks to low costs, R&W is the ideal fit for sub-$100M acquisitions – especially add-ons. However, as I mentioned, due to increased competition in the last several months costs for these policies are going up.
Currently, a $5M policy will cost $225,000 to $240,000.
Another caveat: While deals as low as $10M are eligible for R&W insurance… not all insurers are offering coverage at this level. Due to a surge in M&A activity, the big national insurance brokers don’t have the staff available to handle all the applications coming their way. So, they’re focusing on deals with a transaction value of $200M+.
If your deal falls under that threshold, you should be looking at a smaller firm that focuses on that level of deal—R&W coverage is still out there if you want it, you just have to look a little harder.
(Also, keep in mind that Transaction Liability Private Enterprise (TLPE) insurance is available for deals with a Transaction Value of $250,000 to $10M.)
Having this coverage in place makes for a much healthier environment post-closing, where you didn’t have to grind down the target company in negotiations. These are the folks joining your team, and if they come limping in, you can bet they won’t be as enthused to make the merger work.
In the tech community, Buyers are especially reluctant to penalize their newest partners by using up escrow funds. So they have a dilemma. Do they eat the loss… or risk demoralizing their new partners? With a R&W insurance policy in place, that dilemma is gone.
You want people to hit the ground running. How?
Make sure they get as much money as they can with as little risk as possible. If you are the Buyer, the R&W policy is zero cost to you. And it can be applied directly to the purchase price which Sellers will eagerly accept.
You want these transactions happening fast. You want to integrate the new group into your team in a positive way to ensure a successful transaction. What better way than this tool – Representations & Warranty insurance.
It has withstood the test of time. It’s worked for the big deals, and now it also works for the lower middle market deals.
What To Watch Out For
As the R&W insurance market has matured, different insurance companies now favor different M&A profiles. Some prefer larger risks over $200M. Some prefer lower middle market – $50M or less. So when selecting a broker, make sure you work with one who is focused on your market segment.
You could go to a “brand name” institutional broker for your lower middle market deal. They are not bad people, but they are focused on their bigger deals. They don’t have the bandwidth to handle the smaller transactions. If they have two or three billion-dollar deals going, they can’t handle a dozen $20M deals at the same time.
Another wrinkle is that, due to lower priced R&W coverage, some brokers will add in extra fees to supplement revenue and maintain profitability per deal.
I’m a broker with hands-on experience with the Representations and Warranty insurance product, specializing in insuring lower middle market deals.
To learn more about the protection R&W coverage offers, I invite you to contact me, Patrick Stroth, at firstname.lastname@example.org.
Article Updated: September 01, 2021