I’m helping a first-time client place Representations and Warranty (R&W) insurance, and it’s taking a bit of hand-holding on this first go-around as we get quotes from insurers and review other elements of the process.
We should all keep in mind that the primary thing Underwriters want to see is thorough due diligence. Otherwise, they are going to be a lot of exclusions in the policy.
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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.
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 email@example.com.
Representations and Warranty insurance transfers all the risk in an M&A deal, including the indemnity obligation, to a third party – that’s the insurer.
It’s hard to argue against a major benefit like that. Plus, R&W coverage makes negotiations smoother and faster (and cheaper when it comes to less attorney fees) because all the nitty-gritty of a deal doesn’t have to be picked over. If there’s a breach, a claim is filed, and the insurance company pays.
Easy. It’s no wonder it is more widely available and widely used than ever before.
The perception may be that R&W coverage has gone from an obscure insurance product to something that is ubiquitous in the M&A process. And if you’re Private Equity that may be the case. PE firms are the most common repeat buyers. They’ve embraced this coverage in a big way – so much, in fact, that demand has grown exponentially.
But not everybody is totally convinced of the value of this coverage.
In the case of one Strategic Buyer I interviewed recently, while he didn’t object to R&W insurance being part of the deal, there was definite reluctance on his part. Simply because it was the first time he had used it on a deal.
This reluctance to take on R&W insurance – or at least their lack of exposure to it – on the part of Strategic Buyers is no surprise. In the past, they never really needed it. Until a few years ago, it was more of a Buyer’s market… the Buyer had more leverage, especially a Strategic Acquirer like a massive corporation buying a smaller company.
So, the Buyer didn’t have to accommodate the Seller with R&W coverage. They could impose escrow requirements and essentially be unopposed. The Seller had no recourse. In many cases, Strategics have been convinced by their attorneys that there is nothing more secure than having cold hard cash sitting in an escrow account.
Also a factor: Because Strategic Acquirers have not used this insurance before, there is a fear that it would slow the deal down or alter the process in a way that would cause a delay. They didn’t want to add this new, “foreign” element they weren’t familiar with to get in the way of what had been their smooth, well-oiled machine.
Then, things changed…
Why Strategic Buyers Are Changing Their Mind on Rep and Warranty Insurance
Strategic Buyers seemingly had plenty of reason to push R&W insurance to the side. But they can’t ignore it any longer.
It’s a Seller’s market out there right now. And Sellers, even smaller companies being acquired by vastly larger companies, now have leverage. And they’re using that power to make R&W coverage standard in M&A deals.
So Strategics have been forced to make this accommodation in increasing numbers to make quality deals to buy solid companies they want.
The good news is, the process to secure this specialized coverage, even if you’re totally new to it, is straightforward. Here are some things to keep in mind:
1. A professional Strategic Buyer, when making such a big investment as acquiring a company, is going to be doing thorough and appropriate due diligence. That’s a given.
Well, that means they’ve probably done enough due diligence to qualify for R&W insurance. You simply send the diligence over to the Underwriters. It’ll probably have to be rearranged or organized in a different way, but the diligence is there.
2. Underwriters are ready to work with Strategic Buyers, so it never hurts to look at R&W coverage to see what the options are. Underwriters will provide applicants with a quote that outlines the major policy terms before committing funds for underwriting fees. Within those indications, the Underwriters will comment on what they’re concerned about with the deal, what they call “heightened areas of risk.”
They’ll put in their quote that they’ll be looking closely at Topic A, Topic B, Topic C, etc. So, if a Strategic can respond to these topics and show their diligence in these specific areas, Underwriters will be satisfied.
This eliminates a concern had by many Strategic Buyers: that they’ll pay an underwriting fee to get R&W insurance and then there will be a lot of exclusions on the policy. But it’s not true. You can go in with eyes wide open and get all the details before you spend a dollar.
3. Working with an experienced broker who knows M&A and Rep and Warranty coverage is key. A broker can convey information back and forth between the Buyer and the Underwriter. A broker knows what information is needed. They can manage expectations, provide reasonable timelines, be diligent in following up to make sure the proper due diligence and documentation – in the proper format – is flowing to the Underwriters.
Not just any broker will do. Some less experienced brokers have a tendency to be reluctant to ask a client for more documentation when requested by the Underwriter. They don’t want to be a bother or have the client ask why they didn’t request the document at the beginning of the process.
But the truth is, and an experienced broker knows this, that sometimes, in the course of the underwriting process, there are questions that come up that must be satisfied. An experienced broker can head that off somewhat because they’ll have identified those areas of heightened areas of concern and addressed those with the Buyer upfront.
Where to Go From Here
With the right help, the process to underwrite a R&W policy have this coverage in place in an M&A deal is actually quite easy. That’s even for a Strategic Buyer that has never used this insurance before.
If you’re engaged with accounting firms and law firms experienced in this area, along with an experienced broker who can work with Buyer and Underwriters alike to shepherd the policy from application to closing day, it can be a frictionless process.
And having that coverage means that between Buyer and Seller all the most sensitive issues of a deal – indemnity, escrow, etc. – are now non-issues.
Soon enough, I expect more Strategic Buyers to happily embrace R&W coverage and become converts. All it takes is facing the unknown and going through the process once.
My firm has extensive experience in Representations and Warranty insurance. If you’re looking at this coverage for the first time, or are already an enthusiastic user, you can contact me, Patrick Stroth to chat about your next deal. You can reach me at firstname.lastname@example.org.
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 email@example.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 firstname.lastname@example.org.
As vaccines roll out and COVID-related restrictions are lifted across the country, it’s time to look at the impact the pandemic has had on the use of Representations & Warranty (R&W) insurance to cover M&A deals… and what to expect in the near term.
R&W insurance, of course, transfers all the indemnity risk to a third-party – the insurer. If there are any breaches of reps and warranties post-closing, the policyholder, usually the Buyer, simply files a claim and gets paid damages.
The use of this specialized type of coverage had been steadily growing and becoming more widespread pre-pandemic. Even lower middle market deals were being covered.
Just as M&A deal-making contracted, there was a reduction in the number of R&W policies being written in the first three quarters of 2020. But by the fourth quarter, it had rebounded and even surpassed 2019 levels. That trend continued into the first quarter of 2021.
In fact, according to the BMS Group’s Private Equity, M&A and Tax 2021 Report:
“As the initial challenges of operating amidst a lockdown were managed, deal volume rebounded strongly in Q3 and Q4 was the busiest quarter ever in the M&A insurance market. As we go to press, early indications are that M&A activity has levelled up somewhat but nonetheless we expect 2021 to be a record year for M&A insurance.”
Thanks to a rush to get back to deal-making, as well as the previous pre-pandemic growth, I expect a rising trend to continue as more dealmakers – both Buyers and Sellers – realize the value of this coverage. I forecast that this rebound will continue into 2022.
That doesn’t mean there won’t be key changes.
First thing to mention – especially if you have been hesitant to use R&W insurance – you should know that it’s well established and popular.
The BMS Group report highlighted that:
Key Trends in R&W Insurance to Watch
The pandemic is going to impact how R&W policies are written, cost, and other factors. But some of this would have happened anyway – without COVID – simply due to the increasing popularity of this coverage.
The COVID Impact Is Limited
While it’s still early to make a final judgement, it appears COVID hasn’t had a catastrophic impact on the R&W market.
As it states in the BMS Group report: “Despite the increase in claims frequency and severity, premium pricing has remained relatively low whereas it has hardened across other lines of insurance.”
Going forward, COVID will have zero impact because it’s “known.” R&W insurance covers the unknown. Underwriters won’t necessarily issue blanket exclusions for COVID-related issues, but they will take it into consideration.
Limits on the Rise
Another trend to watch for: Expect buyers of R&W insurance policies to buy more limits. In the last couple of years, Buyers have been securing policies at 5% to 10% of transaction value, which is largely to just cover the escrow. Problem is if you have a $100M deal and a $10M policy, what happens if you have an $18M loss?
The eight million over the R&W policy is uninsured.
As a result, Buyers are seeking to transfer more risk. So, look for them to buy more Policy limits, or select “hybrid” Excess Policy Limits only or Fundamental Reps (the cost of which are a fraction of the R&W pricing). Because there’s no remedy for anything uninsured, as the Seller is off the hook.
In the event there is a breach, and the amount of loss is significantly higher than the amount covered by R&W insurance, Buyers are beginning to make claims of fraud or misrepresentation against the Seller… because they know the Seller has a D&O policy.
If there is a loss that exceeds the R&W policy, Buyers are looking to recoup some costs through the Seller’s D&O policy. So it’s no surprise there has been an increase in fraud lawsuits.
D&O policies don’t pay for fraud. However, that exclusion only happens if fraud has been proven in court. The defendant has to admit they knew of fraud in court, or there must be a final judicial finding that fraud existed.
Up until then, the insurance company pays defense costs. If they settle, which is often the most cost-effective option, the insurance company pays the settlement. As part of the settlement, Sellers don’t have to admit fraud was committed.
This is why Sellers are being required to secure a D&O tail policy (if they don’t already have D&O in place) – Buyers should insist on it – and why they also need a R&W policy.
Costs Are Going Up
As more R&W policies are purchased, the cost will go up.
The rate will go from high 2% to mid 3%. And it’s already beginning to happen. On a minimum premium deal like I do, it’s already at 3%. A $5M policy is $150,000 to $175,000. But on a $20M limit policy it’s going to be at $600,000 whereas last year it was closer to $500,000.
There was a serious contraction of M&A activity in 2020 and the early part of 2021 – no surprise there. PE firms were holding back – not willing to commit their money. Plus, it’s a natural result of meetings moving online, workplaces going virtual, and the like. Many industries slowed down over the last year and lost productivity.
But now, PE firms, who’ve been sitting on all this cash for a year or more, are ready to start deal-making again. They – and their investors – are looking to start adding value to their portfolios again and rebuilding their balance sheets.
Since PE firms are so committed to R&W insurance, there was a natural dip in policies being written that mirrored the drop in M&A activity. But R&W has returned.
Special purpose acquisition companies (SPACs) will also have a hand in this growth in R&W policies being written in the next year or more. There are more than 400 SPACs that must complete an acquisition by 2023 – at the farthest out. That’s deadline pressure.
SPACs mostly target middle market companies – those $100M or more. As these so-called “blank check companies” start doing deals again, expect to see a spike in R&W policies written.
The one purpose of a SPAC is to acquire or merge with an existing company – it makes going public easier, quicker, and cheaper than a traditional IPO. And R&W coverage is perfect for these deals because even in the best of times, SPAC founders face tremendous pressure to get deals done within a two-year window. Because R&W insurance hedges risk for both Buyer and Seller it facilitates fast mergers and acquisitions.
Insurers Scramble for Qualified Underwriters
A natural side effect of the increasing use of R&W insurance over the last few years is that insurers are seriously understaffed with experienced Underwriters compared to demand for their services.
There are only so many Underwriters out there with the “know how” to underwrite M&A transactions. And as more insurance companies have entered the growing market, we’ve actually seen them “poach” underwriting teams from other insurers.
Pressure on Underwriters
R&W insurance is a complex line of coverage. Even if Underwriters outsource due diligence to an outside law firm, they are seriously stretched for time due to the sheer volume of policies being requested.
Many policies are being delayed – even declined – due to an insurer’s lack of bandwidth.
What does this mean for Buyers and Sellers?
You can’t expect Underwriters to turnaround a policy to cover your deal in a week or even a couple of weeks. Insurtech has not reached the R&W world yet. Although it was possible in the past, waiting until the week before closing to begin the R&W process is as prudent as waiting until April 14th to call your CPA for tax assistance.
If you’re interested in having this coverage for your deal, you need to start the Underwriting process at least four weeks out so there are no surprises. Don’t come in last minute and expect miracles. Underwriters are people too.
You can’t push them to the brink without losing relationships. A good Underwriter wants to be your partner; they want to do it right and be as timely as possible. So, start the process sooner rather than later.
A note of caution: Some insurers advertise faster processing, but they are prone to delays. Best case scenario – you’ll find an insurer to cover your deal on schedule but at exorbitant costs (2-3X the normal underwriting fee) that result in extra expense.
What Underwriters Are Watching For
The ideal situation for an Underwriter is to put as few limitations as possible on deal. Their objective is to have as few exclusions as possible because exclusions create friction. But they still need a sustainable product. They must protect the insurance company they work for.
As a result, we’ll see Underwriters exercising more caution on wide open worded Reps. For example, if there is a Rep with the following wording “will continue to be” or “will continue” – which means post-closing – the Underwriter will read that out as if the wording doesn’t exist.
In this market dynamic, Underwriters are also watching out for the definition of “damages”. They don’t want to explicitly cover multiplied or consequential damages, which are very problematic.
But they have been known to strike a balance with policyholders. If, in the agreement the definition of damages is “silent” with regard to multiplied or consequential damages, the proposed policy will match the agreement with the intent that while the policy is not specifically covering consequential or multiplied damages, such damages are not specifically excluded either. This enables the parties to consider such damages in the event of a claim.
It’s essential for the insurance broker to make clear with the Underwriter that silent doesn’t mean excluded. In other words, if it’s not there it doesn’t mean it’s excluded, it means it’s agreed.
Where to Go From Here
As with many things, COVID has had an impact on M&A and the specialized type of insurance that covers these deals: Representations and Warranty. Yet, I expect the true value of this coverage to shine through, and for its popularity and widespread use to not just continue, but to grow and expand.
Here’s how they put it in the BMS Group report:
“We remain optimistic about the outlook for M&A insurance and expect it to continue to play a vital role in M&A, especially given how ingrained it has become in the deal process and the part it plays in unlocking both capital and negotiations which have reached an impasse on M&A transactions.”
In light of these trends, I wanted to offer you a free download of some best practices to consider going forward when it comes to incorporating Representations and Warranty insurance in your next M&A transaction.
If you have a deal coming up or one closing between now and the end of the year, and are open to having a conversation on how R&W can work for your particular deal, you can contact me Patrick Stroth, at email@example.com.
For lower middle market companies looking to be acquired, these owner/founders, often of businesses they have built from the ground up, are looking for a once-in-a-lifetime liquidity event.
They are ready to sail off into the sunset, perhaps into retirement or perhaps another business venture that will require as much capital as possible. They want to truly cash in from the sale and walk away without further obligation or liability.
At the same time, while they are experts in whatever their business does and passionate about their company, they are not well-versed in the world of M&A. You might consider them “unsophisticated” Sellers.
This creates an atmosphere of fear in these Sellers that can make them reluctant to move forward, especially when they realize they are personally liable to the Buyer if any losses are incurred post-closing from a breach of the Seller reps. But, as you’ll see in a moment, Buyers who take the right approach can remove that fear in one fell swoop.
What are these Sellers afraid of?
There could be issues with ESG (environmental, social, and governance) that could come back to bite them years down the line if a lawsuit is looming. Unfortunately, often these companies have not taken out Directors and Officers Liability insurance, which would protect them and pay legal costs and any claims due.
Any number of issues not uncovered in due diligence, such as IP infringement, tax problems, or others, that are no fault of their own, could crop up. In these cases, the money from the sale held-back in escrow could be at risk. This chips away at the major cash payout they were expecting. Money beyond escrow could even be clawed-back in some cases.
Not to mention, there is a lot of uncertainty in the new U.S. government administration.
They feel their future wealth is in danger – in more danger than ever before.
What a Buyer Can Do
Buyers can take away that fear by hedging the Seller’s risk with Representations and Warranty (R&W) insurance. This specialized type of coverage transfers virtually all the risk away from the Seller over to an insurer.
This insurance removes the need for indemnification provisions in the Purchase and Sale Agreement and for a major part (typically 8% to 10%, sometimes more in cases where the Buyer believes there is more risk) of the sale price to be held back in escrow, which makes the Seller happy. If there is a breach in any of the Seller Representations and Warranties, the Buyer simply makes a claim with the insurer. And there is no chance of claw-back.
And claims do get paid consistently, Buyers should understand.
This process also eliminates the need for such extensive negotiation in the lead up to the sale because there isn’t so much back and forth between lawyers for the Buyer and Seller. (Which can have the added benefit of saving both parties on legal fees.) In many cases, a Seller will be okay with a more Buyer-friendly agreement because R&W coverage has so effectively limited their risk.
As you know, Buyers want broad indemnification provisions to cover any potential loss, while a Seller’s goal is to narrow what breaches are covered and the survival period. With R&W in place, and a third party (the insurance company) paying for losses, no need to argue. In fact, some industry watchers maintain that deals with R&W in place are eight times more likely to close.
Previously, R&W coverage was the province of major deals – hundreds of millions or billions in deal size. But in recent years, Underwriters at many major insurance companies are taking on transactions as low as $15M.
And it’s very affordable. Right now, you’re looking at a rate that is 2% – 2.5% of limit, including underwriting fees and taxes, which is a significant drop in what it cost just a couple of years ago. The rising popularity of R&W insurance among savvy PE firms, as well as some Strategic Buyers, means more policies being written. And there are more insurance companies than ever offering this coverage. That has brought the cost down.
Better yet for Buyers, because of the removal of risk and peace of mind, Sellers are more than happy to pay for R&W coverage. Given the choice between accepting risk and the escrow that goes with it, Sellers will eagerly cover the costs, making R&W essentially “free” for Buyers!
It’s clear that for Buyers in the lower middle market space, the advantages of R&W insurance far outweigh any minimal additional cost and additional due diligence required by the Underwriters (which probably should have been done anyway and doesn’t necessarily add significant time to the process).
One important thing to note is that large Strategic Buyers – we’re talking the Apples and Googles of the world – have more than enough leverage that even if a Seller wants it, they are not likely to agree to R&W coverage. For them, any losses from something going wrong when acquiring a lower middle market company are just a drop in the bucket.
Lower middle market deals are right in the sweet spot for R&W. For smaller Buyers who understand that the fastest way to grow inorganically is with key acquisitions, it’s the perfect vehicle to bring Sellers to the table. As more Buyers focus on this space, it’s essential for them to have R&W to be competitive.
Buyers should bring up the concept of using R&W insurance early on, with a provision made at the Letter of Intent stage. It’s a gesture of goodwill of sorts that soothes concerns the Seller may have. Of course, knowing that any losses post-sale will be covered gives the Buyer peace of mind as well.
As mentioned, with this coverage in place at the beginning, negotiations are much smoother and go more quickly.
In the current climate, lower middle market Sellers are running scared. Buyers bringing R&W insurance into the equation will go a long way to gaining trust, making them feel secure and ready to go forward with the transaction.
It’s important to deal with an insurance broker well-versed with Representations and Warranty insurance and its role in M&A. While some of the bigger providers do offer this coverage, they focus the majority of their time and energy on bigger deals.
I specialize in securing this coverage for lower middle market deals, and I welcome your questions. If you’re a Buyer or Seller interested in finding out more, please contact me, Patrick Stroth, at firstname.lastname@example.org.
For many, an IPO is the most exciting event in the life of a business. But I liken it to a team’s top pick in the NFL draft because the IPO itself is just the beginning. There are a lot of expectations for the player (or company) … and it could end up being a bust.
But in M&A, Sellers are done, they’re exiting. To me, that makes these deals life-changing, even generational events. And who wouldn’t want to be a contributor to that process?
If I do my job, I make this life-changing event faster, cheaper, simpler and happier for all sides. If that doesn’t get you fired up, I don’t know what can!
Since I started doing this in 2014, my tool of choice to do just that has been Representations and Warranty (R&W) insurance.
This specialized product removes the need for an indemnification clause in the Purchase and Sale Agreement and for money to be held back in escrow. It ensures that if there are any breaches, the Buyer can file a claim easily and be made whole in a timely manner.
In short, this type of coverage transfers all the risk to a third party – the insurer. And, as you’ll see in a moment, this is just a small sampling of its many benefits.
The first time I was introduced to R&W insurance was with a deal with a long-time owner and founder ready to sell his business for $50M. His goal was to take the money and “ride off into the sunset” to build settlements in Israel. The culmination of a lifelong dream.
He almost didn’t get there.
Because the Buyer was worried there might be a breach two or three years after closing and they would have a hard time tracking down this Seller out of the country, they were asking for half the purchase price to be held in escrow.
I realized we could change the Seller’s life by facilitating the deal the right way. In this case, R&W coverage would allow him to avoid this huge escrow requirement that would see him stuck waiting for the other half of his money for years.
We arranged for a $20M policy with a $1M deductible. So instead of $25M in escrow, the Seller was given the opportunity to exit the country with $49M out of $50M. What I call a clean exit!
Since that day, it’s been my mission to provide this coverage for as many deals as possible.
The use of R&W insurance is more widespread than ever, with PE Firms especially embracing this coverage. There are many reasons why there’s never been a better time to sign up with your next deal.
Lower costs, quicker closings, less money held in escrow… for these reasons and many more, there is no debate. R&W insurance has never been stronger and more available.
That said, there are hundreds of brokers out there offering this product. But instead of going to the big houses where you’ll just be a number and your deal is not a priority, or your local insurance rep who doesn’t specialize in M&A, you should work with a broker who is “geeked out” about the benefits of Representations and Warranty insurance and really believes in this product.
I’m one such broker.
If you’re interested in making Representations and Warranty insurance part of your next deal, contact me, Patrick Stroth, at email@example.com.
As the major player in the industry, AIG has been the long-standing, nearly sole source of claims information for the Representations and Warranty (R&W) insurance market. In 2020, Liberty Mutual, which has been actively writing M&A-oriented policies for about 10 years, issued its first such report based on their own experiences in this space.
An important factor to note is that overall, the number of claim notifications is going up, with 19% of policies bound in 2017 with notifications, up from the 14% from 2012 to 2015, and 15% in 2016. Liberty Mutual expects to hit or exceed 19% for policies written in 2018 and 2019; as notifications are still coming in steadily for those years.
Why the jump? Simple. As R&W insurance, which transfers indemnity risk to a third party (the insurer), has been…
… more policies than ever are being written. It’s only natural that the more policies there are out there, the more claims there will be. It does not point to a problem with this specialized type of insurance in the M&A world at all.
I’m not worried that this rising trend in notifications and claims will impact the viability of R&W insurance. Neither will this cause coverage to shrink or prices to rise. This trend is not foreshadowing a rate increase or lack of capacity.
Quite the contrary, because there are good reasons for this increase in notifications and claims: not only are more R&W policies being placed than at any point in history, including many deals in the sub-$250M transaction value, but policyholders are more aware that they can use their R&W policy for reporting.
The increased reporting of breaches in recent years will not trigger higher prices because properly underwritten deals have not suddenly become riskier to insure despite the increase in notification frequency. As the report points out, no more than a quarter of notifications actually result in a request for payment from the policyholder. And only a fraction of reported breaches actually exceeds the retention and lead to payment by the Insurer.
It’s also worth noting that tax-related notifications (in the form of audits) are among the most common breaches reported, usually within three years. Tax authorities aim or are required to commence an audit within one to two years of receiving returns due to the statute of limitations.
There may be nothing wrong, but because the IRS is launching an audit, policyholders will report it to the insurance company to put them on notice so they can bring their resources to bear to defend them if necessary. However, these audits usually do not result in a claim. Most agreements require a six-year survival period for tax Reps, which may not be necessary.
Overall, R&W insurance has established itself as credible, reliable, and sustainable. This is a respected, solid product. It’s on everybody’s checklist right now.
The simple fact that Liberty Mutual has issued this report is reassuring. AIG was the only insurance company to put out any information about claims before now. This new report shows this is a maturing market.
More competition brings better products and services and lower prices. It’s innovation in action.
It’s also important to note that insurers like Liberty Mutual and AIG do pay these claims. As Gareth Rees, Liberty GTS Chief Underwriting Officer, put it:
“In the past, R&W insurance was essentially something that helped solve a deal problem and get a deal over the line, but then often forgotten about post- closing. Now it is also seen as an asset from which an insured can recover value in the future, and much greater thought is given from the outset as to whether a policy claim exists.”
The Liberty Mutual report, 2020 Claims Study: Exclusive Insight Driven by 10 Years of Data, is worth a close look, especially the section on emerging trends in the claims R&W insurance policyholders make. Here are the issues they expect to be leading claims generators in the next 12 months.
There are a few elements at play in these types of claims, which, as you might expect, are most common in retail and manufacturing businesses and mostly involve slow moving, obsolete, or damaged stock. The COVID-19 pandemic has only intensified this trend.
There is more risk if the business is seasonal, or if the products in question are frequently updated or subject to price volatility or physical damage. There is even more risk, says the report, in so-called locked-box deals with no stock-take at, or following, closing.
Why are these claims relatively common?
Gareth Rees says: “The reality is that stock can be a difficult area to diligence, particularly on a deal that is moving very quickly. A lockdown situation obviously makes it difficult to carry out any physical checks.”
“Also, there will be many companies that have built up large quantities of stock as a result of the lockdowns, but which may not have updated their policies around obsolete and slow-moving stock to reflect this. This is an issue of heightened underwriting focus for our team at the moment.”
As with the previous trend, we are likely to see a pandemic-related impact here as well, which is why underwriters are taking a closer look at “the size of the accounts receivable figure in the accounts relative to the size of the balance sheet and asking more questions around this issue.”
Common allegations with regards to accounts receivable claims include the setting of inadequate bad debt reserves and errors in quantifying the acquisition’s total accounts receivables. In some cases, it’s unclear in these times whether a customer on the books is “real” or will disappear or even shut down due to COVID.
Essentially, this is when you have onsite audits from software providers to check how many people at a company are using software that has been licensed. According to Liberty Mutual’s report, these types of audits are on the rise.
An acquired company could state that they have 100 licenses, but it turns out that 300 employees are actually using the software. That’s a big no-no. Punishments range from penalties, to a requirement by the vendor that the company buy new software at list price and pay support costs.
This issue could be very impactful for SaaS companies and other tech businesses.
Insurers are taking a closer look at software licensing in the underwriting phase too, says the report, which states: “[We] expect it will also become an area of focus for buyers and their advisors during the due diligence process as target businesses become more digitally enabled and more reliant on licensed software.”
When you sell a company, you can’t have zero cash in the bank on closing day. The incoming Buyer needs money for payroll, leases, etc. for, say, 90 days post-closing. The Buyer will make an amount, say it’s $9M, part of the deal. But they will ask the Seller what amount is needed for operating expenses for that 90 days.
This can be trickier than you might think when you consider the different ways revenue is recognized and then booked for accounting purposes. When there is a disconnect, a claim results.
According to the report, this is an issue particularly with project-based work. In these cases, revenue is recognized over time and compared to incurred costs, instead of in line with actual income received. The fact that the projects involved are long-term and have multiple elements makes this even more complicated. This means tougher due diligence in this area.
States the report: “We are increasingly looking for signs that management have been challenged appropriately in key areas of judgement associated with the entity’s revenue recognition practices and sufficient evidence has been obtained to support those judgements.”
This has become such as issue that SRS Acquiom is adding side-escrows for revenue recognized and net operating revenue in the deals they oversee.
Minimum wage provisions are excluded by most R&W policies. So, although this can be a serious issue to those companies impacted by employees’ claims for backpay, increased tax liabilities, and fines from governmental authorities, it’s not something that insurers have to worry about in most cases.
State governments, facing reduced tax receipts and pressure from advocacy groups, are increasingly seeking to classify independent contractors as employees. California is the perfect example.
This could, says the report, “result in a large number of notifications with the potential for significant consequences for a business, both in terms of increased tax liabilities and payroll costs.”
With increased regulation, especially in the real estate sector, and more stringent compliance measures, we are seeing more claims related to breaches of health and safety laws. The result, as the report states, are significant business disruption and remedial costs to get into compliance.
As the report states: “We anticipate that this will lead to buyers and their advisors focusing more on this area as part of their due diligence, with technical reports addressing this specific issue becoming more common.”
The Liberty Mutual report does see climate change as an area of concern and increasing risk, but it’s mostly an issue for companies operating in the European Union.
As I stated earlier, more R&W insurance policies are being written, so more notifications are being made. More notifications that don’t result in claims being paid out means that R&W isn’t any riskier than before.
This trend of rising notifications actually points to sustainability and maturity in the R&W insurance market. As a result, we should have stable pricing for the foreseeable future.
One thing to keep an eye on are new trends related to COVID-19, with Underwriters scrutinizing new potential areas of exposure, such as:
For guidance on the use of Representations and Warranty insurance in the time of COVID-19 and beyond, contact me, Patrick Stroth, at firstname.lastname@example.org for all the details.
If you’re the Buyer in a merger or acquisition, you can take one action at the start of the deal—at the offer stage—that will