Would you buy a house without a home inspection or a title search?
Of course not. It would be way too risky.
That’s why Underwriters insist on thorough due diligence when they put together insurance policies covering multi-million-dollar M&A deals.
As a prospective Representations and Warranties (R&W) insurance policyholder, you have a very important role to play in the due diligence process.
The Underwriter depends on the Buyer to do the legwork. The Underwriter’s role is to “proofread” the sales data, potential liabilities, and other issues you find in your research and determine possible problem areas.
To give you an idea of an Underwriter’s scope in this process, let’s consider a typical $100 million deal. It takes about a year for a Seller to arrange all the material for a Buyer to look at. Then it takes several months for the Buyer to examine the data to determine if they want to proceed with the deal.
The Underwriters take even less time—a couple of weeks—to review and vet the Buyer’s work, which is why the Underwriter’s job is so dependent on the amount and type of due diligence that is done.
Sounds like a lot of responsibility.
Fortunately, it can be painless if you follow some best practices. And it’s a process worth going through; you’ll get comprehensive R&W coverage if you do a thorough job.
An R&W policy will protect the Buyer from financial loss in the case of any breach of the Seller’s representations in the sales agreement. Instead of a legal battle to recover lost funds, a third party—the insurer—pays the claim.
Your R&W policy is based on the scope of the Reps and Warranties in the sales agreement. If there are elements in an M&A transaction not detailed in the agreement, Underwriters will not consider those elements or make them part of your policy.
Here’s what Underwriters want to see to kick things off:
A narrative from the insurance broker explaining the generalities of the transaction. They want to know who the Buyer and Seller are, as well as the purpose of the transaction. If it’s a hostile transaction, they’ll want to be informed.
A preliminary draft of the purchase and sales agreement. Here should be outlined the Reps and Warranties of the Seller who will be subject to the insurance.
Financial statements. If they have not been audited, they should be reviewed. They might also include a quality of earnings report that gives additional supporting context for the financial health of the company.
The executive slide deck or Confidential Information Memorandum (CIM). This is the presentation Sellers show potential Buyers to highlight the strengths of the company and show how they see a deal working.
All this is very helpful to the insurer as the Underwriters start crafting the terms of your R&W insurance policy.
The Buyer’s M&A attorney will often compose a diligence report, which walks their client (the Buyer) and the Underwriters through the steps the attorneys took for due diligence. It includes, step-by-step, what they looked at and what they found. It’s essentially a roadmap for Underwriters as they look over everything.
With that initial information, the Underwriters can quickly put together a letter of interest, called a non-binding indication letter.
It includes the general terms, the policy limit, deductible, premium, the underwriting fee (generally $25,000 to $50,000), and instructions for wiring the money. These terms will be subject to the Buyer providing answers to a laundry list of additional resources the Underwriters need to look at before crafting the final policy.
The Underwriters will also highlight any uninsurable reps, or reps they need more information about, as is possible with some environmental and tax issues. If they are a big enough concern, some may be best insured under another policy.
So far, these have been the preliminaries. Now it’s time to get more “interactive” with the Underwriters.
Once the underwriting fee is paid, the Underwriters need access to the Buyer’s diligence team and data room (digital document storage vault, accessible online).
Underwriters usually outsource the hands-on due diligence review to M&A attorneys.
During the review, they will look at the documents in the vault; are any missing from the list in the due diligence report? They’re looking for potential red flags. Let’s say a financial statement or financial schedule is put into an unrelated human resources file; why there?
They look at financial, operational, organizational, technological, environmental, and related issues.
Once they have access to the due diligence documentation, it takes Underwriters about three business days to complete their review.
Next, a conference call is scheduled with the Underwriters, their M&A attorneys, and the Buyer and their due diligence team (their M&A attorneys and in-house counsel). Experienced insurers will provide an agenda or a list of questions to be answered on the call.
The questions/agenda will cover each area of the business. They’ll speak to the CEO and CFO, and—if there is one—the CIO or CTO.
It’s literally a checklist: do you have an employment contract, yes or no? Are there any concerns about intellectual property, yes or no?
If things are missing or something catches the Underwriter’s eye, they will ask about it and the Buyer can provide an explanation. The more information the Buyer shares, the more clarification offered, the better.
The Underwriters need these answers so that if there is ever a claim, they can say they checked the box in the underwriting process and it didn’t seem like a big deal.
These meetings should be held in a spirit of cooperation, not confrontation. And they usually are; the CEO and CFO are proud of their diligence efforts and love to “brag.”
It’s generally a fast-moving conversation, with the average call running one or two hours.
The formal offer to insure the deal is quick as well, usually coming within two days of the conference call. The Underwriters will have a pre-set policy number for closing. If there are any outstanding supporting documents, those are listed as conditions of the policy taking effect.
To give an IT example, the Underwriters could ask, “Did you perform a penetration test to make sure they have good cybersecurity?” The Buyer says, “Yes, and here are the results.”
The offer includes the final terms of the R&W policy and instructions for wiring the money.
The Underwriters will want a copy of the final, signed purchase and sales agreement. They’ll ask for a digital copy of all the data from the data room should they need it for a claim years from now. The Policyholder will also need to sign a warranty letter (provided by Underwriters) confirming no known breaches or known circumstances that would lead to a breach as of the closing date.
It routinely takes less than 3 days from the diligence call to the release of the formal R&W policy proposed terms.
As you can see, underwriting due diligence is a straightforward process. The more thorough and detailed you can be in the report and the data you provide to the Underwriters, the better.
To help ensure that you cover all the bases, we’ve put together a due diligence checklist. Basically, it’s a list of the types of questions the Underwriters will typically ask. By going through this list, you’ll be well-prepared for your interactions with them.
You can download Sample Questions for Buyer’s Due Diligence Team here for free.