The W&I Insurance market is rapidly evolving and is playing an ever more prominent role in changing the nature of the way UK M&A transactions are structured, particularly in the case of private equity exits. As insurers have become more sophisticated and competition between insurers in the market has increased, it has opened the door over the last couple of years for the utilisation of innovative insurance products, such as synthetic tax deeds, tipping excess thresholds and blanket awareness qualifiers for warranties combined with a knowledge scrape.
A recent innovation that has come to the fore is the use of nil recourse structures (also known as the £1 liability cap) in transactions involving operational businesses. Previously limited to real estate transactions, the number of operational deals with a £1 liability cap has become a notable feature in the market over the past 12 months.
Whilst it is not yet considered to be a market norm on operational deals, as this trend continues to grow some consideration has to be given to the potential impact this will have on private equity transactions and, in particular, managements approach to disclosure if they are not required to leave some “skin in the game”.
The market trends:
In the market we would typically see the claims threshold under the SPA or management warranty deed set for management and/or sellers in the region of 0.5%-1% of the overall deal value, which would generally be reflected in the excess under the W&I policy. In the event there is a claim for breach of warranty for an amount less than the excess under the W&I policy, it would be for the buyer to bring this claim against management and/or the sellers.
However, statistics show that the average excess under W&I policies as a percentage of deal value has been reducing year on year. This has resulted in a downward trend in the level of cover provided by management and/or sellers, and insurers and buyers have become increasingly comfortable with accepting the concept of nil recourse structures. Indeed, in the real estate sector the £1 liability cap is considered to be market standard, with thresholds only included on transactions where there are large portfolios or operating hotels and leisure businesses.
In a nil recourse structure transaction, whilst the liability of management and/or the sellers under the SPA is limited to £1 (in the absence of fraud), the excess under the policy will remain in place (usually set at 0.5%-1% of overall deal value) and the risk ultimately lies with the buyer. Interestingly, based on our experience on recent transactions and speaking with brokers in the market, adopting the £1 liability cap does not generally result in materially higher premiums, though (depending on the nature of the business) it may lead to a slightly higher excess under the policy.
Is this approach justifiable/advisable?
Understandably, there is still some reluctance on the part of buyers and underwriters to accept this position, in particular when the target business operates in an industry which would be considered to be at greater risk of a claim materialising. Likewise, there appears to be some unwillingness on the part of buyers to take on the excess (a problem that does not arise on real estate deals where the £1 liability cap is more predominant). Ultimately it depends on the attractiveness of the target business and the quality of the sell-side advisers and the disclosure process undertaken, but when going to market with an aggressive approach like the £1 liability cap, some consideration needs to be given as to whether or not it might result in making the target business less attractive to potential buyers.
Perhaps even more pertinent in a private equity context, is the concern that if management and/or sellers are not required to retain some “skin in the game”, there will be less incentive to go through a thorough disclosure process. While this is certainly a justifiable concern, it is offset by the fact that insurers are requiring evidence that a thorough disclosure process has been undertaken in order to provide cover. Furthermore, if management and/or sellers are recklessly negligent in their disclosure exercise, they may be stumbling into the realms of fraud. In this scenario, all bets are off and the W&I policy cover and the limitations under the SPA no longer apply, leaving management and/or sellers exposed. So while the £1 liability cap seems an attractive option in theory, in practice it is important that management and/or sellers are appropriately advised of the potential pitfalls of not taking the warranty and disclosure process seriously on these sorts of transactions.
As insurers seek to differentiate themselves from their competition and new and more commercial approaches are adopted, it is quite likely that the number of operational deals with a £1 liability cap will continue to increase year-on-year.
As noted previously, this is still a relatively recent development on operational deals, perhaps understandably given the potential risks, both in terms of the buyer having to take on the excess under the policy, and also in respect of management taking a more laid-back approach to the disclosure process.
However, there is a commercial and pragmatic opinion that in the context of a large transaction which is backed by a W&I policy, the potential impact of a claim being brought for less than 0.5% or 1% of the deal value is quite low. Similarly, in an industry like private equity where the relationship with management teams is so fundamental to the success of private equity backed investments, it is unlikely that a private equity buyer will bring a claim against its incumbent management team in any event.
Indeed, taking the converse view, the acceptance of private equity buyers of the £1 liability cap could be used to provide management with some comfort and could potentially assist in fostering a more productive relationship with management teams going forward.