Stapled W&I policies and synthetic policies will likely be increasingly common features of E&I transactions, although their feasibility should be assessed case by case.
Warranty and indemnity insurance (W&I) is a long-established feature of M&A transactions in Europe, especially with private equity sellers. The 10th edition of the Latham & Watkins Private Equity Market Study shows that nearly 48% of all European M&A transactions in 2023 involved W&I with 65% of private equity sellers favouring W&I-backed exits. However, on the flipside, our market study indicates that on an aggregate basis only 35% of energy and infrastructure (E&I) transactions involved W&I, with varying levels of adoption across European geographies.
Certain recurring characteristics of E&I transactions could explain the dislocation in this trend: the sometimes challenging nature of the assets and jurisdictions for these transactions and the assets themselves frequently having a fragmented shareholder base, which usually means that there are no negotiated business warranties to be covered.
Along with a recent softening of the W&I market, two developments can help bridge this gap for E&I transactions: stapled policies and synthetic coverage.
“W&I stapling” involves a seller initiating a buy-side W&I policy, either as a hard staple or a soft staple. The clue is in the name — a hard staple involves a substantially negotiated policy between the seller and the underwriter, which is then handed over to the buyer with the requirement that the buyer either uses the negotiated policy or does not avail of W&I. Alternatively, a soft staple approach typically involves the seller instructing a broker to prepare a “non-binding indication” from underwriters based on limited underwriting work. It is then incumbent on the buyer (if they wish to pursue insurance) to work with the broker to finalise the selection of underwriter, and then negotiate the policy with the selected underwriter.
In our experience, E&I transactions that feature W&I typically adopt the soft staple approach as it affords more flexibility to both transacting parties. The buyer may negotiate the policy and scope of warranties as per its requirements whereas the seller is not tied down with the cost and effort of negotiating the policy and can focus on other aspects of the sale process. That said, an auction process could be expedited with a hard staple if the seller front-loads the disclosure and underwriting process as long as it is willing to incur the upfront cost.
The jurisdictions and assets related to the E&I sector sometimes make W&I coverage more challenging. Non-OECD energy assets, for instance, could face extensive exclusions leading the seller to have to agree other recourse options. Over the last 12 to 15 months this has moved slightly but how a seller takes advantage of it is key.
Latham acted on two contrasting deals recently, both with non-OECD assets and jurisdictions. In one, with Latham on the buy side, the seller had soft stapled insurance and spent little time preparing its disclosure processes. As a result the policy was suboptimal and alternative resource arrangements were required, to that extent therefore failing the seller’s aims. On the other deal, the seller hard stapled and spent a lot of time on disclosure and underwriting, resulting in much better coverage and ensuring a limited recourse exit.
The buyer can seek “synthetic” coverage if a seller does not agree to provide SPA protections required by a buyer (for example, if a seller only provides tax warranties a buyer may negotiate a synthetic tax indemnity with the underwriter).
The availability of this product has been historically limited to single jurisdiction and asset backed transactions with few employees. While such transactions remain the easiest to support through synthetic W&I, appetite has expanded to support multi-jurisdictional and more operational assets, provided commensurate due diligence is conducted.
Synthetic policies typically are more expensive than W&I on a non-synthetic basis. However, brokers have informed us that the softening of the market over the last 12 months has led to an approximately 30% reduction in premia for synthetic policies, which results in their cost being more or less similar to W&I on a non-synthetic basis.
While synthetic enhancements are common in the market, we understand from discussions with brokers that there has been a recent uptick on wholly synthetic policies as well. In such policies, the warranties to be covered are almost entirely negotiated directly with the underwriter with the seller having little to no involvement in this negotiation process.
This development is interesting in the context of E&I transactions in which the assets often have fragmented shareholder bases, which result in minority sales if the minority seller is unable to provide any meaningful business warranties on the target. Additionally, sellers that did not receive any warranty coverage on their acquisition will typically adopt the same approach on their exit. A synthetic policy may bridge this divide in the right circumstances.
Unlike non-synthetic W&I, in which sellers should engage with the W&I process as early as possible, synthetic W&I only requires the seller’s willingness to assist the buyer with a diligence process. Underwriters will usually expect a well-populated data room, involvement of a management team with knowledge of the day-to-day operations of the target, and a sufficiently robust Q&A process. This is the main challenge for adopting synthetic W&I on minority sales as minority sellers may find it difficult to deliver this level of diligence.
The Road Ahead
It is relatively uncommon for buyers in E&I transactions to receive other forms of comfort in lieu of W&I (such as escrow arrangements for warranty claims, management rollover arrangements, or seller re-investment) so W&I products are a feasible risk mitigation tool in this sector. Synthetic solutions make these products even more attractive. However, the devil is in the detail and policy negotiation is key. In particular, maximising the coverage position and limiting exclusions are the main objectives during the policy negotiations and underwriting process. An expedited timeline with limited diligence on a complex business may result in numerous exclusions, which would mean the policy is of comparatively little use given the effort and expense of putting it in place. Overall, we expect stapled W&I policies and synthetic policies to be an increasingly common features of E&I transactions but E&I is a broad market with transactions ranging from single asset, single shareholder in a single jurisdiction through to the polar opposite so it needs W&I products that cater for all scenarios, structures, and risk appetites.