For PE-backed deals, specifically, competition for assets continues, as Mergermarket notes: ‘[The H1 2018 M&A figures for PE-backed transactions] indicate that PE firms are willing to get involved in the current seller’s market even if valuations do not favour them, due in part to large amounts of available capital and perhaps a push to deploy it before interest rates rise’ (source: H1 2018 Monthly M&A Insider, mergermarket, 24 July 2018).
Notwithstanding an expected gradual tightening in the interest rate environment, this buoyant deal climate and competition for assets has stimulated the need for creativity in M&A and explains how transaction liability solutions – particularly, warranty and indemnity (W&I) insurance and tax insurance (together, M&A insurance) – are being developed with increasing frequency and sophistication as corporates, PE and other financial investors vie with each other to secure their investments on the buyside and enhance their returns on exit.
M&A insurance – quick recap
M&A insurance was originally adopted by the PE industry in the 1990s as dealmakers sought ways to manage deal risk and improve execution. It offers a viable alternative to a buyer’s escrow or seller indemnity, allowing the parties to manage and allocate transaction risk to the insurance market for a fixed cost. This, in turn, enables buyers to bid more aggressively to win assets and allows sellers to receive more unrestricted funds at closing.
W&I insurance covers liabilities arising out of a breach of one or more of the warranties in an M&A transaction where such breach relates to matters unknown to the buyer. Policies are tailored to the terms of the sale and purchase agreement (SPA) to respond, subject to underwriting and customary insurer exclusions, to the warranties as agreed by the parties, and address the amount and duration of coverage required by the buyer. W&I insurance is flexible enough to provide more beneficial terms for the buyer under the policy than under the SPA, such enhancements including warranty coverage extended beyond the jeopardy period in the SPA, a ‘synthetic’ tax deed, disapplication of knowledge qualifications and sole recourse for the buyer. Although initially structured to cap the liability of selling shareholders, W&I policies are now predominantly structured with the buyer as the insured.
Tax insurance can help a company reduce or eliminate its exposure to an identified risk of a loss arising from a successful challenge by a tax authority to the expected tax treatment of a proposed or historic transaction or situation. Significantly, in contrast to W&I insurance, tax insurance addresses known areas of uncertainty. A specialty insurance market has developed to help companies manage tax risks of many types, ranging from M&A-driven issues, such as whether carried forward losses in a target company exist and will survive a change of ownership, to risks facing a company in other situations, such as the tax neutrality of a group reorganisation.
An appreciation of the strategic benefits offered by M&A insurance is key: for the buyer, W&I insurance can bridge the ‘warranty gap’ and provide recourse against a highly rated insurer rather than the seller or management team – potentially pivotal in a competitive auction where sellers are not prepared to stand behind warranties or where there is a significant management rollover (and, as such, particularly appealing for an incoming PE sponsor); for the seller, not only can W&I insurance remove the need for an escrow to cover warranty breaches and allow sale proceeds to flow to investors immediately but, in the current seller’s market, the ‘staple’ W&I solution has become prevalent to capitalise on the competition for assets among buyers.
Recognition of the role of insurance in facilitating M&A is evident from the experience of advisers. In its M&A Insights for Q1 2018, Allen & Overy reported a ‘significant’ increase in W&I insurance globally in 2017, noting its use in 47 per cent of the PE exits the firm advised on and in 27 per cent of all transactions the firm advised on where operational warranties were given. Aon’s own experience of the substantial rise in the use of M&A insurance is consistent with this, as the amount of insurance placed by Aon on deals in Europe, the Middle East and Africa (EMEA) has grown significantly year on year since 2015 (See chart ‘Aon EMEA M&A Insurance Limits and Transactions’).
One driver for continued growth in the use of M&A insurance is the rise of the corporate insured, which, given the seller’s market backdrop referred to above, we do not see as surprising. The chart ‘Aon EMEA M&A Insurance Limits and Transactions’ estimates that Aon placed the same amount of insurance for corporate insureds in 2017 as for all types of insured client the year before. We see this as a reflection of two factors: (i) corporates competing with PE buyers for assets but having to consider W&I insurance because sellers are not prepared to stand behind operational warranties, whether through bilateral pressures or becoming the preferred bidder on a structured sale process where a seller-initiated W&I insurance solution is ‘flipped’; and (ii) given current market dynamics, corporates themselves – when selling – adopting a more aggressive approach to operational warranties and requiring buyers to use W&I insurance to bridge the gap.
The current deal environment has also increased the use of seller-initiated insurance solutions in auctions as PE and corporate sellers look to increase competitive tension across prospective buyers and optimise commercial terms offered. One approach is the ‘hard staple’, where a substantially underwritten W&I insurance policy is presented, together with the SPA, as a package solution to facilitate rapid execution once the insurer completes its remaining underwriting based on buy-side due diligence, either in tandem with final SPA negotiations or shortly post-signing; another approach is the ‘soft staple’, where the seller procures indicative insurer terms that are summarised in its insurance broker’s report and made available to bidders, enabling them to select an insurer and proceed to underwriting.
To varying degrees, both approaches allow the seller to manage its deal risk proactively by positioning W&I insurance terms more closely to the auction draft SPA, catering for a process that is more structured than simply leaving bidders to make their own W&I arrangements from the outset. Advisers should consider which approach and strategy is more appropriate for the client, given the deal dynamics, likely buyers and how the process will be run, particularly whether bidders will be put through a contract race, or exclusivity granted to a preferred party. Greater seller control on the W&I process through a ‘hard staple’ requires more preparatory work (vendor due diligence (VDD), in particular), seller input and potential cost; whereas the ‘soft staple’ is less seller intrusive, quicker and cheaper to implement but affords less sell-side control over the process. Depending on the auction strategy – contract race or exclusivity – the insurance broker should advise on the suitability of key insurers for the transaction given risk, sector or geographic appetite as well as their ability to execute including, but not limited to, their ability to run separate workstreams for multiple bidders, if required.
As M&A insurance has become a regular deal feature, the number of insurers and amount of capacity from London has increased, from about 15 providers of W&I insurance offering an aggregate capacity of approximately £700 million in 2015 to more than 26 providers of W&I insurance offering an aggregate capacity of over £1.1 billion in 2018, to date.
The larger insurers now have capacity to underwrite up to £80 million–£175 million per transaction, and transactions of £1 billion or more, requiring limits of £100 million–£300 million or more each, are not unusual.
In conjunction with an increase in the supply of capital, we have noticed clients purchasing more insurance relative to the value of their transaction across most deal sizes since 2015, as illustrated in the chart ‘Aon EMEA W&I Metrics’.
The dawn of the insured megadeal
As clients increasingly attribute tangible value to M&A insurance, so the boundaries continue to be pushed in placement terms as the structuring of global programmes to source insurance capital across different regional markets becomes more complex.
A clear example of this was the €1 billion W&I policy that Aon placed in early 2018 on a €10 billion megadeal for a long-standing client acquiring a global business. Structured to respond to a highly competitive sale process, this W&I placement – believed to be the largest such policy placed, globally – involved 19 insurers, requiring Aon to source capacity from London, Europe, North America and Bermuda as well as the Aon Client Treaty (ACT), an exclusive Aon sidecar facility. While the result helped the client to differentiate its bid, win the auction and manage deal risk – a classic strategic benefit of W&I insurance – it demonstrates how far M&A insurance has developed in responding to the demands of cross-border dealmaking. Early 2018 also saw Aon’s EMEA tax team place a US$750 million tax insurance policy, also believed to be globally the largest such policy placed to date, requiring the support of more than 10 insurers based in Europe and Bermuda and the involvement of ACT.
Top five W&I insurance deal questions for counsel (buy-side)
Rationale for M&A insurance: clean seller exit, additional comfort, specific issue? Approach to risk: what areas concern the buyer the most and are they known or unknown issues? Recourse: is seller providing any recourse or will insurance fully bridge that gap? Enhancements: what policy enhancements are most relevant or desirable? Diligence: expected scope of diligence (general rule of thumb: no diligence, no insurance cover) and materiality level of review.
Tax insurance has followed a similar dramatic path to W&I insurance in recent years, becoming firmly established as a solution for addressing known risks either in a deal context or on a stand alone basis, such as a group restructuring. The commercial backdrop for this growth is the continued increase in the complexity of tax rules in many countries, coupled with a more aggressive approach from government agencies, which has changed the way many companies view their tax affairs.
The volume and value of specific tax policies bound by the Aon team in EMEA has increased significantly year on year since 2015, with the amount of insurance bound in Q1 2018 alone exceeding FY 2015 by seven times on double the deal volume, as illustrated in the chart ‘Growth in Tax Insurance Placed by Aon in EMEA’.
We see a trend of much larger tax insurance deals coming into the market with enquiries emanating from most jurisdictions in Europe as well the United States and the wider Americas and increasing interest from the Asia-Pacific region. One global head of tax at a client we spoke with recently expressed surprise that, although in receipt of expert advice, he was expected to make judgement calls on tax liability matters that could have a potentially material impact on the group balance sheet yet, by comparison, other parts of the group routinely insure their operational risks.
Tax insurance – case study
A target company had significant non-operating losses (NOLs) in respect of which seller and buyer agreed consideration value. The SPA contained a condition precedent that a ruling be obtained from the relevant tax authority to the effect that the NOLs would survive the change in ownership of the target company and a contemplated post-closing restructuring. Despite the parties’ efforts, with only two weeks before the SPA long-stop date the tax authority had not responded to the ruling request. To keep the deal on track, Aon’s EMEA tax team structured and placed a tax insurance policy that protected the buyer against the risk of the tax authority challenging the availability of the NOLs post-closing. This solution gave the buyer and its advisers sufficient comfort to enable the buyer to waive the relevant SPA condition precedent and close the deal. The purchaser having taken tax insurance, the parties withdrew the ruling request.
Contingent risk insurance
Addressing known issues, tax insurance provides the conceptual foundation for managing other forms of known risk, such as litigation and other ‘contingent risk’ insurance. Deal-savvy buyers embrace this in an M&A context to differentiate their proposal (so that, having transferred the known risk to the insurance market, it is unconditional in that respect) while experienced sellers look to arbitrage the cost of insurance against the cost of an escrow or price chip that the buyer would otherwise require.
Sellers would be well advised to consider arranging insurance to address known issues that could have a deal impact – third-party litigation or the commencement of a file review by a tax authority, for instance – rather than allow buyers to seize that initiative, lest value is left on the table. Equally, contingent risk insurance can benefit clients outside a deal context by providing a wrap solution to facilitate the winding up of PE, real estate or other fund or structured arrangement to address legacy issues – including potential residual liabilities arising from warranties given in prior transactions or tax claims – or relieve trapped cash held in escrow, allowing clients to manage both their legal risk and fund administration matters more efficiently and cost-effectively.
M&A sector focus – technology, media and telecoms
In its mid-year deal drivers review, Mergermarket sees technology, media and telecoms (TMT) as one of the leading industries for EMEA deal activity over the coming months (Mergermarket H1 2018 Deal Drivers EMEA, 2 August 2018). From an M&A insurance perspective, we have seen sellers of technology businesses manage their deal risk more proactively by preparing for disposal in a more sophisticated way, including commissioning sell-side scans of open source code and more extensive VDD on intellectual property (IP) and cyber risks.
Given the expected volume of technology deals across EMEA, key points for advisers and clients to consider when contemplating M&A insurance in this space include:
Insurer selection: obvious, perhaps, but most importantly the W&I insurance broker should carefully consider which insurers have an appropriate understanding of the sector and a sufficiently pragmatic and flexible approach to both underwriting and coverage to match. Cyber: many insurers typically exclude cyber risks as a starting position, which, for many technology clients, is significant. While insurers may relax this once they have reviewed the due diligence, clients should ensure – at the broker selection stage – they are satisfied with the W&I insurance broker’s experience in this regard. The quality and amount of cyber risk insurance that the target company carries is often an important factor for the insurer’s approach on coverage, so investing in relevant due diligence to address this often pays dividends. IP: a key risk on technology deals, coverage is particularly dependent on the scope and quality of the diligence performed and how much comfort it gives the insurer; given that insurers tend to rely particularly heavily on IP diligence, the flexibility and pragmatism of approach referred to under ‘Insurer selection’ above becomes real. the General Data Protection Regulation (GDPR): given the legislation only came into effect in May 2018, insurers have, so far, taken a generally conservative view on GDPR matters, but coverage is possible if robust due diligence has been performed and a flexible underwriting approach is taken. Contractor risks and holiday pay: many technology businesses engage large numbers of individuals on a contractor basis, rather than employee basis, which can be challenged by authorities in a target company’s jurisdiction of operations if such contractors are deemed to be employees and entitled to statutory benefits (pensions, holiday pay, etc) for which the target company is liable. Authorities’ hawkishness varies from jurisdiction to jurisdiction but insurers will look to underwrite this area in detail and thorough diligence will be key to coverage.
Insurers’ need for appropriate due diligence in the specialist areas of technology deals is a recurring theme. In support of clients’ deal-making in this space and to provide a comprehensive, differentiated offering to clients in M&A, Aon has developed specialist risk due diligence capabilities in cyber and IP through the acquisitions of Stroz Friedberg and 601West, leading firms in their respective fields.
Insurers recognise that the long-term viability of M&A insurance is dependent on valid claims being processed and, where appropriate, settled promptly, a point that clients often focus on when selecting an insurer. From our discussions with new capital providers in the M&A insurance market, we note they are aware that their first claims experience will be crucial for their reputation.
We recommend that clients consult their insurance broker when considering making a claim under an M&A insurance policy to ensure the claim is prepared and presented to the insurer appropriately. Aon’s M&A team includes former litigation and insurance law firm partners to help dedicated claims specialists manage this key aspect of the process.
Over the past year, Aon US has helped negotiate payment on 12 representations and warranties (R&W) insurance claims resulting in payments from six different insurer groups in amounts ranging from US$400,000 to US$17.5 million. The claims comprised both first- and third-party claims and arose from a variety of breach types, including financial statement and tax breaches, material contract issues and wage and hour complaints.
Where next for the insurance industry?
In an increasingly globalised environment, M&A continues to perform a key function in promoting economic activity and facilitating growth. For the insurance industry to be effective in supporting more cross-border activity, a global strategy is required that is attuned to local market conditions, cultural influences, language, domestic law and buyer preferences, as well as an ability to execute. Aon’s market initiative to help clients obtain US R&W coverage in EMEA represents a key example of this.
As M&A insurance becomes increasingly prevalent in cross-border dealmaking, clients and advisers should ensure that the parties they are dealing with – brokers and insurers – present the right capabilities. In our view, this requires a global strategy and presence that allows clients to access capital from multiple jurisdictions. It is not uncommon for large, complex placements to source insurance capital from Europe, North America, Bermuda and the Asia Pacific regions and, as such, the ability to provide access to best coverage, underwriting processes and capital in any given region is fundamental to supporting clients in the execution of their global M&A strategy.
* The author gratefully acknowledges contributions to this article from other members of Aon’s M&A and Transaction Solutions team, including Alistair Lester, David McCann, Tom Saunders and Charles Inglis.