Private Equity Funds are investors with a time horizon. A private equity fund is already planning its exit upon entry into the financing of a portfolio company. Such an exit (exit) regularly takes place through the sale of its stake to a strategic buyer (trade sale) or other private equity funds (secondary buyout), or alternatively via an IPO. With regard to the exit, a distinction is made between the sale of a portfolio company (single exit) and the sale of all or the last of a portfolio company, which finally leads to the liquidation of the fund.
The top priority for a private equity investor is: “Cash is King”. He can only channel back to his investors what the private equity fund generates at exit (i.e. the purchase price that is actually available). The cash flow is measured by the performance of the private equity fund. Thus, actions that lead to an improvement in cash flow also always lead to an improvement in performance.
With every exit there is an information gap. The selling private equity fund regularly, over a longer period of time, has full information about the business development of the selling portfolio company. However, the fact that the private equity fund itself is usually not involved in the daily operations and, during the sale of the portfolio company, must trust the information from management – who is generally changing sides following the sale – represents limitations.
The buyer stands on the other side and receives limited insight into the portfolio company to be acquired as part of due diligence which is generally limited and fixed as of a cut-off date. However, a qualifying comment may be made here that, depending on the scope and timing of the due diligence, this insight may be more comprehensive than the level of knowledge on the part of the private equity fund making the sale.
This information gap results in certain provisions in the asset purchase agreement, which have long been standard and are intended to offset the lack of information of the buyer:
- Warranties or guarantees (Reps & warranties),
- Tax exemptions (tax indemnity),
- Exemption from environmental issues (environmental indemnity),
- Exemptions from litigation matters, and
- Exemptions from other risks identified in the due diligence.
The provisions alone are not sufficient to protect the buyer against the adverse effects resulting from his limited knowledge of the portfolio company to be acquired. Because warranties and indemnities only make sense if, in case of a breach of warranty or if the conditions of the exemption are met, the seller has sufficient realizable assets. Otherwise, the buyer bears the risk of insolvency of the seller. Since private equity funds regularly make their investments through intermediary companies (SPVs), which on their part regularly have only minimal equity, creditworthiness on the part of the seller is generally lacking from the perspective of the buyer. In addition, the selling SPV is generally liquidated after the sale, in order to pay out the entire sale proceeds to the investors. It becomes more dramatic for the buyer in the event of the fund liquidation, because in this case he knows that there is absolutely no more liability once the fund has been liquidated. For this reason, the buyer regularly requires financial protection for its potential warranty and indemnification claims.
Such protection can be achieved by:
- The seller guaranteeing his payment obligations with his “good name”,
- Group warranty (Letter of comfort),
- Purchase price retention,
- Trust Account (Escrow), and/or
- Bank guarantee/bank surety.
The first two types of security are not realistic in the case of private equity funds making a sale, as the fund is not consolidated into the group, and also the good name of a private equity fund alone cannot make up for the disadvantage that the SPV-seller regularly has minimum equity and has no claims against the fund. These last three forms of security again – from a selling point of view – have a negative influence on the Cash Flow. This is because as a result the seller, at the close of the business sale contract, does not receive the full purchase price or, in terms of an external bank guarantee, is charged additional costs which reduce the purchase price, or a cash deposit is required for the bank guarantee.
Improvement of the Cash Flow through representation & warranty insurance
A possible – and in Germany rarely used – option to improve Cash Flow at exit is obtaining representation & warranty insurance. Representation & warranty insurance (in the USA: Representation & Warranty Insurance, in Great Britain: Warranty & Indemnity Insurance) is not a new insurance product; it has been on the market for 20 years, and in Germany for 10 years. The providers are almost exclusively from the US or the UK, for example: Ace, Ambridge, AWAC, Beazley, Chartis, Chubb, HCC, Pembroke, Zurich (London market, source: Willis) as well as AIG and Hartford in the USA. The purchased insurance amount worldwide currently stands at approximately USD 1.6 billion (source: Jupiter Capital Partners).
Warranty insurance offers coverage for faulty warranties (i.e. breach of warranty) or the occurrence of events against which the indemnity clauses are intended to protect the buyer. A corresponding insurance policy can be obtained by the seller as well as the buyer. Depending on who obtains the insurance, the warranty insurance has certain features which at their core (i.e. the insurance risk), however, are the same. Warranty insurance has benefits for both parties, but the advantages for the seller in most cases outweigh those for the buyer.
Most importantly, from the perspective of the cash effect, as a result of the warranty insurance, the buyer’s claims that arise from a breach of warranty or indemnity are no longer directed against the seller, but against the insurance company. Since the buyer assumes the solvency of insurance, he does not need purchase price retentions, escrow or bank guarantees to cover its warranty and indemnification claims, and thus the seller receives the undiminished purchase price. Only the cost of the insurance (more on this to come) is deducted in a business sense because it is either paid directly by the seller or is charged by the buyer as a (transparent or concealed) deduction from the purchase price. A short sample calculation that illustrates the cost savings when using warranty insurance – see next site.
Click here to view table
At the same time, the calculation example above shows the potential advantage for the buyer who is in a bidding competition with other potential buyers: By knowing the cash effect, the buyer may offer to the seller that he himself (i.e. the buyer) shall obtain warranty insurance. Even if in this situation the purchaser deducts the cost of the warranty insurance from the offered purchase price, his offer is still better off by more than EUR 1.5 million than that of competing bidders who offer the same nominal purchase price. The buyer can thus gain an (possibly quite significant) advantage in the competitive bidding process. In addition, there is a psychological effect that should not be underestimated: If the buyer takes over the existing management, he can take them out of the “line of fire” upon the exit of the private equity fund by purchasing warranty insurance, because often the selling management is supposed to provide more extensive warranties than the private equity fund making the sale. If from the outset, the warranty to the buyer is not directed against the seller (including the management), but only against the insurance company, then the buyer exempts the managers de facto from liability – and thus can get him on his side at an early stage of a competitive bidding process.
The buyer requests EUR 10 million escrow to secure its warranty for a period of three years. The escrow amount has a 4% interest rate per year. With immediate availability of the escrow amount, the seller would make an alternative investment at 10%. Warranty insurance would be available up to 5% of the insured amount.
Click here to view table
In this case, the costs of the Escrow (EUR 2,061,360) are 4x higher than the costs of the warranty insurance (EUR 515,500). Of course, the amount of the cost savings depends on the alternative investment, however the cost of the escrow already predominates at an alternative investment of 6%. (1) Future value (with alternative investment at 10% p.a.)
However, the purchase of warranty insurance also has some disadvantages that should be considered when making an overall assessment: The most important drawback (in addition to the cost of the insurance policy) is that vendors and purchasers are at the negotiating table with a third party and must conduct parallel negotiations with the insurance company. This may lead to a delay in the negotiation process, and thus in the transaction. Last but not least, there are two new elements of uncertainty on the part of the buyer: Are there insurance gaps? And what is the “payment behavior” of the insurer? To the latter aspect must be added, however, that warranty insurance represents a commercial insurance product. An overly defensive behavior of insurance in case of a loss event would quickly get around in the market with the result that the insurer would have little chance against the competition.
Details on the contents of warranty insurances
According to industry information, warranty insurance with coverage of 15 million to 35 million GBP can be obtained from individual insurers, in the event of syndication even up to £ 200 million to 250 million (currency amounts in British pounds, as most insurers who offer warranty insurance in Europe come from the London market). A coverage amount below single-digit million euros for a warranty insurance is however not interesting for insurers. The term of warranty insurance can be up to seven years.
The insurance premiums for warranty insurance are regularly measured against the coverage level and in the case of a seller policy are around 1 to 4% of the insured amount, and in the case of a buyer policy this is 3 to 6% of the coverage, but not less than EUR 50,000. There are also one-off costs for the administrative expenses of the insurer (underwriting fee around EUR 20,000) and costs of legal counsel that are incurred even if the insurance is not concluded. Do not disregard the deductible of the policyholder (about 1% of the transaction value), which can often be adapted to the liability exemptions in the asset purchase agreement, so that to that extent there is correspondence in amounts. The insurance contract is generally very flexible, but mostly includes the following elements:
- Insurance amount (possibly with terms and conditions)
- List of insured warranties and coverage information (Coverage Spread sheet)
- Final purchase contract
- Statement that there are no known liability events
Unlike insurance intended for private consumers, which consists predominantly of non-negotiable terms and conditions, the contract provisions in most warranty insurances are negotiable; and this is also partly true for the following standard exclusions. These include:
- Blanket coverage - only concrete warranties are insurable.
- Warranties that include future prospects
- Warranties/exemptions with regard to taxes (supplemental insurance possible)
- Warranties/exemptions with regard to environmental damages (supplemental insurance possible)
- Indemnification for other (e.g. resulting from due diligence) risks (supplemental insurance possible)
- Warranties for cross-insurance policies (e.g. product liability)
- Breach of warranty of which the insured was aware at the time the insurance was purchased
- Fraudulent concealment of warranty claims (for the seller policy only)
- No personal injury or purely financial damages
- Note the restrictions according to the coverage spread sheet
- Take into account minimum limits
- Damage limitation (i.e. no consequential damages, penalties), negotiable
- No subsequent changes to the purchase agreement
- Breach of covenants
Negotiation and conclusion of warranty insurances
The underwriting process generally is as follows. According to some insurers, in a best case scenario an insurance policy can be concluded within four weeks. Of course, this does not apply in the case of complex corporate transactions.
First estimation: The respective insurer can usually give a statement of insurability within one week of receipt of all documents.
Commission: Commissioning can usually be done quickly.
Risk assessment may begin after payment is made for the insurer’s legal counsel and the insurance coverage and terms are coordinated. Risk assessment: Individual insurance companies indicate that in some cases they complete risk assessment within two weeks of submission and review of all due diligence reports and other necessary documentation.
Contract documents: The negotiation of the warranty insurance requires coordination with the sales contract and is thus done parallel to and with a certain time delay after the negotiations of the purchase contract.
In the context of the risk assessment, the insurer requires, among other things, the following information: Information Memorandum (where available), due diligence reports from the consultant of the purchaser, data room documents (data space index and Q&A list), details of the consultants of the policyholder (quality check: known or rather inexperienced consultants), as well as the most current draft of the contract at the time of underwriting. It is important to know that the insurer does not conduct its own due diligence, but rather relies on the available due diligence reports. It is unclear whether the insurance requires an acceptance of liability from the respective consultant (reliance) in case of inaccuracy of the respective due diligence report.
Whilst negotiating the insurance contract, a number of issues need to be addressed first and foremost from the perspective of the buyer – who will ultimately be dependent on the insurance. Aside from the time aspect of the parallel negotiations, the buyer must ensure that the purchase and insurance contract cover each other (matching). In order to accomplish this, it must first be ensured that both contracts are subjected to the same legal system and that the basic interpretation of the law (i.e. that of the purchaser and the insurance company) is the same. After that the buyer must ensure that the warranties in the asset purchase agreement are covered exactly by the insurance contract. The best situation for the buyer is when an insurance event contains a reference to the purchase agreement. The insured event then automatically triggers liability in accordance with the asset purchase agreement. If such a reference cannot be made, then the buyer must closely examine if the meaning of the insurance terminology and the definitions therein (e.g. of “breach of warranty” and “damage”) match. Finally, the buyer must ensure that the scope of the guarantees in the asset purchase agreement is the same and that it is transferred into the insurance contract. Finally, the buyer must check whether his deductible (according to the insurance policy) does not exceed the indemnity limits of the seller (in the acquisition agreement). Further provisions in the insurance contract which the buyer must take into account apart from the asset purchase agreement:
- Start of insurance protection
- Legal consequence of a breach of the duty to provide information
- Exclusions (see above)
- Knowledge attribution
- Obligations of the insurer in case of an insurance event
- Procedures for the submission of insurance claims
When is it useful to purchase warranty insurance?
In any event, the (intended) purchase of warranty insurance results in additional expenditure of time and costs for buyers and sellers. It is therefore appropriate to consider carefully whether it makes sense in the given situation to purchase warranty insurance. From the perspective of the seller, it is always worthwhile if a substantial cash-out effect is expected and if from the sellers perspective the success of the transaction is crucial (as in the case of private equity funds where effectiveness is measured primarily against RRI). From the buyer’s perspective it is important to avoid the risk of insolvency of the seller. Additional benefits – and this has already been mentioned – can be had if the buyer gains a competitive advantage in a bidding process. Either because, during the same bidding process, he can offer an economically higher price because of the cash effect of the warranty insurance, or because the management prefers the buyer’s offer because of the limitation on their own liability (and can assert this against the seller). Also, the (selling) management itself could consider taking out warranty insurance, which then acts simultaneously as a legal protection insurance, if purchaser asserts a claim against management. Situations could also arise in which a warranty insurance policy covers only part of risk, but in which this partial risk depends on the completion of the business transaction; for example, if environmental risks were identified in the course of due diligence but the occurrence of damage is uncertain. In such a situation, the seller and buyer could enter into a contract of sale in which the seller is liable for the regular observance of the warranties given by him and the insurance policy covers the environmental risks. To the purchaser, the warranty insurance also serves as additional insurance after the warranty period in the contract expires, if the limitations period provided in the purchase agreement is too short from the buyer’s perspective.
In summary, it can be said that the warranty insurance usually has advantages for both parties due to the positive cash effect and coverage of the risk of insolvency of the seller. However, warranty insurance is not a panacea, especially in the case of problematic due diligence results. Because of the expense associated with the conclusion of the insurance, whether the costs are in proportion to the (purported) advantages of warranty insurance should be reviewed in any event.