We continue our series of articles concerning issues surrounding distressed M&A transactions with some observations on potential approaches to and the efficacy of due diligence and warranties, and the potential for warranty and indemnity insurance (W&I).
In theory there is no reason why the areas of focus for a buyer's due diligence in a distressed M&A process should vary significantly from a traditional M&A process. However in a distressed M&A process information is likely to be limited, especially where a target company's administrators are running the process or its managers are absent or otherwise disengaged. Given the accelerated timetable for most distressed M&A processes, there is also likely to be less time for due diligence even if information is available. That means less time to address any risks and/or information gaps identified as part of due diligence. It is therefore particularly important to identify key issues early on and prioritise due diligence on areas that are most proximate to value.
Acquisition structures also impact the scope of due diligence. Liabilities stay with the target company, so if an acquisition is structured as a share sale it will be critical to identify the target company's material liabilities. It will also be important to ascertain whether value deriving from key assets may be exposed as part of the transaction. For example, a customer or supplier might have a right to terminate its contract upon a change of control of the target company.
Asset sales offer more flexibility, as a buyer can cherry pick the assets it wishes to acquire. If an acquisition is structured as an asset sale, potential areas of focus include:
- the formalities for transferring assets, including whether any consents are required;
- potential third party claims to the assets (for example, retention of title clauses);
- the potential for employees to transfer to the entity acquiring the assets by operation of the TUPE, especially if only a certain part of the business is being acquired. In some instances it may be possible for a buyer to negotiate a retention from the purchase price for known risks of this nature; and
- commercially, the impact of the transaction on third parties and in particular whether third parties will continue to trade with the 'business' in its new form if historic liabilities are not addressed.
The extent to which the sale process will facilitate substantive due diligence is a key initial consideration, especially as warranties are unlikely to be available to 'plug' information gaps. Establishing a due diligence team and settling on an achievable scope are both key initial considerations. The COVID-19 pandemic will complicate matters further as restrictions (whether imposed by Government or the parties themselves) may impact access to documentation and site visits.
Warranties are generally split into two broad categories:
- so-called 'fundamental' warranties (for example, that the seller has the right and capacity to sell the shares free from all encumbrances); and
- business warranties (for example, that the target company is not involved in any litigation).
In a traditional M&A process it is customary for the acquisition agreement to contain both fundamental and business warranties. The scope for warranties in a distressed M&A process will depend on the circumstances but will be narrower and it is not uncommon for acquisition agreements to contain fundamental warranties only. Should the transaction be structured via an insolvency process warranties will not be available.
This places more importance on the effectiveness of the buyer's due diligence in identifying and mitigating risk. However, as explained above, that process may not be wholly satisfactory. If the existing management team are staying on and being incentivised as part of the transaction it may be possible to ask them to provide some warranty cover. The effectiveness of that cover will depend on a number of factors, including the extent to which those managers have sufficient covenant strength and the willingness of the buyer to claim against managers on whom it may be relying to turn around a business’s fortunes.
Even where a buyer is able to obtain some degree of warranty cover, the warrantors' liability is likely to be limited, especially if the consideration for the transaction is non-cash or nominal (as is often the case in a distressed M&A process) or otherwise where the covenant strength of the seller is unlikely to facilitate settlement of any claim. In these circumstances the main benefit of warranty cover is the information it provides to a buyer through the substance of the warranties and any disclosures made against them. It follows that all roads lead back to valuation, pricing and the buyer's appetite for risk balanced against the potential rewards of completing the transaction.
Issues around warrantors' covenant strength, appetite to provide cover and limitations on liability can be addressed by W&I. The product enables a buyer to claim directly against an insurer in the event of a breach of warranty. This is naturally very attractive to sellers and may tip the balance between bidders in a competitive process, especially where a potential buyer is able to present a W&I policy as part of its bid.
W&I policies in respect of traditional M&A transactions are customarily subject to certain limitations, including:
- a level of liability for the warrantors before the buyer can bring a claim under the policy (although it is not uncommon for this to be as low as £1); and
- areas of known risk (including specific issues identified during due diligence or through disclosure) expressly carved out of the policy.
Traditional W&I policies are an increasingly popular option on M&A transactions and the product has evolved and adapted to demand from the market.
One such evolution is 'synthetic' W&I. This is where warranties are contained in the W&I policy rather than the acquisition agreement. Accordingly they are negotiated with the insurer rather than the seller. A prescribed minimum level of due diligence is typically required to unlock a synthetic W&I policy. Premiums are also higher and coverage is likely to be more limited than under a mainstream policy. However they have the potential to offer significant comfort to a buyer and may be a viable means of addressing risk in a distressed M&A process where adequate protection might otherwise be unavailable.