The prospect of unknown business risks between buyers and sellers is often a major hurdle in mergers and acquisitions deal negotiations. Neither side wants to assume responsibility for issues such as financial statement errors, taxes, contracts, intellectual property, or undetected compliance violations. To address this problem, during the last ten years the insurance industry has taken on some of the risk in M&A deals, so that the buyer and the seller are not the only parties who face this uncertainty.
Many underwriters now provide representations and warranties (R/W) insurance policies to allow third-party insurers to assume a portion of transaction risk, particularly in the middle market segment of private equity M&A transactions, helped by a decline in premium amounts as more insurance carriers offer R&W insurance products and more claims history data becomes available to insurance carriers. R/W insurance includes both “seller-side” policies and “buyer-side” policies, but buyer-side policies are significantly more common because they free up a greater portion of the closing proceeds for sellers, and buyers can recover damages even if their claims do not exceed the policy retention.
Buyer-side R/W insurance enables the buyer to recover losses that result from a breach of the seller’s representations or warranties from the insurer once the retention has been covered. Since the insurer assumes the buyer and seller will each cover half of the retention, the buyer is incentivized to do its due diligence and the seller to actively negotiate its representations and warranties. Premiums are usually between 3 and 4 percent of the policy limit, with the responsibility of payment generally falling to the seller for buyer-side policies. Retention amounts are usually between 1 and 1.5 percent of the enterprise value for deals over $50 million and 2 to 3 percent for smaller transactions. The retention typically “steps down” after 12-18 months, and only the buyer’s part of the retention remains. This often means that sellers only have 0.5 to 1 percent of the purchase price in escrow for 12-18 months, which is their entire transaction exposure, excepting instances of fraud.
Insurers currently offer a range of policy amounts from $5 million to over $500 million. They normally are not willing to offer coverage for less than $5 million, which means deals that are less than $50 million typically won’t have R/W insurance if the buyer wants coverage for at least 10 percent of enterprise value. However, an increasing number of parties are willing to buy a $5 million policy for deals valued under $50 million in order to maximize closing proceeds.
A buyer-side R/W insurance policy offers benefits to both sides in a transaction.
- In an auction, a buyer can include R/W insurance as part of a bid to help distinguish its offer, although as this becomes an increasingly common practice, it will transition to be an expectation of a strong bid rather than a distinguishing factor.
- Buyer-side R/W policies commonly offer longer periods of time during which the buyer can assert a claim then do normal market purchase agreements.
- With the seller’s exposure considerably less thanks to R/W insurance, sellers may be less likely to contest specific contract provisions.
- Underwriters usually give buyers the option to make a claim for “multiple of EBITDA” or “multiple of earnings” type damages, which are typically resisted by sophisticated sellers.
- Supplements the indemnification provided by seller which is beneficial in cases where seller has leverage to negotiate for limited indemnification obligations.
- Helps protect continuing business relations by avoiding the complex dynamics of seeking indemnification from a management seller, or where seller is an institutional investor with which buyer wants to maintain a relationship.
- Provides buyer with recourse in the context of a seller who may be difficult to collect from or who is required to liquidate or otherwise wind up with limited indemnification obligations (for example, a private equity fund nearing the end of its life).
- R/W insurance allows sellers to leave only a relatively small portion of the purchase price in escrow for a short period of time.
- R/W insurance can provide greater clarity regarding liquidating distributions for private equity funds nearing the end of their life cycle.
- For minority sellers, R/W insurance can ease concerns about being joint-and-severally liable for indemnification claims.