Warranty & Indemnity insurance – allowing private equity to boost IRR
May 2014 | EXPERT BRIEFING | PRIVATE EQUITY
Warranty & Indemnity (W&I) insurance has been used for private M&A transactions since the 1990s to overcome specific deal hurdles. It is only more recently that W&I insurance is being used as a ‘deal tool’, allowing the parties an alternative approach. A growing number of PE funds and leading corporate lawyers are using W&I insurance on every deal. This piece explains how PE funds are using W&I insurance to boost their internal rate of return (IRR).
How W&I insurance works
The premise behind W&I insurance is simple: in the event of a warranty breach or claim under an indemnity, it is the insurer, not the seller, that picks up the bill. Whilst the seller normally introduces W&I insurance to a deal, it is typically the buyer who is the insured.
The policy is held by the buyer and tracks the warranties and indemnities in the underlying agreement, but an A-rated insurer – not the seller – is the counterparty to the contract. In the event of a warranty or indemnity claim, the buyer claims directly against the insurer. There is no need to involve the seller in the claim; the insurer will make good the buyer’s financial loss.
As the insurer is indemnifying the buyer for any loss that it suffers, it allows the seller to greatly reduce its risk in the underlying agreement. This is because the buyer is getting the protection that it needs directly from the insurer. So the seller is able to cap its risk at a much lower level, typically 1 percent of the deal value.
What has changed?
Historically PE funds have taken the position of limiting the warranties and indemnities to title and capacity, with the buyer having to ‘price in’ the risk. In recent years this position has become increasingly difficult. There is a heightened awareness of risk, and buyers are demanding a full set of warranties and indemnities, capped at an appropriate level.
As a result of these changes, PE sellers face certain choices. Firstly, they can dig in their heels and refuse to provide warranties. This approach is likely to limit the pool of buyers, raise execution risk and suppress value (as buyer’s price chip to adjust for the higher levels of risk). Secondly, they can provide warranties to the buyer. Often these will need to be supported by placing a portion of sale proceeds in escrow. This will limit, and delay, returns to investors (money will need to be retained to avoid claw-back) and prevent the fund from liquidating . Or, finally, they can use W&I insurance to provide buyers with the protection that they need. This avoids the two pitfalls identified above.
There is now a highly competitive market in London for W&I insurance resulting in big improvements to both process and price. Premiums are now 1-2 percent of the policy limit. So for a $150m deal, that requires a policy limit of $20m, the premium is in the region of $200,000-$400,000. This is a one-off premium for the entire policy period, typically seven years.
W&I insurers require an arm’s length negotiation between buyer and seller. The buyer will still need to carry out its usual due diligence, whilst the seller will be required to carry out a thorough disclosure process with management. Whilst negotiation of the contract needs to remain robust, the presence of W&I insurance allows the parties to avoid lengthy disagreements over the caps and survival periods. In turn the insurer is paid a premium for carrying this risk. Typically the seller’s warranty caps are set to a very low level, around 1 percent of the deal value.
A practical example
A UK PE house was selling a portfolio business to a US PE house for a consideration of $200m. At the heads of agreement stage the seller made its position clear: the seller’s warranty cap would be $2m, backed by a $2m escrow. The remaining protection was to be provided by a W&I insurance policy, in the name of the buyer. The seller agreed to pay the premium for a $30m policy limit.
The buyer accepted the position on the condition that the policy provided it with the protection it required. The deal was then approached in the usual manner – the buyer conducted due diligence on the portfolio company. The seller and buyer then negotiated the deal in the usual way, save for the arguments over caps, survival periods and escrow. This is because the insurer, not the seller, was carrying the risk.
The premium was $450,000, but the seller avoided placing $30m in escrow, enabling it to boost returns to investors and raise the IRR.
On private M&A transactions, buyers are taking an increasingly cautious approach; the threshold of contractual protection that they require is much higher than pre 2008. As a result, W&I insurance has played an increasingly important role in the deal process, particularly for PE sellers who are able to use insurance to increase their IRR.
Whilst the growth of W&I insurance over the last few years has been rapid, continued improvements point toward it becoming an ever-growing feature of the deal landscape.
Richard French is an associate director and head of Transactional Risk Insurance at Howden Insurance Brokers, UK. He can be contacted on +44 (0)20 7645 9313 or by email: email@example.com.
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