Considerations for strategic acquirers in the R&W insurance market
September 2019 | EXPERT BRIEFING | MERGERS & ACQUISITIONS
Over the last few years, the US market for representation and warranty insurance (RWI), has continued to mature, with notable increases in the number of policies priced and bound. These increases have been driven by improved pricing resulting from competition among established markets and newer carriers entering the space, as well as greater acceptance of policies by both financial and strategic buyers.
The RWI market initially developed overseas, particularly in Europe, and was first championed in the US by private equity (PE) sponsors and other financial buyers, typically limited in their ability to compete on price, looking for other ways to sweeten their bids. Because an RWI policy is designed to function as a rough substitute for a traditional seller indemnity for breaches of the reps and warranties in the main M&A agreement, the RWI market provided sponsors with the means to offer sellers a transaction structure that largely eliminated the risk of post-closing claims, in the absence of fraud. And as this practice became more common, a ‘virtuous’ cycle developed: additional carriers entered the RWI market, the increased competition that resulted reduced the pricing of policies, and cheaper RWI policies diminished the cost to financial sponsors of offering sellers the right to walk away cleanly at closing.
At the same time, as the US M&A market has remained hot, with sustained pricing for assets at historical highs, other bidders, including traditional strategic acquirers, have increasingly been pushed to accept a ‘no post-closing remedies’ structure in order to remain in the bidding for attractive auctions, particularly as financial sponsors increasingly have record levels of committed capital, or dry powder, with which to compete on price. Like the financial sponsors before them, these strategic acquirers have also turned to the RWI market to provide them with some source of post-closing recovery in the event of a breach of reps and warranties.
In our experience, however, tapping the RWI market presents unique challenges for many corporates or other strategic acquirers.
Determining ownership of the RWI process
In the financial sponsor context, outside counsel usually manages the RWI process, with some input from the sponsor’s in-house counsel. In the strategic acquirer context, navigating this process can sometimes be more complicated. In-house counsel typically works independently with outside counsel on due diligence, marking up the main M&A agreement and preparing the bid submission, but when the topic of ‘insurance’ arises, other constituencies take notice – treasury departments, chief risk officers and similar managers who generally have responsibility for the company’s regular-way insurance arrangements. Many of these managers often have had little exposure to RWI policies and more generally may not be as well versed on M&A transactions as in-house counsel. At the same time, they may approach the sourcing of an RWI policy with a broader set of considerations, outside of the four corners of the transaction, often with their own preferred insurance broker, who, depending on the individual, may or may not be familiar with RWI policies.
If one of these managers leads the RWI process, it is important that he or she works on an integrated basis with in-house and outside counsel, both to understand how the RWI process fits into the overall auction timeline and to ensure that the RWI policy synchs up with the underlying M&A agreement and related risks uncovered in due diligence. It is also essential that he or she works with a broker knowledgeable about RWI policies.
Avoiding the ‘dead bird’ diligence report
Because RWI policies do not cover known issues uncovered in the insured’s due diligence, it is often suggested in M&A circles that buyers of RWI policies have an incentive to do as little due diligence as possible, though in practice the RWI carriers are quite adept at sniffing out self-imposed scope limitations in their underwriting processes. We believe that this can be a dangerous line of thinking, as even in an insured deal the RWI policy will have deductibles, coverage limits and policy exclusions that the buyer is effectively self-insuring – risks worth diligencing. But a different phenomenon is often at work with strategic buyers.
Strategic buyers often have their in-house functional teams conducting the diligence of the target in their respective areas – the person charged with responsibility for managing the company’s environmental issues will review the target’s Phase I and Phase II environmental reports, the in-house real estate team will review the target’s leases, and so on. Because these people will ‘own’ these issues following closing, they sometimes feel an incentive to flag each and every issue to the chief dealmaker or management for when these issues inevitably resurface post-closing. Particularly for strategic buyers without a sophisticated in-house deal function, chief dealmakers can be flummoxed by due diligence reports from functional teams flagging ‘dead birds’ if they are not put into the context of the overall deal or provided with recommendations on how to address or cabin them off.
Strategic buyers can avoid the awkwardness that can flow from dealmakers being presented with ‘dead bird’ issues by embedding specialists at their outside law firm with these functional teams as the law firm specialists can often help to provide better context for the overall deal and assist the functional teams and dealmakers in distinguishing between customary risks borne by buyers and issues that may require real escalation.
Reducing the ‘PE advantage’ in policy negotiations
Strategic acquirers are often surprised to learn that the terms of RWI policies are not standardised and, in fact, repeat buyers of RWI policies – principally the financial sponsors that gave birth to the US RWI market – get more favourable policy terms from the major RWI carriers, typically starting with the form of policy from their last deal or other previously negotiated form. These forms can often be materially more favourable to the insureds than the carriers’ off-the-shelf policies.
Of course, some of the more active strategic acquirers have now built up a significant library of RWI policies that have been improved over time. On the other hand, less active strategic acquirers should understand that the negotiation of their policies may take some additional back-and-forth, potentially over the sourcing of multiple policies with a particular carrier, to improve their forms and at the margin, there may be some terms the carriers are not as willing to offer a party that is not as active. In our experience, however, this is usually manageable and, in some cases, strategic acquirers can also enlist a financial sponsor seller to help put pressure on the primary carrier to bring the strategic acquirer’s policy more in line with the sponsor’s own form. Strategic acquirers may also be able to exert additional leverage during negotiations with particular carriers given their spend with the lead carrier across the entirety of their overall insurance portfolio.
Getting claims paid
Similar to policy negotiations, financial sponsors are often viewed as enjoying a distinct advantage in getting their claims paid by RWI insurers. The theory goes that, because financial sponsors are repeat buyers, carriers are reticent to deny a claim by them lest that result in the sponsors no longer buying policies or steering their business elsewhere. Strategic acquirers that do not play in this space as frequently are often left to question whether they will get the same white-glove treatment.
That perception may be overstated, however. First, the strategic acquirer may have other relationships with the carrier that it can leverage in claims negotiations. Any remaining disadvantage can potentially be further reduced by focusing any sourcing of RWI carriers on one carrier or a small subset of carriers to improve the perception that the strategic acquirer is a repeat player. In addition, most of the top-tier brokers in the RWI space now offer some assistance and limited consultation in the claims management process as an included service for their clients. These broker teams can help strategic acquirers to improve their chances of getting paid on claims, and instill a bit of discipline on carriers who may be concerned that the brokers themselves will steer their clients elsewhere if claims are not paid.
For the uninitiated strategic acquirer, navigating the RWI market can seem daunting, but with the assistance of experienced counsel and the right broker, strategic acquirers can improve the attractiveness of their bids in competitive auctions by using RWI policies as a substitute for a traditional seller indemnity, often when competing against the very financial sponsors that first championed its use.
Paul M. Tiger is a partner at Cleary Gottlieb Steen & Hamilton LLP. He can be contacted on +1 (212) 225 2495 or by email: email@example.com.
© Financier Worldwide
Paul M. Tiger
Cleary Gottlieb Steen & Hamilton LLP