De-risking M&A in EMEA: risk management and insurance
July 2019 | TALKINGPOINT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
July 2019 Issue
FW moderates a discussion on de-risking M&A in EMEA through risk management and insurance, between Kit Westropp, Mark Storrie and Carl Christian Rösiö at Euclid Transactional UK Limited.
FW: What are the main risks currently facing buyers and sellers conducting M&A transactions in EMEA? How do risks differ between such a wide range of geographies across the region?
Westropp: One risk affecting nearly all transactions is uncertainty. This affects both sides of a deal but particularly the selling side. An M&A transaction involves a huge commitment of effort and resources and nobody wants to see all their efforts and cash wasted if or when a deal fails to go through. In the UK, for example, ‘Brexit uncertainty’ is a consideration in virtually every transaction as buyers struggle to make plans when the future relationship with the EU remains up in the air. In all transactions, an inherent source of uncertainty is negotiation, a necessary part of every deal but, nonetheless, a source of friction and potential disagreement. Transaction parties must agree fundamental issues, such as purchase price and transaction structure, but also agree complex contractual documentation, including the level of contractual protection the seller will provide for problems with the business pre-closing.
Christian Rösiö: From a seller’s perspective, the main risk is deal certainty, coupled with the risk of losing control of an auction process with ever more increasing pressure from bidders throughout. From a buyer’s perspective, risk allocation and risk assessment have always been, and will remain, one of the key aspects of conducting M&A, since it directly impacts both valuation and post-merger integration. The ability to factor in the ‘known known’ – meaning risks you are aware of and can quantify – but also to diligence and assess the ‘known unknown’ – meaning risks you are aware of – and perhaps even the ‘unknown unknown’ – meaning risks you are not even aware of – is pivotal. With the inflow of more international capital into Europe – for example US and Asia investments – there is an increased focus on understanding cultural differences and properly understanding the risks of investing into a lesser-known territory, with often very different legal, regulatory and political landscapes.
Storrie: Changes to the political landscape and the introduction of new legislation can give rise to issues that have the potential to impact an M&A transaction at any time. While individual issues are highly jurisdiction-specific, there is a clear trend toward greater levels of uncertainty across Europe, the Middle East and Africa (EMEA); from macro-level issues such as Brexit for businesses in the UK and the EU, through to more incremental but significant developments such as the introduction of tax in the Gulf Cooperation Council (GCC) region, which has presented a particular challenge for transactions in the retail sector. Another challenge is the increasing pressure to complete deals quickly, particularly where the process is run as an auction. This time pressure makes it more difficult for a buyer to assess whether the target is in compliance with recent legislative changes and, if not, to obtain appropriate protection from the seller.
FW: What role can M&A insurance play to mitigate these risks and assist buyers and sellers to get deals done?
Westropp: M&A insurance seeks to remove some key areas of deal uncertainty. One area is negotiation of the level of liability for warranty breaches. Buy-side M&A insurance involves an insurer agreeing to be liable for breaches of warranty instead of the seller, such that a seller can limit its liability under the purchase agreement to a much greater extent than would previously have been possible, generally being liable only for the level of excess or ‘retention’ under the insurance policy or in some cases capping liability at £1. A second area is the strength of the seller’s covenant and whether it will be available, willing and able to compensate a buyer if it were to make a claim for breach of warranty. An M&A insurance policy provides the policyholder with the comfort that an insurance company with a strong balance sheet will be available to compensate it for loss suffered when a business is not what it seemed.
Christian Rösiö: Given the traction and development of M&A insurance over the last decade, underwriters today have gained lots of experience and expertise to assess these risks across different jurisdictions, sectors, industries and businesses. Insurers and insureds are aligned in the sense that insurers can help insureds to avoid some of the more common pitfalls and also assist insureds by ascertaining that they have tried to assess the relevant risks. Generally, underwriters today are more proactive and commercially driven than before, which also means that the insurance process runs more smoothly alongside the transaction, thus increasing deal certainty, even in the most challenging auction deals with very tight timetables.
Storrie: The purchase price and the allocation of business risk between the buyer and seller will always be at the heart of the discussion on any sale process and, if a negotiation breaks down, it will almost always be due to a fundamental disagreement on one of these aspects. M&A insurance can assist with both areas and, in certain circumstances, create value in the transaction for both the buyer and the seller. For example, a potential tax exposure identified late in the process may result in a buyer demanding an indemnity from the seller, which the seller may not be able to give. It would therefore be necessary to agree an up-front price reduction, but it often proves very difficult to find an acceptable middle ground for risks that will have a significant impact but a low likelihood of arising. A specific tax insurance product will give a buyer the protection it requires and allow it to pay the full purchase price to the seller, at a cost which is significantly less than the price reduction that the seller would otherwise have needed to agree in order to avoid giving an indemnity.
FW: Does insurance on an M&A transaction reduce the need to conduct due diligence? What are the key areas that need to be considered when scoping a due diligence exercise for an insured transaction?
Westropp: M&A insurers will always want to see that a normal M&A process has been undertaken, in particular that a buyer has conducted customary due diligence on the material elements of a business. M&A insurance generally covers matters that a buyer is not aware of, having conducted a normal due diligence exercise. As such, M&A insurers during underwriting will seek to establish that a buyer is aware of all the matters that it should know through normal due diligence. When a buyer is scoping its due diligence, it should bear in mind that insurers are generally unwilling to provide coverage for material topics or jurisdictions that have not been subjected to proper due diligence. In general, we find that clients do undertake proper due diligence, which stands to reason since they are still buying a business and it is far more desirable in any event to uncover and deal with issues before signing a deal, rather than discovering them later down the line.
Christian Rösiö: Insurance on an M&A transaction does not reduce the need to conduct due diligence – especially if insureds are looking to obtain the best possible cover and protection out of their policies. However, insurers can be a helpful speaking partner in terms of understanding which areas are key and which areas might be of less concern. Thus, while insurance does not imply a lesser need to conduct due diligence, it does often imply that the parties can be more focused and efficient in their diligence work, thus giving the parties ‘more bang for the buck’. Given today’s structure of insurance policies with very low retentions or deductibles, this does imply an increased focus on both scope and quality of diligence – in particular where a business has operations spread across multiple jurisdictions.
Storrie: M&A insurance is not intended to replace due diligence; it is there to cover the risks that have not come to light after a reasonable diligence exercise has been conducted. This allows a buyer to address any identified issues in the sale agreement or through a specific insurance policy while having protection for issues that have not been disclosed. We would therefore encourage buyers to scope the due diligence exercise in the same way as they would have done if insurance was not being used.
FW: What key advice would you offer to buyers and sellers when looking to introduce M&A insurance into a transaction process? What options are available and how have they evolved in recent years?
Westropp: My key advice would be to involve a broker as early as possible in the process to ensure that insurers are lined up well in advance of signing. This will also allow a broker or insurer to provide input on the proposed warranty package to the buyer or seller, as applicable, to ensure that coverage will be possible for all warranties proposed. The product has evolved on many fronts in recent years, for example insurers have a much broader appetite for sectors and jurisdictions that would previously have been difficult. A more recent development is the possibility of obtaining ‘US style’ cover on European deals, which allows a US buyer to obtain the type of cover it is used to stateside on its deals in Europe.
Christian Rösiö: The importance of using experienced advisers and underwriters with a solid track record within the relevant jurisdictions and industry cannot be emphasised enough. With experienced advisers and underwriters comes efficiency and quality throughout the process, which results in greater deal certainty while also enabling the insured to focus on the other workstreams in the transaction. Over recent years, focus has shifted from obtaining the cheapest policy toward obtaining a best-in-class policy in terms of execution, cover and claims handling.
Storrie: We would advise that buyers and sellers speak to their broker as early as possible in order to ensure there is sufficient time to work through the potential issues and obtain the broadest possible coverage. For sellers, this should be before a draft sale agreement has been provided to potential buyers to ensure that none of the terms offered are uninsurable. Stapled insurance products, where the process is controlled by the seller and partially underwritten before being handed over to the leading bidder, or bidders, in the final stages are becoming increasingly common in auction sales. It is now possible for the larger underwriting teams to handle four or more bidder workstreams simultaneously, but we would recommend that sellers carefully consider at what stage the process should be handed over, and to how many bidders, in order to avoid limiting options in the market.
FW: How has the appetite changed for M&A insurance in the EMEA region in recent years? Is it being used more frequently and what changes are you seeing with regard to the coverage, terms and pricing of M&A insurance policies on the market?
Westropp: We have seen a steady increase in the appetite for M&A insurance in EMEA. In the UK, it has become standard for private equity exits and is also now becoming popular with strategic buyers as well. At the same time, pricing has reduced – although I would say pricing has become stable in the UK over the last year – and coverage has widened considerably.
Christian Rösiö: Across EMEA, we definitely see it being used more frequently. The Nordic region is perhaps the most advanced region, both in terms of appetite for using insurance and also in terms of experience from using the product. It is today extremely rare to see a mid-market deal in the Nordics without insurance involved. This has had a very positive impact for both sellers and buyers, since there are now plenty of experienced advisers – commercial, legal, financial, tax, environmental, technical, and so on – with a very good understanding of the rationale for using insurance, what it can offer and what insurers need to complete their underwriting.
Storrie: M&A insurance is now available on transactions in a wide range of EMEA jurisdictions. We have seen M&A insurance become commonplace on transactions in the UK and Europe, with a similar dynamic now driving growth across the wider EMEA region.
FW: Can M&A insurance also be used to address specific or known risks where buyers and sellers are unable to agree how to allocate these or the extent to which they should impact the sale price?
Westropp: While standard warranty & indemnity (W&I) policies do not generally cover ‘known issues’, some insurers offer contingent risk policies which will cover known risks, generally where the risk is a matter of interpretation of legal or tax analysis. Most of such contingent risks insured are tax risks, and these can be a great help to transaction parties where a specific indemnity or escrow is not palatable. In the UK in particular, insurers have a wide appetite for identified low risk tax contingencies, and pricing in the market reflects this.
Christian Rösiö: The counterparties in a transaction typically have differing views on both risk assessment and risk allocation – for example, the seller may view a risk as both low likelihood and low severity whereas the buyer might assess the very same risk as a higher likelihood coupled with perhaps higher severity. Insurance will view the same risk from another, perhaps more objective angle, and assess it accordingly with an aim to de-risk the transaction from an issue that otherwise could have had a material negative impact on the deal timetable, and thus in the end, on deal certainty.
FW: What trends are you seeing in terms of claims? How is the claims process typically run and to what extent is this being taken into account when selecting an insurance provider and putting a policy in place for an M&A transaction?
Westropp: The increase in M&A insurance policies written has naturally led to an increase in claims activity. Claims processes will vary between carriers and claims capability should be a key factor when choosing an insurer. Only a few carriers and managing general agents (MGAs) have specialist M&A claims personnel. It is vital that the claims process is collaborative and efficient, and the insurer should strive to ensure the best outcome for clients.
Christian Rösiö: We see an increase in both claims notified and claim payouts. This demonstrates both the need for insurance, but also that the policies are providing adequate and equitable protection. It is important to distinguish between first-party claims where the insured has found discrepancies within the target itself and third-party claims where a third party – for example a customer of the target – is claiming against the target for discrepancies in their relationship. First-party claims will take longer to assess, given that they may involve valuation metrics of the insured to apply to the underlying claim. Third-party claims will often take less time for similar reasons, but depending on the identity of the third party, such as a customer, a supplier, an employee or the authorities.
Storrie: Having assurance that valid claims will be settled fairly and efficiently is often the most important factor for buyers of M&A insurance when selecting an underwriter. We have seen an increasing number of claims in the market as M&A insurance products have gained traction, and it is essential to the future success of the market that these claims are dealt with in a way that gives confidence to buyers and sellers when allocating risks.
FW: How do you see transactional risk management in general, and M&A insurance in particular, developing in the months and years ahead?
Westropp: We are entering an interesting phase in the M&A world as many expect a slowdown in certain sectors and markets. In the short to medium term, I therefore anticipate that a more cautious attitude from buyers will lead to a focus on risk identification and mitigation. I would also expect M&A insurance to be an increasingly important solution to facilitate transactions, and that the successful insurers and MGAs will be those that can build and maintain successful partnerships with investors through efficient and commercial underwriting, but also responsive and pragmatic claims handling.
Christian Rösiö: From a holistic perspective, the tendency seems to be more regulation rather than deregulation. Regulation is also becoming increasingly complex to assess, with data protection regulations one recent example. Add to that the implications of Brexit – both for the UK and the EU – and the uncertainties of the trade and tech war between China and the US, and there is a general sentiment of an upcoming slowdown in the economy. All of these uncertainties and risks will impact M&A and to some extent also the underlying sentiment of trust. The insurance market has always tried to respond to such uncertainties by providing certainty wherever possible, be it through new insurance products or superior underwriting capabilities. The M&A insurance market is in that way no different: it will have a pivotal function in terms of delivering that certainty.
Storrie: While the relative lack of suitable acquisition targets for both institutional and strategic investors continues, we expect to see greater focus on managing potential risks, as there may be limited commercial alternatives to completing the transaction. In this context, M&A insurance would be expected to play a greater role in bridging the gap between the parties and ensuring that a deal is done. In the slightly longer term, we also expect technology to play an ever greater role, and allow insurers to deliver products with greater speed and efficiency.
Kit Westropp is the managing principal of Euclid Transactional UK Limited. Previously, he was the UK and Nordics manager at a leading international insurance company. In this role, Mr Westropp was responsible for managing the development, underwriting and marketing of transactional insurance products across EMEA. Mr Westropp is a qualified solicitor and practiced as a senior associate at Ashurst LLP, where he advised clients on a wide range of corporate matters, including mergers and acquisitions and corporate finance. He can be contacted on +44 (0)20 3950 6154 or by email: email@example.com.
Mark Storrie is a principal at Euclid Transactional UK Limited. He was previously the emerging markets M&A manager at AIG, where he was responsible for managing the transactional insurance business in Africa, India, MENA and Central and Eastern Europe. Mr Storrie qualified as a solicitor at Clifford Chance LLP and has over 10 years’ experience of advising on and underwriting M&A transactions, in particular private equity buyouts and transactions in emerging markets. He can be contacted on +44 (0)20 3950 9349 or by email: firstname.lastname@example.org.
Carl Christian Rösiö is a principal at Euclid Transactional UK Limited. He previously worked as a senior underwriter for a leading international insurance company in its Mergers & Acquisitions department. Prior to that position, Mr Rösiö worked for insurance broker Jardine Lloyd Thompson Group (JLT) in Stockholm, where he advised and assisted on M&A deals. He is a qualified lawyer and has previously practiced in Sweden at law firms Lindahl and Baker & McKenzie. He can be contacted on +44 (0) 20 3950 6156 or by email: email@example.com.
© Financier Worldwide