Indemnification solutions for distressed deals
March 2013 | SPECIAL REPORT: DISTRESSED M&A AND INVESTING
Financier Worldwide Magazine
In M&A transactions, buyers and sellers must agree on which party should bear the risk of unexpected loss in the transferred business after the deal closes. A seller will typically make representations about the business being sold and a buyer will typically require some indemnification for inaccuracies in such representations that lead to loss. Coming to agreement on risk allocation can be particularly difficult in the context of distressed M&A, and representations and warranties insurance (RWI) is a tool that may help overcome this difficulty.
Common issues in distressed deals
In typical M&A transactions outside of the distressed context, buyers are accustomed to being able to receive indemnification caps of as much as 20 percent or more of the transaction value. When buyers come into distressed transactions hoping for a traditional indemnification package from the sellers, they can encounter a few common issues that make sellers more determined to limit their exposure. These issues can create obstacles to completing a transaction.
One common issue is that sellers are often unwilling to provide indemnification in amounts in excess of the net proceeds they receive in a transaction. In distressed deals, sellers’ net proceeds often represent a very small portion of the deal value, since much of the gross purchase price may go towards the repayment of the target company’s creditors. Additionally, of the cash the sellers do receive, they are often loathe to put this minimal amount of money at further risk. A second problem is that a distressed company can be owned by debtholders that have foreclosed on the business. In this situation, when the debtholders try to sell the company, they do not feel comfortable making representation about the business or having significant indemnification obligations because they have not been managing the business on a day to day basis and often do not have the expertise to monitor the business. A final problem with the indemnification structure stems from the creditworthiness of the sellers. Often sellers of distressed businesses are not creditworthy and a buyer may not feel comfortable receiving indemnification from an entity that it will have difficulty collecting against.
Bridging the gap with insurance
One solution that is increasingly being turned to by parties in distressed transactions when such obstacles arise is RWI. RWI may pay claims when there is a breach of the representations and warranties made by the sellers or the target company in the acquisition agreement that results in a loss by the buyer after the closing.
RWI policies can be crafted to address both buyer- and seller-specific concerns. A buyer-side policy is intended to cover the buyer for losses resulting from inaccuracies in the seller’s or target’s representations and warranties, and in many cases may allow the buyer to recover losses directly from the insurer without the need to initially pursue recovery from the seller. A seller-side policy may pay losses on behalf of the seller resulting from claims by the buyer, basically protecting the seller from having to return a portion of the purchase price.
RWI therefore may be used to shift the risk of having to make indemnification payments in the event of a breach to the insurance markets, rather than the sellers. The use of RWI can enable a buyer to avoid having to negotiate a substantial indemnity from the seller to protect against breaches of warranties, and allows the seller to avoid having to agree to putting proceeds in escrow or providing other types of financial guarantees.
In distressed transactions, a common RWI formulation has arisen to deal with the concerns of buyers and sellers over indemnification terms. The market standard for the deductible amount on R&W insurance policies is currently between 1-3 percent of the transaction value. Frequently, the parties will agree that the seller will be liable to the buyer for only up to the retention amount on the RWI policy. This limited exposure is much more palatable to sellers than the 10-20 percent cap that is often requested by buyers in private M&A transactions. Once the retention has been satisfied, the buyer can purchase as much indemnification protection as it desires from the insurance markets. Many markets have up to $50m of capacity to insure transactions, and programs have been put together for limits of up to $300m in some recent US transactions. RWI can therefore be a useful tool for transactions with enterprise values as little as $15m and as large as $2bn.
Recent trends and insurance basics
The use of R&W insurance has increased drastically in the United States in recent years. Certain leading insurance markets are reporting that they issued as many as 70 percent more policies in 2012 than they did in 2011, a year that saw policy issuance increase by 30-40 percent for many markets over 2010. In certain foreign jurisdictions, such as the UK and Australia, R&W insurance is even more prevalent than it is in the United States. As deal parties have gained more experience with the use of the product, they have realised that it can be a valuable tool to bridge the gap between buyers’ and sellers’ expectations. More importantly, they have had practical experience with the insurance markets paying out millions of dollars in claims. Private equity firms remain the most frequent users of R&W insurance, but strategic acquirers, often late adapters to innovations in the deal world, have increasingly been using the product as a tool to get deals done as well.
As the product has matured, the process of obtaining RWI has changed. Many RWI underwriters and brokers are now former M&A attorneys and are therefore accustomed to working within the tight timelines that often characterise distressed transactions. It is typically free to obtain a quote for RWI. If an insurance underwriter is provided with readily available documents pertaining to the transaction, the underwriter can typically provide a firm quote for insurance within 48 hours. If the client decides to go forward with the insurance, it can typically be underwritten in full within an additional 3-5 business days, depending on the complexity and stage of the transaction. In addition, the premium on most RWI policies is typically between 2-4 percent of the limit insured in the United States for a policy period of up to six years. Deal parties have found those prices to be something that can fit into the tightest of distressed deal budgets.
Parties involved with a distressed M&A transaction that hits an impasse over indemnification terms should not let the deal go off the rails or compromise on an indemnification package that does not fit them or their client’s needs. Instead, they should make a call to their insurance broker to see if RWI is a viable solution.
Jay J. Rittberg is a vice president, and Yem T. Mai and Phil Casper are regional underwriting managers, at AIG. Mr Rittberg can be contacted on +1 (212) 458 6203 or by email: Jay.Rittberg@aig.com. Ms Mai can be contacted on +1 (212) 458 6328 or by email: Yem.Mai@aig.com. Mr Casper can be contacted on +1 (212) 458 1445 or by email: Phillip.Casper@aig.com.
© Financier Worldwide
Jay J. Rittberg, Yem T. Mai and Phil Casper