Mitigating risk in M&A and private equity transactions
October 2012 | 10QUESTIONS | PRIVATE EQUITY
FW speaks with Michael J. Schoenbach, CPA, a managing director at Aon Financial Solutions, about mitigating risk in M&A and private equity transactions.
FW: Could you outline the growth of M&A insurance (or ‘transaction liability’ (TL)) products over recent years? How much capacity is currently available for M&A insurance programs? Who are the insurers?
Schoenbach: The use of TL or M&A insurance has expanded exponentially over the past 10 years. We estimate that the global market will place in excess of $5bn of policy limits for 2012 based upon historical placement rates. Product acceptance has grown, consistent with the desire to minimise risk and quality of coverage provided; the knowledge that the products exist and have performed as advertised; the decrease in cost combined with the increase in the speed of execution; and the reliability and ease of the underwriting process, which is not invasive or time consuming. The largest buyers of these products have been private equity firms who utilise them to transfer risk at a fixed price and solve a variety of problems including tax, litigation, representation and warranty (R&W) / indemnification, contingencies, and fraudulent conveyance. Capacity will vary by product but generally up to $300m in limits are available for all products. Insurers include well-known and stable carriers including Lloyd’s of London, Hartford, Chartis (formerly AIG), Zurich and a variety of supporting companies and new entrants.
FW: What is the claims process? Do insurers pay claims under these policies? What exclusions exist?
Schoenbach: Exclusions are generally straightforward and minimal. Unlike traditional insurance products, the TL solution addresses a specific issue – for instance, whether a tax position can be insured or not. Thus the policy is customised for each situation and all wording is signed off prior to binding by the client’s team of advisers including counsel and brokers who specialise in these products. The intent of coverage is clear, which results in less ambiguity when a claim is presented. If the policy covers existing litigation, or tax, the primary exclusion will be for fraud. For an R&W policy, the principal exclusion will be actual knowledge of a breach upon inception of the policy, with knowledge limited to key deal team members. Since this business revolves around reputations and the universe of participants is relatively small, failure to pay an otherwise covered claim by an insurer will cause the carrier extreme difficulty in attracting new business in the future.
FW: Very briefly, can you provide an insight into the details of these policies, such as who is typically covered under an M&A policy; the duration of the policy; the standard pricing; and how long it takes to place these policies?
Schoenbach: M&A insurance allows buyers or sellers to transfer specific risk inherent in an M&A transaction to insurers. Examples include strengthening the seller’s indemnity to the buyer for breach of R&W, or replacing a specific indemnity to the buyer for a known tax issue or pending litigation. Coverage is designed to replicate or enhance the general term of an indemnity. R&W policies can match or exceed the survival period in a given transaction whereas tax and contingent liability policies will generally track the relevant statute of limitations. Pricing is generally expressed as a percentage of the policy limit desired, is paid as a one-time premium at the close of a transaction, and will vary based upon product, risk profile and geography – insurance is generally more expensive for US risks than European risks. For example, an R&W policy may cost 3 percent of the policy limit in the US but could be as low as 1 percent in Australia or the UK. Tax is more expensive due to the statute of limitations, and potential for a large loss as well as the likelihood of settlement, while litigation policies are the most challenging to underwrite and are therefore the most expensive, and can range from 8-10 percent with exceptions higher and lower on a deal by deal basis. R&W policies are designed to cover unknown breaches while tax and litigation policies generally cover known events. The retention will influence price, as the insurer will seek to align interests with the insured. On timing, it is generally advisable to reserve a minimum of two to four weeks for underwriting and policy drafting to achieve best results, and longer for litigation, but the individuals working on these are M&A professionals and work on deal time, and much shorter deadlines have been met.
FW: How can M&A insurance be used strategically to improve a bid, allow sellers to achieve a clean exit, or simply remove a roadblock?
Schoenbach: Strategically, shifting risk to the insurance markets creates opportunity to alter leverage in a negotiation. R&W insurance is the perfect example in a bid or auction scenario. By utilising R&W insurance, buyers can offer sellers a below-market indemnity cap while maintaining significant indemnity protection, through their R&W policy, for a minimal incremental cost that can be shifted to seller through the purchase price negotiation. Similar tactics can be used around tax issues and other specific indemnities. Alternatively, in order to seal a great deal, the seller may agree to an onerous indemnity provision if it can obtain an insurance backstop. Or, the seller can dictate a below-market indemnity cap to the buyer if it can simultaneously present the buyer with a comprehensive insurance solution. The policy closes the gap between the indemnity that the seller can abide and that the buyer needs. Roadblocks arising out of tax issues, pending litigation or other specific indemnities can be similarly overcome by shifting risk to the insurance markets.
FW: What considerations should parties take into account when determining whether an M&A insurance policy is right for their particular situation?
Schoenbach: The deal dynamics that lend themselves to the successful utilisation of M&A insurance include a disconnect between the buyer and seller over the scope of the indemnity and what may be ‘market’ or ‘customary’ for the deal in question; practical limitations in securing or offering sufficient levels of indemnity; competitive auctions in which buyers seek to distinguish bids while avoiding competing on price alone; or sellers seeking a clean exit from its investment with little or no lingering post-closing liabilities. The spectre of known issues, whether a tax matter, lawsuit or other contingent liability, may also create an impediment possibly surmounted by M&A insurance. Generally, the cost of such insurance is quite small in comparison with the value proposition of closing a deal and transferring risk. We recently helped a new client close a $750m transaction utilising R&W insurance to supplement an escrow and indemnity, which also had the favourable impact of reducing the purchase price.
FW: What are the functions and benefits of representations & warranties insurance?
Schoenbach: R&W insurance offers parties the ability to transfer the risk of loss resulting from breaches of the seller’s representation & warranties to a third party insurer. There are many benefits to this arrangement, including protection where seller indemnification is limited or not available. R&W insurance can supplement such reduced cap or stand in as sole recourse where indemnification is not provided. R&W insurance also affords sellers ‘sleep at night’ insurance, serving as a backstop to the seller’s indemnity, and provides a creditworthy counterparty to satisfy claims. This is particularly useful if the buyer has concerns with the seller’s financial wherewithal and ability to collect on indemnity claims in the future, particularly when survival periods last several months or years after the closing date. Further, the ability to utilise R&W insurance as a means to accommodate a seller’s desire to reduce or eliminate an escrow/indemnity cap, while meeting a buyer’s goal of robust protection should issues arise, affords the parties a great deal of leverage and may free up negotiating capital to focus on other key aspects of the deal. Additional benefits to incorporating R&W insurance into a deal include the ability to assign the policy to a future buyer of stock or assets of the target company as well as the ability to secure significant limits for a greater level of protection – up to $300M in the marketplace for any one deal.
FW: What role can tax insurance play in an M&A deal – and do you need a tax opinion?
Schoenbach: Tax insurance is an economically efficient vehicle that will indemnify the insured party for taxes, interest, penalties, and contest costs if the relevant tax authorities – whether federal, state or local or foreign – do not respect the insured tax positions, especially when the amounts at risk are large and the price to transfer risk is low. For example, tax insurance has been used in the context of tax-free reorganisations, net operating losses, transfer pricing, FIN48, and tax credit investments. It also is not uncommon for tax insurance to be written to protect a seller against liability under a tax indemnity provided by a seller to a buyer. It is not necessary to have a tax opinion, although a memorandum or ‘road map’ will help underwriters get up to speed quicker. A rough ‘indication’ of cost and whether or not coverage is likely to be granted can usually be provided within 48 hours. Several sellers have successfully utilised tax insurance in difficult situations to bridge a purchase price adjustment by purchasing coverage subject to the anticipated closing.
FW: What are contingent liability policies or litigation buyout policies, and what value can they bring to a transaction? Are there other unique policies available to insure ‘special situations’?
Schoenbach: Nothing can get in the way of concluding a transaction like pending litigation or an expected claim. Litigation buyout policies are unique insurance policies that introduce insurance capital to transfer or ringfence these issues. The litigation buyout policy offers a means to bring certainty to the buyer over its financial exposure should the result of the litigation be worse than expected. This will allow the buyer to ask less of the seller or enable the seller to ‘box’ the exposure for a fixed cost without incurring indemnity or an escrow. Potential subject matters are broad, ranging from traditionally insured risks, such as securities claims, employment practices claims and construction disputes, to other subjects, such as intellectual property, tax controversies, and so on. The insurers that will underwrite litigation buyouts policies and the other transactional risks can also be very adept at offering capital to protect against other one-off risks, such as policies covering successor liabilities.
FW: Are there insurance solutions designed to address the unique issues and problems associated with distressed M&A? What about cross-border deals, including those into emerging markets?
Schoenbach: An insurance policy from a strongly-rated insurance carrier offers more reliable protection than a promise from a ‘going concern’ seller. In other situations, sellers in ‘wind down’ mode structured insurance policies into their proposed purchase and sale agreement that would stand in place of traditional indemnities and were issued to the buyer at close with the seller absorbing the cost of the insurance. While more time-consuming, programs can bring certainty to distressed transactions where insolvency is a concern. One example is fraudulent conveyance coverage which insures that a particular transaction will not be challenged as a fraudulent or preferential transfer should there be an insolvency following the transaction. With respect to cross-border transactions, M&A products have been very well received, particularly with foreign buyers – in fact, in some areas, such as Australia, the use of R&W policies in lieu of a seller’s indemnity is now the norm. Competition in these areas has driven down the price of these programs, especially R&W.
FW: What are the benefits of using a broker with a specialty M&A practice that is experienced with transaction liability products?
Schoenbach: The TL business is highly specialised and requires a level of expertise and creativity to accomplish most client objectives. Brokers must be familiar with the complexities of the M&A process, appreciate the nuances of the transaction structure and have dedicated staff working within aggressive time constraints. This assures a smooth process and confidence that the insurance part of the transaction will be at the closing table. Absent that skill set, an insured runs the risk that the entire process can go sideways and delay or kill a deal. Many brokers who are not familiar with TL products will rely on the insurance markets to explain and dictate the process to their clients, which may lead to gaps in coverage or fail to achieve anticipated results. On the back end, should a claim arise, experience, knowledge and leverage are equally important to ensure the best outcome possible. Ultimately, the more extensive the relationship between a knowledgeable broker and the insurance markets, the better the result for the client.
Michael J. Schoenbach, CPA, is a managing director at Aon Financial Solutions based in New York City. He has 33 years of accounting, finance and insurance experience. Prior to joining Aon, he consulted to a major underwriter and helped them retool their underwriting guidelines. He has successfully managed an underwriting facility for Lloyd’s and has been with Aon for 21 years, where he has developed TL products and led a team working with clients to provide ongoing transaction solutions. He is supported by teams of lawyers and insurance professionals in NY, Philadelphia, Denver, London, Bermuda, Sydney, Tokyo & Singapore. Mr Schoenbach can be reached on +1 (212) 441 2337 or by email: email@example.com.
© Financier Worldwide
Michael J. Schoenbach
Aon Financial Solutions