Representations and warranties insurance and competitive auctions: how buyers are shifting risk to win deals
June 2013 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
In today’s competitive M&A landscape with private equity ‘dry powder’ at historically high levels and Fortune 500 companies holding record stockpiles of cash, auction sales of private businesses often attract multiple bidders. Traditionally, a buyer will conduct due diligence on a target business and ask a seller to make representations and warranties about that business to confirm what the buyer and its advisers have learned from the due diligence process. In most sales of privately held companies, a buyer will also require that a seller indemnify the buyer if any of the seller’s representation and warranties about the target business are inaccurate and cause the buyer to lose money after the transaction closes. In many cases, a cash escrow or purchase price holdback would serve as security for a seller’s indemnification obligations.
On the other side of the deal, sellers, including private equity and individual sellers, typically want to sell businesses with limited post closing indemnification or escrow obligations and want to avoid having their sale proceeds tied up, sometimes for years. A buyer can make its bid at auction more attractive to a seller by offering to accept little to no indemnity or escrow from a seller with respect to a seller’s representations and warranties about the target business. However, offering a seller a cleaner exit with limited indemnification may expose a buyer to more post-closing risk than they might like to accept. After all, when a buyer purchases a business it often assumes the liabilities of that business, including with respect to compliance with law, payment of taxes and employment related issues.
The current competitive environment and these differing interests of buyers and sellers have increasingly led dealmakers to consider representations and warranties insurance (RWI) as a way for buyers to distinguish bids while still retaining protection against loss from breach of seller’s representations and warranties.
RWI – how does it work in an auction?
Here is an example of how RWI can impact an auction:
A private equity firm is selling the last portfolio company in one of its funds. The business is attractive, and two bidders have made offers to the private equity seller. Bidder A is willing to pay $100m dollars for the business, but requests that the private equity firm leave $10m dollars in escrow after the deal closes to protect the bidder from potential losses that could arise from breaches of the seller’s representations about the target business. Bidder B on the other hand, is also willing to pay $100m dollars for the business, but is only requesting that the private equity seller leave $2m in escrow for breaches of representations and warranties. Bidder B plans to purchase an $8m RWI policy to gain additional protection for breaches of representations and warranties. With Bidder A, the private equity firm would collect $90m dollars when the deal closes and would be forced to leave $10m in escrow for 2 years. With Bidder B, the private equity firm would collect $98m at closing and would only be obligated to leave $2m in escrow for one year.
Clearly, the private equity firm, with its fund at the end of its life, would select Bidder B, who allows them to exit the deal and provide its limited partners with $8m more money up front, rather than possibly in two years if no claims from the buyer reduce the amount in the escrow. After winning the auction, Bidder B could seek recourse from the seller for the first $2m of post closing losses from breaches of representations and warranties and then seek recourse against the insurance company that provided the RWI policy for the next $8m of loss. The cost of an $8m policy such as this would likely be in the range of $160,000 to $240,000.
Increase in the use of RWI
According to some industry broker statistics, there was a nearly 40 percent increase in the use of RWI insurance in 2012 as compared to 2011 and a record number of policies issued. Some US carriers insured over 60 percent more transactions in 2012 than in 2011 and have seen the upward trend continue into 2013. The growth in these products can be attributed to the following factors:
Lower cost – insurance can be less expensive than investment returns on capital. The price of an RWI policy has dropped significantly in recent years. In the recent past, a policy could cost as much as 4-8 percent of the amount being insured. Today, most deals in the US can be insured for 2-3.5 percent of the policy’s limit of liability. As in the example above, sellers that are able to free up cash by using RWI are often glad to pay the 2-3.5 percent policy cost since they can now invest the free cash and potentially generate returns on their capital far in excess of 2-3.5 percent.
Improved process. It is critical for service providers to move quickly on M&A transactions. RWI carriers can now typically bind coverage in a number of days, rather than the weeks that it used to take to underwrite and bind coverage in the past.
Better terms and conditions. After years of negotiation between insurance carriers and leading M&A law firms and brokers, RWI policies are able to provide coverage similar to, or better than, what a buyer would normally receive from a seller. RWI policies can now provide narrower exclusions, longer policy periods and higher limits of liability than ever before.
Claims paying history. After more than 15 years of selling RWI, insurers can now talk to dealmakers about how and in what circumstances RWI policies have responded to claims. Millions of dollars in claims have been paid out for breaches of representations and warranties and there are a number of clients with positive claims stories.
Greater acceptance in the deal community. Private equity firms and corporations are now using RWI on a repeat basis. Some larger middle market M&A law firms have utilised RWI on a significant number of their clients’ transactions in the past few years. Some sellers now include RWI proposals in bid request packages when marketing their business for sale, and buyers are using RWI as a tool to win auctions. All of these factors are making RWI a more standard part of doing M&A deals than ever before.
Implementing RWI strategically in an auction
If you are involved in an M&A deal and want to use RWI as a tool to gain a strategic advantage on your transaction, either as a seller looking to free up cash or as a buyer trying to make your bid more attractive, getting the insurance markets involved sooner rather than later can lead to a better result. RWI is no longer seen just as a product to address issues on difficult transactions, but rather as a tool that dealmakers are implementing to walk away from a deal with more cash and provide the protection necessary to make buyers and sellers more comfortable.
Jay Rittberg is the head of M&A Insurance for the Americas at AIG. Mr Rittberg can be contacted on +1 (212) 458 6203 or by email: firstname.lastname@example.org.
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