Managing transactional risk
September 2018 | ROUNDTABLE | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
September 2018 Issue
The transaction process is complex and challenging, driven by many, often incompatible interests. Historically, acquirers have paid close attention to expected and potential post-closing risk during the due diligence process and, following the financial crisis, are even more focused today. Given its complexity, it is crucial for acquirers to have recourse to experts with deal knowledge and experience, in order to identify, assess and manage risk – thus maximising the chances of a successful transaction.
FW: Do you believe today’s acquirers, in general, are paying enough attention to identifying and assessing risks during the transaction process? Are they falling short on particular aspects?
Cowhey: The nature and structure of the underlying transaction may impact the depth and scope of the due diligence exercise undertaken by the buyer. Generally, it has been our experience that competent and well-experienced due diligence providers routinely provide buyers with sufficient insight on organisational, operational, legal and financial exposures so that the buyer is prepared to arrive at a well-informed investment or acquisition decision. Of course, business is not static and diligence processes on issues such as cyber security and intellectual property, among others, continue to evolve.
Kaden: Today’s acquirers are very familiar with transaction risks. They understand the importance of identifying and managing these risks through a focused due diligence process. I do not see many shortcomings but occasionally a buyer underestimates certain non-income tax risks – the most common being sales and use taxes. In recent years, states have become more aggressive with sales and use taxes. The recent Supreme Court ruling in South Dakota v. Wayfair, Inc. held that states may require retailers to collect sales taxes even if the retailer has no physical presence in the state. If overlooked, non-compliant sales tax filings can create a significant legacy liability.
Timpani: Today’s acquirers, in general, are more sophisticated, and are more attentive in identifying and assessing risks, particular relating to overpaying for deals. However, despite this, many deals still fail to add the value or capture the synergies expected during the planning and execution process. Limited M&A experience and the availability of the internal team are critical issues that can be overlooked during a transaction process. Successful integration is often the most overlooked risk area, and one of the biggest impediments to ultimately realising the full value of the deal. Part of the challenge, from an integration and execution perspective, comes from the challenges relating to securing the requisite involvement, insight and sustained focus and urgency from the operating team in both the pre- and post-close periods. Transition risks associated with people and culture, perhaps not surprisingly, are another area which can be overlooked in both domestic and international transactions.
DeLott: Acquirers, in general, are committed to identifying and assessing risks as early as possible during the transaction process. To that end, acquirers will often engage legal, accounting, tax and other professional advisers to bring their particular expertise to bear in a transaction. Negotiations between buyers and sellers will often focus on allocating risks, both known and unknown, between the parties. That said, things often come to light after closing that were not captured in due diligence. Ideally, the buyer will have negotiated appropriate indemnities or M&A insurance for protection. When acquirers do fall short in assessing risk, it is usually a function of the time allowed for thorough due diligence. Sellers usually have the leverage to play acquirers off one another and to demand compressed time frames for due diligence, prior to signing a transaction.
Bolsinger: Acquirers have historically paid close attention to expected and potential post-closing liabilities during the due diligence process and, following the financial crisis, are even more focused on downside scenarios to ensure that acquisitions will be successful. Then and now, the acquirers work with an army – in-house and third-party advisers – to perform a plethora of different reviews of the target: business due diligence, industry research, quality of earnings and other financial due diligence, background checks on key employees, environmental desktop and Phase I reviews, legal due diligence, insurance and benefits review, information technology due diligence, customer and supplier interviews and, where applicable, regulatory due diligence. My experience has been that acquirers in the era of widely available M&A insurance – representations and warranties (R&W) insurance in the US and warranty and indemnity (W&I) insurance in Europe and Asia – perform the same vigorous due diligence as they have when more traditional indemnification arrangements were prevalent. The simple reason for continued due diligence discipline is that M&A insurance by and of itself will not turn a bad deal into a good deal.
Rittberg: While transaction processes can vary significantly, the vast majority of deals we see have comprehensive diligence and disclosure processes. We see buyers continuing to conduct robust diligence reviews into the legal, financial, operational and other risks that they could take on if they acquired the target business. While claims and problems do arise on deals, we do not think that buyers are broadly failing to pay attention to risk areas.
Cowen: Each individual acquirer will, of course, have its own perception of the key risks to its potential purchase. Whereas private equity may focus on threats to growth and return on investment, strategic buyers might consider the difficulties of future integration and the retention of key personnel as heightened risk areas. From a company due diligence perspective, the types of deals that are brought to the insurance market for W&I cover are, on the whole, well diligenced from a risk identification perspective. The challenge usually comes when the analysis detail is not clear enough for us coming into the process as a third-party. This is when we need to ask to see the workings behind the analysis so that we can form a view of the risk from an underwriting point of view. The areas where we most often see acquirers falling short, or not addressing the risks at all, are fraud, tracing open-source code origin or licensing and cyber security threats.
FW: What are the key areas that need to be considered as part of a due diligence process? To what extent is the scope of due diligence widening to incorporate ‘non-traditional’ areas of assessment?
Kaden: The financial due diligence process should always be target specific. An effective scope is based on knowledge of the target and its industry and the acquirer’s specific concerns. The foundation for a successful due diligence process is based on validating the acquirer’s investment thesis, which is typically focused on two key valuation drivers: earnings before interest taxes depreciation and amortisation (EBITDA) and net working capital (NWC). A quality of earnings analysis (QOE) is performed and presented to demonstrate the target’s adjusted EBITDA, a common proxy for sustainable earnings. An effective analysis of NWC provides the acquirer with insight to the quality of the target’s assets and liabilities. In addition to financial due diligence, today’s acquirers typically engage specialists to perform due diligence focused on legal, environmental and tax risks. As technology has become an integral part of every business, we are seeing a growing number of acquirers successfully extending due diligence to IT and cyber security. Today’s acquirers understand the importance of a smooth and successful post-closing transition. We see buyers focused on carefully planning and executing integration strategies to achieve critical synergies, which increase the target’s ultimate value.
Timpani: Due diligence continues to be focused on retained value, and so quality of earnings remains crucial. However, areas of financial due diligence are moving from the traditional focus on historical results toward a forward-looking examination of top-line risks and the validation of the real achievability of synergy opportunities, an activity that includes challenging the execution plan. Business continuity and continued growth are critical when considering an acquisition. The identification and retention of key people and the client relationships held by them should always feature highly in any acquisition due diligence. The emergence of new threats to company performance and continuity are changing the face of due diligence, however. Areas such as cyber crime, IT due diligence and other commercial aspects of a target company are becoming more prevalent as technology, and the potential opportunities and threats it leads to, rapidly evolve.
DeLott: In addition to the traditional areas of due diligence, such as legal, accounting and tax matters, there is also an emphasis today on a target company’s exposure to cyber intrusions. Does the target have adequate resources in place to protect the company, and its customers and other counterparties, from cyber attack? Does the company have adequate cyber insurance in place to protect in the event of a cyber attack? Other ‘non-traditional’ areas of assessment include human resources issues. Does the company have a history of treating all of its employees, including women and members of minority groups, appropriately and respectfully? What procedures are in place to ensure compliance with company policies in this area? What are the resources of the human resources department? How committed is the board to routing out problematic behaviour?
Bolsinger: In addition to the traditional due diligence topics, acquirers focus on new areas of exposures. As of late, cyber security and the handling of personal data are becoming more important, free-standing topics of review.
Rittberg: We typically see diligence on legal risks that face of the company, including corporate, employee benefits, tax, environmental, intellectual property and regulatory risks. We see increased focus on data protection and cyber security and corruption and bribery on international transactions. We also see particular focus on financial, operational and market diligence, with buyers seeking to understand potential exposures for the target business going forward. On healthcare transactions, we often see advisers focused on billing and coding related risks.
Cowen: From a W&I insurer’s point of view, we would expect to see thorough due diligence into the legal, financial and tax aspects of the target business at the very least, with local counsel input where necessary to pick up any issues specific to key foreign jurisdictions. I would consider these to be the ‘traditional areas’ of assessment. The prevalence of additional specialist due diligence providers engaged to prepare separate reports into other areas of potential risk, such as IT systems or on-site technical reports, is certainly increasing and this is welcomed by M&A insurers.
Cowhey: While the depth and scope of a diligence exercise may vary, depending on the nature of operations of the target company, it is relatively standard among due diligence practices to focus on fundamental issues, such as capitalisation, as well as financial, tax and legal exposures of the target company. Additionally, a buyer generally conducts a diligence review on specific operational risks of the target company, including reviewing material contracts, employment agreements, leases, insurance and permits, as well as forming a view on the target company’s implementation of, and adherence to, its established protocols on issues, such as its development and use of intellectual property. Diligence itself evolves with trends in the marketplace, such as cyber, for example, and tends to be a function of what ultimately are the key areas of operational exposure at a target company.
FW: Given the complexity of the transaction process, how important is it to engage external, specialist experts and advisers to help identify and measure potential risks associated with a target company?
Timpani: Time and delays are the killers of all deals. Undertaking a transaction, whether acquiring or divesting, is a time-consuming process, with numerous complex workstreams running simultaneously. It can be a full-time job on top of a full-time job. Quality advisers will help shield shareholders and management from a vast amount of the workload, seeking instruction and offering advice on key matters, but leaving management to focus on running the business. Specialist M&A advisers will likely have significantly more experience of the transaction process than a management team and will be more likely to identify key issues, which impact value and execution risk. As the areas of risk in businesses develop into more specialist areas, including IT, fraud, tax and so on, specialist advisers will be needed to supplement any due diligence process.
DeLott: Engaging external, specialist experts and advisers is extremely important. The best advice often comes from those with deep experience in the target company’s industry. Particularly active acquirers will maintain a roster of industry-specific specialists to bring in on any given transaction to assess potential business risks. These specialists also can be invaluable as a source of leads for other acquisition targets and sometimes serve as informal recruiters should the need for new management or board members arise. These specialists are often quite prominent in their respective industries, some having recently retired after having served many years in key roles.
Bolsinger: It is extremely important to have the best players on the field with both subject matter expertise and deal savviness for each of the relevant areas of due diligence. Whether those players are external, specialist experts or highly qualified in-house professionals depends on the acquirer. While a strategic acquirer might work with a large in-house team and a few external specialists, a financial acquirer might outsource most of the due diligence to third-party advisers.
Rittberg: We think it is particularly important that insured buyers identify the right advisers or internal subject matter experts to help them understand the business they are acquiring. Strategic and financial buyers often have different processes, but there are many paths to understand a target and identify risk. We carefully consider an acquirer’s experience investing in the target’s sector and jurisdiction in evaluating which advisers are appropriate.
Cowhey: There has been a pattern of buyers retaining expert outside diligence service providers to assist in the diligence process. The apparent benefit of accessing the depth of experience of an external team stocked with a broad array of talents cannot be overstated. The use of external specialists in conducting granular analysis of complex and fast evolving areas is clearly advantageous to the buyer looking to acquire a thorough understanding of the operations, finance and exposures of a potential acquisition target. Perhaps best is the combination of an experienced and inquiring strategic or financial buyer, alongside the orderly protocol-driven process of a team of seasoned transactional diligence professionals.
Cowen: Specialist expert advice is critical. From an insurance perspective, without this sort of targeted due diligence the cover that can be afforded to a buyer may be very limited. It may be a well-worn phrase that W&I insurance is not a replacement for good due diligence, but it still holds true. While insurers can make risk assessments during underwriting, there is no substitute for specialist experts and so the scope of cover can be affected in their absence. Whether or not external advice is required will depend on the nature of the buyer, as a major corporate acquirer may have the internal expertise to assess the relevant risks better than external advisers.
Kaden: Today’s transactions are not only complex but fast. To maintain a competitive position in the sale process, the acquirer’s due diligence has to be efficient and effective. Given the complexity and the speed of the transaction process today, it is critical that acquirers engage external advisers with the appropriate level of experience and resources.
FW: In your experience, are acquirers starting to spend more time looking at the IT, cyber and data systems of a target company, to evaluate potential weaknesses and ensure regulatory compliance is being achieved? Do you believe this has become essential in today’s business world?
Cowen: IT, cyber and data systems are hot topics in today’s corporate world and for good reason, especially with the introduction of the General Data Protection Regulation (GDPR) in Europe, and the M&A community is responding with increased focus. Cyber insurance is now a must-have for almost all businesses, and if an acquirer discovers that a target company does not have sufficient cover it should look to put this in place as soon as possible. Most major insurers will have a cyber product to cover risks of attack and data breach.
DeLott: Cyber security is often near the top of the list of due diligence concerns. Acquirers spend considerable time, effort and money getting their own houses in order regarding cyber security and they want to know that the target company has successfully completed the same exercise. In regulated industries, such as healthcare, insurance, banking and brokerage, there is an additional element of legal compliance related to cyber security. Acquirers also are concerned that tensions in the current geopolitical environment, notably between the West and Russia, North Korea and Iran, increase the risk of cyber attacks against prominent Western companies. Acquirers also want to know that a target company maintains appropriate levels of cyber insurance.
Bolsinger: While intellectual property (IP) and information technology (IT) have always been part of the due diligence process, it was something people thought of as one topic. Now, there are multiple sub-categories, each with its own experts. The ones mentioned are taking prominent spots on every acquirer’s due diligence list.
Rittberg: We do see a greater focus on data security related risks for businesses and believe this is important given the increased risk of cyber attacks and potentially expensive claims related to data breaches. Acquirers are often looking towards specific insurance policies and procedures to reduce the risk from technology-related exposures.
Kaden: There are very few, if any, businesses operating without an IT system. An effective, properly developed and maintained IT system is often a key operating asset of a target. Alternatively, a weak or underperforming IT system hurts a target and may even create a liability. I am seeing more acquirers with increasing concern and interest in the risks attributed to an underperforming or outdated IT system. An appropriately designed IT due diligence engagement provides strong financial, operational and security feedback to acquirers.
Cowhey: A fulsome diligence process should be expected to address all types of issues which may present a potential for material exposure. With that said, it seems the media reports daily on new and increasingly harrowing examples of hacked systems, breaches of confidential customer information and the erosion of consumer confidence in the ability of corporations to adequately safeguard their own intellectual property, as well as their customers’ personal data. Moreover, a growing patchwork quilt of regulations and guidelines creates a fast-evolving compliance environment.
Timpani: PE investors are increasingly aware of cyber and data risks and are perhaps more likely to dig deeper here. Cyber crime, and a business’ susceptibility to it, along with the potential impact it can have on trade, are forming an increasingly important part of due diligence. Most companies cannot operate without their IT system in full flow, so assessment of the company’s vulnerability in this respect is becoming increasingly common. This area of due diligence is likely to increase in light of the EU’s GDPR and recent negative coverage received by numerous companies off the back of data manipulation.
FW: To what extent is an acquirer at risk of assuming the legacy liabilities of a target company? How can it go about avoiding this eventuality?
Kaden: Acquirers are keenly aware of the risks associated with legacy liabilities. This is typically addressed through the structure of the transaction. An acquirer generally assumes all debt and legacy liabilities in a stock purchase transaction. Alternatively, an acquirer with concerns of existing or legacy liabilities can structure the transaction as an asset purchase and exclude or limit the liabilities it assumes.
Rittberg: Depending on the structure of a transaction and the agreement between parties, acquirers can assume significant responsibility for liabilities of a target, particularly in deals structured as stock sales. To avoid loss from unknown liabilities, acquirers often look to R&W insurance to avoid exposure to unknown, undisclosed liabilities. The price of such policies has decreased over the years and risks can be insured for a price of approximately 3 percent of the insured amount, depending on the deal. Even when parties structure a deal as an asset sale to avoid liabilities flowing to the acquirer, there is risk that the structure does not fully accomplish the goal of cutting off liabilities. In those cases, R&W insurance can help, along with a contingent liability policy to address the risks related to potential successor liability or fraudulent conveyance.
Cowhey: In a stock sale, the buyer is acquiring the entirety of a target and therefore it is generally taking on all historical liabilities. As a result, a stock purchase or merger agreement will typically contain representations and warranties which attest to compliance related to the target’s historical operations. One common mechanism used by transaction professionals in a situation where a buyer may be reluctant to assume historical liability is to structure the transaction as an asset sale. In this way, the goal is to expressly state which assets and liabilities are being acquired by the buyer and which are being retained by the seller. However, under certain circumstances, there may be an exception to the perceived protection of an asset sale structure. Notably, successor liability can occur, pursuant to certain federal statutes such as the Employee Retirement Income and Security Act (ERISA), the Family and Medical Leave Act (FMLA) or the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA).
Timpani: By acquiring the shares of a company, an acquirer will always assume the legacy liabilities of it. The surest way to avoid doing so would be to acquire only the trade and assets required. This is a structure which rarely works for vendors though, particularly in the mid-market when a share sale is almost always preferred in order to avail the vendors of attractive tax reliefs. When acquiring shares, acquirers can seek protection through the appointment of strong advisers, particularly lawyers. Seeking appropriate protection through warranties and indemnities is critical to limiting the exposure in respect of historical liabilities. Risk mitigation products, such as WI insurance, continue to be available and are reasonably priced.
Cowen: Warranties are designed to capture legacy liabilities and provide recourse against the seller for the buyer. However, contractual recourse is only as good as the amount of money that is there to claim against. With the inherent risk of the seller’s future credit strength and the increased prevalence in the UK and Europe of sellers limiting their liability for warranty breaches to £1, an acquirer can find itself in a position where there is no-one to fill an unexpected financial hole in its new business. One way to avoid this is an escrow, but in today’s sellers’ market in the UK and Europe, and with many assets being sold through a competitive auction process, it can be an impossible task to convince a seller to tie funds into escrow for any useful period of time. W&I insurance is the other solution, providing cover for historic unknown liabilities resulting in loss to a buyer arising from a warranty breach.
Bolsinger: The legacy liabilities of the target – whether exposure to shareholder, environmental, tax, benefits, product liability or other liabilities – should be closely investigated prior to structuring the transaction. Some, but not all, of these liabilities can be left behind if the transaction is structured as an asset deal. However, asset deals come with their own set of problems – in the US, generally higher tax liability for the seller and additional hurdles, in connection with the assumption of certain contracts or the transfer of licences and permits. In the end, the structure of the transaction is driven by many, sometimes incompatible interests, and legacy liability is only one of these interests.
DeLott: One way to limit an acquirer’s exposure to legacy liabilities is to structure a transaction as the purchase of assets rather than the purchase of stock, although sellers often are resistant to ‘asset deals’ for a variety of reasons. Another way to limit an acquirer’s exposure is to obtain indemnification from the seller for legacy liabilities. However, in today’s ‘hot’ M&A markets, seller indemnification is often quite limited. Increasingly, sellers are demanding a clean exit, especially where the seller is a private equity fund that needs to distribute transaction proceeds to investors within a certain period of time. Therefore, many acquirers turn to M&A insurance for protection.
FW: What key advice would you offer to acquirers when it comes to negotiating representations and warranties with the seller?
Rittberg: From the insurer perspective, just because a seller is willing to give you a representation, it does not mean that it will be insurable. Particularly when a seller is not standing behind a representation with an indemnity or escrow, an insurer will consider how the representation could be made by the seller and what diligence the buyer has done, or could do, to verify the accuracy of such representation. If an insurer has doubts that the seller could make the representation and the buyer has no information to show that they investigated the representation, it may be excluded from coverage. The insurance is not intended to change the representations that a seller would ordinarily make to a buyer.
Cowen: If the intention is for the deal to be insured, involve the insurance professionals – whether it is a broker or underwriter or both – as soon as possible to understand any warranties or warranty drafting that would be uninsurable. I can sympathise with an acquirer’s frustration if, after weeks of warranty negotiation with the seller, they are told that certain warranties cannot be covered in the form presented to the insurance market. The earlier this feedback can be provided, the more likely it is that a set of insurable warranties can be negotiated with the seller.
Timpani: Focus on the big ticket items and start with a commercial position in the first instance. Sellers’ advisers will always be looking to limit their clients’ exposure and if a buyer is overly aggressive to start with, negotiations can be protracted and take longer than necessary. There will be a number of key risk areas in the business and focus should be given to these when it comes to seeking protection for a buyer. If you do not do deals regularly, ask your adviser what the current market practice is. Understanding the specific key risks of the business and the likely eventuality of a warranty claim can vastly reduce the time spent negotiating and allow all parties to focus on other import deal execution matters.
Bolsinger: Most importantly, explore early on in the pursuit of the target whether M&A insurance would generally be available for the transaction and have an understanding of the basic terms. Having M&A insurance will speed up the process and streamline the negotiations. In addition, having substantially completed the due diligence process will enable the acquirer, and the seller, to have a focused discussion. Lastly, while solid, commercial, acquirer-friendly representations and warranties are expected in today’s market, do not ask for the moon – the stars should suffice.
DeLott: The key to negotiating representations and warranties is to understand what risks are most material to the business and to focus the negotiations around those issues only. There is no reason to require an overly aggressive representation or warranty for issues that do not materially impact deal value. Moreover, sellers are often more receptive to providing fulsome representations and warranties when the indemnification exposure is capped at a reasonable level. When M&A insurance is part of a transaction, the seller’s indemnification obligation is dramatically reduced, with the insurer serving as indemnitor. However, M&A insurers expect to insure only a customary set of representations and warranties. If the transaction documents include any ‘off-market’ representations and warranties, those should be discussed with the M&A insurer early in the process.
Cowhey: Seller representations and warranties in a transaction are basically a set of promises of past activity that the seller offers as an inducement to the buyer. Not surprisingly, representations and warranties are often the most heavily negotiated elements of a transaction agreement. Such coverage serves as a supplement or enhancement of the seller’s indemnity obligation, and not as a replacement for a fulsome buyer diligence. As a result, when negotiating representations and warranties where the use of insurance is contemplated, it should be noted that the insurer considers the breadth of the representations and measures their scope against the depth of the diligence undertaken and breadth and scope of the seller’s disclosure process.
FW: Are you seeing an increased adoption of M&A insurance to help manage risks and see deals through to completion? Could you outline some of the trends you are seeing in M&A insurance offerings, with regard to policies, coverage, terms, pricing, and so on?
Cowen: We estimate that between 20 to 25 percent of mid-market private M&A transactions in the UK take W&I insurance. This figure has more than doubled in less than five years and the growth shows no signs of stopping. My understanding is that in the US, the percentage is closer to 30 to 35 percent. I also understand that it is becoming a requirement to show a PE firm’s investment committee either the existence of a W&I process or a solid justification for not having one. This is a positive development which shows just how integrated into the M&A process M&A insurance is becoming. In the UK and Europe, increased market competition has seen premium come down by around 30 percent over the last three years. Further, excess levels on the policy have come down, now being typically 0.5 percent of the target company’s enterprise value or even as low as zero for real estate transactions, compared to 1 percent in 2016. Insurers are now much more willing to offer enhancements to cover at either no extra cost or without a significant increase to the price.
Timpani: M&A insurance appears more appropriately priced than it has been historically. It is more common in deals involving private equity or sponsors where there is reluctance for investors to provide warranties and therefore insurance is required to provide surety to an acquirer. For strategic acquisitions, it appears less common in our experience, with strategic trade buyers more cognisant of the risks being assumed and the potential risk of a material warranty claim to be significant enough to justify insurance.
Bolsinger: M&A insurance started with the highly sophisticated financial acquirers looking for an advantage in competitive auctions in the early 2000s, then moved to a fundamental product in middle-market auction processes, and is now used widely by financial and strategic acquirers – even outside of a competitive sale process – as a key tool to streamline the negotiation of the purchase agreement. With the success of M&A insurance, many additional players have entered that market and, as a result, terms and pricing have become slightly more insured-friendly. Additional transactional risk insurance products – among them tax insurance and contingent liability insurance – have become more established. In addition, transactions in certain industries that, five years ago, were almost impossible to insure – such as healthcare transactions with a significant portion of the services being subject to government reimbursement – have become more insurable with the development of deeper industry expertise among certain underwriters and brokers. Overall, the transactional risk insurance market is no longer in its infancy and has grown up and become an established industry.
Cowhey: The use of R&W has dramatically risen over the past decade. While the product has been commercially available for some time, the increased uptake of this specialty insurance has been driven by an increased awareness in the existence and the utility of the product, as well as a marked improvement in coverage terms and conditions, both of which may be attributable to a growing and evolving marketplace. To be sure, pricing and retentions have improved and have played a major part in the increased commercial use of R&W insurance. However, another driver may be found in the investment of some underwriters and brokers in developing a team of experienced deal professionals and in broadening areas of expertise to include coverage for areas previously difficult to insure, such as environmental, intellectual property or industry specialisation in areas such as healthcare.
DeLott: We now see M&A insurance on every deal in which either the purchaser or seller is a private equity firm, and on an increasing percentage of deals in which the purchaser is a strategic buyer. The ‘sweet spot’ for the use of M&A insurance is deals valued between $500m and $2bn. As the number of carriers that provide M&A insurance has grown, there is tremendous competition on both price and coverage terms. It is a buyers’ market for M&A insurance. As of the summer of 2018, the rate on line – the premium cost per dollar of insurance – is around 2.5 percent and even less on particularly large transactions. The number of ‘standard’ exclusions in M&A insurance policies has decreased over the years. Today, the only ‘standard’ exclusions in M&A insurance policies are for asbestos, underfunded pensions and transfer pricing issues.
Kaden: Today, more deal participants are including R&W insurance to help manage risks. This can often be a differentiator in being the acquirer with the winning bid. Insurance companies will cover many different types of risks from financial statement representations, to material contracts, to litigation risks, to tax liabilities and compliance with rules and regulations. As insurance companies gain more claims experience, more are issuing such policies. The increase in competitors is resulting in lower premiums and more frequent usage.
Rittberg: We are seeing increased adoption of M&A insurance to help reduce risk and overcome deal obstacles. Over the last 12 years, we have witnessed more than a tenfold increase in the use of insurance on deals in the US. This increase in use is attributed to the product covering a broader range of loss, including for diminution in value and multiplied damages, reduced pricing and deductibles, and payment of insurance claims. The insurance has evolved to the point where it can provide as good, or better, level of protection as a seller indemnity has in the past. Policies can also be obtained in a much shorter time frame than years ago, in a number or days rather than weeks, and the market has demonstrated that it can respond to the needs of dealmakers, even on the fastest moving transactions. Insurance is also available on deals where sellers are providing little or even no indemnification to a buyer.
FW: What are the benefits of establishing a dedicated deal team to oversee the process and ensure it runs smoothly and efficiently? In what ways can this reduce overall risk?
Bolsinger: Somebody needs to be the quarterback of every transaction – somebody who understands the overall picture, business objectives and workstreams – in order for relevant information to be collected and shared, and tasks to be coordinated among the multiple teams of professionals. If nobody is at the helm, there will be areas that will remain uncovered and issues will fall through the cracks. In addition, the due diligence process will become very frustrating for the target and the seller if there is not somebody coordinating, tracking, avoiding duplication and driving the process for the acquirer.
Cowen: The continuity a dedicated deal team brings is very helpful. For a W&I insurer, having a core group of deal team individuals who can show us that they are across all the natural risk areas for the target business and explain how these are being dealt with, gives huge comfort and ultimately better coverage.
DeLott: Having a dedicated deal team is the most efficient way to execute a transaction. The deal team can bring in other resources as necessary. Using a dedicated deal team to manage transactions is particularly beneficial for acquirers that pursue transactions on a regular basis. A dedicated deal team often can ‘parachute’ into a transaction with established procedures for due diligence and negotiation techniques. Using a dedicated deal team also provides upper management with the ability to focus on other matters, such as running existing operations, without getting into the weeds of a deal. The deal team can seek input and authorisation from upper management as necessary.
Kaden: The timing and tempo of a transaction are always challenging. Acquirers leveraging the oversight of the transaction process to management with existing day-to-day responsibilities are unnecessarily elevating the risk of mistakes or even transaction failure. A deal team with transaction experience is key to effectively addressing planned and unexpected events during the process.
Cowhey: The scope of expertise of a deal team, whether it is the buyer’s diligence team or the underwriting team working to assess and frame a proposal of insurance for the transaction, are essential. From time to time, issues arise and the benefit of an experienced and driven diligence team that has the skill sets necessary to redirect diligence in real time in response to unexpected findings in the diligence process is an advantage in managing the ups and downs of the diligence process. Similarly, an underwriter with a strong and deep bench should offer the prospective insured a measure of comfort that the prospective insurer has both the skills and sufficient resources readily available to review and process document review and to complete their analysis in a timely fashion that does not lead to unnecessary delays in the transaction.
Rittberg: Acquirers that use dedicated deal teams to manage the deal process benefit from the attention to detail and timing which can help avoid risks being missed or ignored. Dedicated deal teams can leverage experience from prior deals to save time and energy and identify concerns that less connected deal parties might miss.
Timpani: It is important to remember that most of the internal operating people also have a ‘day job’, running the existing business. When you layer an acquisition on top of that, many companies struggle. The fact that most companies run fairly lean is a simple but important reason why they may struggle to realise the full value of their M&A deals. A dedicated deal team, including both internal and external resources, allows sufficient focus to be put in place on all aspects of the transaction process. On top of the time aspect, an area that is often overlooked is the integration process. Integration failures are often the result of insufficient management capabilities to ‘bring the target into the acquirer’s fold’.
FW: Given that cultural clash has the potential to derail a transaction and destroy value, what steps can acquirers take to plan for post-deal integration covering systems, processes and personnel?
Cowhey: It might be said that the road to M&A is filled with once-excellent acquisition targets that were poorly executed. In this regard, preparing for integration is every bit as important as the transaction itself. The diligence process can assist in the implementation phase by focusing not only on matters of finance, tax and legal, but also on operational issues and assessing the existing management team and their ability to lead the company, post-transaction, in implementing the buyer’s strategic plan. Effective execution can help mitigate overall transaction risk by improving the likelihood of the buyer achieving its ultimate goal of a successful and accretive acquisition. A transactional insurance policy can also be a beneficial tool in management or seller rollover.
Kaden: Many business managers and operators will say “the real work begins after the deal closes”. A successful post-deal integration plan begins prior to closing the deal. Some key steps to consider include, firstly, designing the plan to reflect the key objectives and principles of the merger – share findings and observations from the diligence process. Secondly, organise transition leaders and teams based on key functions – participants from both buyer and target – to mirror the value drivers of the merger. Thirdly, get both teams on board. Manage the transition as a discrete process that is separate from the day-to-day running of the business. Fourthly, communicate success targets – costs and revenue – and update throughout the process. Finally, prioritise objectives correctly and work to a ‘first 100 days’ objective.
DeLott: Planning for the integration process should start well in advance of closing. Culture clashes arise in many deals and are a common aspect of cross-border deals. The initial objective should be to identify the most capable persons – on either side of the transaction – responsible for systems, processes and personnel to manage their respective combined business units on a going-forward basis. Culture clashes can be reduced by soliciting input from relevant parties on both sides of the transaction. We have seen culture clashes arise out of issues big and small, from working hours to dress codes, and from holiday bonuses to the food served in the company cafeteria.
Timpani: Understanding the cultures of both the acquirer and the target is useful to determine which cultural differences matter and must be addressed in the integration change management plan. There are myriad challenges, with respect to people and culture, in an M&A deal. In addition to the more transactional issues around compensation, benefits and general employee onboarding, there are a series of strategic issues surrounding ‘how to win the hearts and minds’ of the acquired company’s employees. Some practical steps which can help companies navigate the commercial transition more effectively include incorporating an element of commercial, customer and employee diligence into the due diligence to understand the culture from an internal and external perspective.
Rittberg: We often see buyers using R&W insurance to avoid post-closing issues between acquirers and the management team that they have acquired. The insurance allows the buyer to seek recovery from the insurer for breaches of the representations made by the seller and the management team, instead of having to seek recourse from the seller or management. Avoiding the friction of an indemnification claim between a buyer and the management team allows the parties to focus on integration and growing the business rather than the dispute over accuracy of the representations.
Cowen: A W&I policy offers a distinct avenue for claim. This can eliminate the need for a new business owner to have to sue its own management team for breach of warranty if, as is often the case, they were themselves selling shareholders. This is hugely valuable given the ongoing success of a business fundamentally rests with the people running it. Preserving this relationship and their motivation can be make or break.
Bolsinger: Books have been written about preparing for and implementing the integration of one business into another. To summarise: assess, listen, value and learn from each other’s differences. Also, prepare, embrace diversity and inclusiveness, promote buying-in into the plan by everybody and follow the plan.
FW: Could you provide an insight into the additional challenges that often arise when managing transactional risk in the context of a cross-border deal?
DeLott: Cross-border deals bring additional challenges, including differing practices with respect to management compensation, varying legal landscapes and tax issues. Cross-border deals also require an appreciation for differences in customs and mores. Will taking an aggressive stance in negotiations cause a deal to collapse? How quickly can your counterparty be expected to move in a transaction? What level of consultation is required within a foreign company? Are key executives at the target company typically ‘on holiday’ for the entire month of August? Are there political issues at play? Would certain business practices that are considered ‘normal’ in the domicile of the target company be deemed to be illegal corruption in many Western countries?
Cowen: The obvious challenges are the differences in local law and regulation, and this is where local counsel input into an acquirer’s due diligence is important. The trickier area is probably the difference in approach and expectations of the process or features of the deal when transacting abroad. For example, a US investor into Europe may not expect to see the contents of the data room qualifying the seller’s liability under the warranties. They would also expect loss to be paid on a pound-for-pound indemnity basis rather than the UK assessment of damages, while a Nordic investor into the UK may expect the seller to freely warrant the accuracy of all the information it has provided, which would be a very aggressive buyer demand on a UK domestic deal. W&I insurance may be able to help to plug some of these gaps in expectation.
Timpani: Among other things, cross-border transactions add employee regulatory, policy and cultural challenges. Spending time in the jurisdiction of a potential acquisition target to understand the culture and competitive environment can be as important as doing effective due diligence. Synergy capture is much more difficult in a cross-border deal due to the need to adapt sales and marketing strategies, language differences and cultural nuances. Integration is an often overlooked risk that only increases in the context of a cross-border deal. A cross-border deal requires a longer and more intense integration plan, which should be thought-out and planned well in advance of completion of the deal.
Rittberg: For cross-border deals, it can be challenging to for any party to get comfortable with the laws and risks in jurisdictions with which they are not familiar. Buyers and sellers may disagree on the appropriate deal structure and governing law for a deal that crosses borders. Transactional insurance can help bridge these gaps by giving a buyer additional protection and recourse in their home jurisdiction, rather than a less familiar one, and increase the amount and duration of protection.
Cowhey: The ability to seamlessly swing from one geographic jurisdiction to the next in a diligence exercise is not a simple task. Given the increasingly global nature of business and the transaction marketplace, the capability of a diligence provider to provide clear, concise and consistent advice from one region to the next is invaluable. Likewise, an underwriter’s ability to review, assess and provide a responsive coverage grant with limited, if any, boundary restriction is pivotal to the effective use of transactional insurance on a cross-border transaction. For this reason, the effective global capabilities of an underwriting operation should be a key criterion in assessing and determining the right insurer for a particular transaction.
Bolsinger: The additional challenges that need to be navigated have more to do with non-substantive issues – languages, exchange rates, time zones, cultural differences and different ways of doing transactions, to name a few. Of course, there are additional substantive issues as well, including transfer pricing, exchange rate hedges and shared resources across borders.
Kaden: Cross-border deals certainly add additional transaction risks which are most commonly addressed with an international diligence team. The more common issues are taxes, wages and benefits, basis of accounting and general nature of accounting systems and records. These challenges are most effectively addressed when the multinational diligence team includes members that are familiar with a target’s local practices and requirements.
FW: How do you expect transactional risk management to develop in the years ahead? What changes do you anticipate in attitudes, strategies and techniques?
Timpani: The key issues which underpin transaction risk – people, culture, business interruption and so on – will remain, but methods of assessing and managing them will evolve. W&I insurance products will remain relevant for particularly complex transactions. The easiest way to manage transactional risk is to be appropriately prepared, and that speaks to both buyers and sellers. If you are selling your company, spending time in advance to ensure the house is in order, well before pressing the button on a sale process, will maximise the chance of delivering an efficient process and significantly reduce execution risk stemming from deal delays and information flaws.
Cowhey: While the use of transactional insurance has been growing for some time, there remains much room for continued development in the space. Certain underwriters will continue to lead with further innovation and development. For example, we anticipate continued progress on the development of insurance solutions for areas such as intellectual property, cyber and environmental risk, as well as implementing procedures to continue to improve and further streamline the underwriting process.
Rittberg: The use of transactional insurance to manage deal risk will increase as more dealmakers and advisers become familiar with the product and its benefits. Products will be used more frequently for strategic acquirers which have not adopted the products as much as private equity buyers in the past. Claims handling procedures will continue to improve and partnerships will strengthen between insurers and acquirers.
Bolsinger: M&A insurance will continue to mature. More transactions will be covered by insurance but will likely never reach more than 80 percent of total transactions. There will always be players who will not want to insure a transaction, transactions that are not insurable and transactions that still follow a traditional indemnification approach. The material terms of the policies will also become more standardised. Acquirers will continue to refine and perform their due diligence on targets, deal professionals will figure out how to utilise artificial intelligence (AI) in the due diligence process and the sophistication level of professionals involved in transactional risk management will continue to elevate.
Kaden: We are seeing more emphasis on two very different aspects of risk. Data analysis is becoming a more frequent element of the diligence plan. Target data is evaluated and used to identify key trends and to efficiently corroborate certain representations. Commercial due diligence is also becoming more important as acquirers want to better understand the risks associated with the target’s customers and market.
Cowen: The prevalence of W&I is certainly continuing to shift the focus of risk management away from contractual protection and towards broader risk transfer options, as the benefits of insurance are better understood by M&A practitioners. The M&A insurance market has become, in the last six to eight years, more sophisticated in its approach and more appreciative of the demands of a transactional process. Insurance companies are also becoming wiser to the value that other lines of insurance can deliver to provide a more complete risk management solution. M&A acquirers will look to incorporate insurance strategies into their acquisition approaches even more as they realise the advantages both from a claims perspective and from the freedom it can give in allowing them to focus on other, more negotiable priorities of a transaction with the seller.
DeLott: We expect the transactional risk management process to continue to evolve to meet the needs of businesses around the world. We also expect the transactional risk management process to become ever more professional as shareholders recognise the risks of poor transaction execution, particularly in large, transformational deals. Transactional risk management will receive more attention in business school classes, by using notable failed transactions as case studies. And the insurance industry and financial markets will likely create new products to address transactional risk, including political risk, risks relating to a warming planet and risks that have yet to emerge.
Jeffrey D. Cowhey is co-founder and president of Ambridge Partners LLC, a managing general underwriter of transactional, legal contingency, specialty management and intellectual property insurance products. Established in October 2000, Ambridge provides customised and responsive underwriting solutions for a wide variety of exposures that prevent a transaction from being completed. Ambridge’s wholly owned subsidiary, Ambridge Europe Limited is an underwriter of complex risks in the UK and other countries in the European Union. He can be contacted on +1 (212) 871 5402 or by email: email@example.com.
Josh Cowen is head of M&A underwriting at Aviva leading the team focusing on warranty & indemnity insurance, tax liability and contingent liability insurance for both UK domestic and cross-border M&A transactions. A qualified corporate solicitor, he began his career at Macfarlanes LLP following which he led the UK private equity M&A underwriting team at AIG, before joining Aviva. He can be contacted on +44 (0)7384 534597 or by email: firstname.lastname@example.org.
Kevin Kaden has over 25 years of experience providing accounting and consulting services to large and middle market clients. He is a leader within BDO’s private equity industry practice and has a proven track record of supporting transaction decisions of financial buyers, strategic buyers and lenders. Mr Kaden has significant experience with mergers & acquisitions and business restructuring. He focuses on identifying and resolving critical deal issues. He can be contacted on +1 (212) 885 7280 or by email: email@example.com.
Matteo Timpani is a partner specialising in mid-market M&A in the Corporate Finance team at Crowe U.K. LLP. His clients range from small and medium sized companies to large corporates, public companies, banks and private equity firms. Mr Timpani specialises in guiding business owners and management teams through significant events in the business lifecycle including mergers, acquisitions and debt & equity fundraising, and regularly undertakes strategic reviews for his clients with a view to adding long-term value. He can be contacted on +44 (0)20 7842 7171 or by email: firstname.lastname@example.org.
Dr Markus P. Bolsinger structures and negotiates complex transactions, including domestic and transatlantic mergers and acquisitions, leveraged buyouts, recapitalisations, going-private transactions, bank and mezzanine financings, and venture and growth investments. Dr Bolsinger’s experience extends across industries, including agribusiness, consumer, food and beverage, healthcare, industrial, packaging and restaurant sectors. In addition, he has extensive expertise in transactional risk insurance for mergers and acquisitions, and frequently speaks and writes on the topic. He can be contacted on +1 (212) 698 3628 or by email: email@example.com.
Jay Rittberg is managing principal of Euclid Transactional, LLC, a transactional insurance underwriting and claims handling managing general agency. Prior to joining Euclid Transactional in April 2016, he was senior vice president and Americas M&A manager at AIG, where he was responsible for managing the development, underwriting and marketing of transactional insurance products. Previously, he was a corporate attorney at Schulte Roth & Zabel LLP, where he advised clients on a wide range of corporate matters. He can be contacted on +1 (646) 517 8808 or by email: firstname.lastname@example.org.
Steven R. DeLott is senior insurance counsel at Simpson Thacher & Bartlett LLP and a member of the firm’s corporate department. His areas of focus include representations and warranties insurance, directors’ and officers’ liability insurance and insurance regulatory matters. He is a former adjunct assistant professor at the College of Insurance in New York City where he taught courses in insurance law and insurance regulation. He can be contacted on +1 (212) 455 3426 or by email: email@example.com.
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