W&I insurance as a regular transaction element
June 2018 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
June 2018 Issue
European M&A markets posted significant growth (14 percent) in terms of overall deal volume in 2017, and so far there are no indications of a significant slowdown in 2018. Within a strong overall environment, Germany continued to outperform its European neighbours with 45 percent growth year-on-year.
One of the dominant German market trends in the last couple of years (which has certainly played its part in fuelling a booming market) has been the increasing popularity (and use) of warranty & indemnity (W&I) insurance. This comparably young insurance product line in principle provides covers for losses arising from warranty breaches or for claims under tax or other indemnities given by a seller in the acquisition agreement in the context of an M&A transaction. While W&I insurance had a rather slow start in a traditional and conservative German market when introduced about 10 years ago, it has since become a very popular tool in every major category of transactions, including corporate, strategic, private equity and real estate. Based on our experience, we would estimate that W&I insurance plays a role in more than two out of three deals.
The buy-side motivation for seeking additional protection through W&I insurance is manifold. Obvious cases are scenarios in which a buyer doubts the seller’s financial power – and therefore its ability to honour warranty and indemnity claims – after completion of a transaction, or a private equity seller desires to distribute funds to investors right after closing. Insurance can also facilitate deals in sell-side markets when sellers have the bargaining power to limit their monetary exposure at very favourable (i.e., low) levels or can successfully push for shorter limitation periods than a buyer is prepared to accept. In auction bidding processes, the insurance can reduce sell-side exposure and hence make an individual bid more attractive to the seller.
W&I insurance may at first glance look like the philosopher’s stone and solution for all problems. Conceptually, it is designed to cover unexpected risks inherent to a transaction target, i.e., the so-called ‘unknown unknowns’. Therefore, one should not forget one very fundamental point: insurers by nature do not (and cannot) take irrational and unassessed risks. They clearly expect that a buyer seeking insurance cover has conducted a reasonably detailed due diligence review of the target and its business in a scope and level of detail in line with market practice.
To put it differently: W&I insurance is not a substitute for conducting professional and proper due diligence. All insurers refuse to cover ‘black box’ risks, i.e., risks associated with areas which have not been ‘diligenced’ are categorically excluded from cover positions. This makes it obvious that the overall motivation for conducting a professional and thorough diligence review with regard to an acquisition target is supplemented by one additional element: it is no longer only about validating financials and underlying assumptions, understanding operational and legal structures or about identifying threats and risks for the business, but in parallel to all of the aforementioned to also prepare the stage for making a deal ‘insurable’.
Experience has shown that it tremendously facilitates the running of a smooth and efficient W&I process if the due diligence exercise is structured, scoped and conducted with the insurance purpose in mind. It may significantly distract deal makers down the road if they have to shift resources (which are limited by definition) to this workstream. Slowing down the deal process is collateral damage caused by careless diligence planning.
It has proven helpful to have the following items in mind right from the outset when considering an ‘insured’ transaction.
Scope diligence properly. The scope of the due diligence has to be aligned with the desired scope of insurance. Otherwise, one may end up having to conduct an extra round of diligence for areas which were initially left out at an advanced stage of the process.
Use of professional advisers. Insurers generally want to be presented with deals where diligence was conducted by independent third parties as neutral observers. While there is no doubt that covering certain specialist areas ‘in-house’ makes a lot of sense for numerous reasons, it may be counterproductive for insurance purposes.
Clarify the diligence approach. Better insurers understand how a diligence process is approached and structured, so it is easier for them to ‘tick the box’ on diligence. Due diligence reports should therefore clearly describe the scope of review (fields of law, specific data room folders, individual documents, etc.) and the approach toward reporting (materiality thresholds, specification of terms such as ‘red flag’ or ‘exemptions only’, etc.).
Create the ‘look and feel’ of sell-side cooperation. Another important point for insurers is to get a feeling of how the sell-side organised itself in the context of the diligence process. They are looking for an assessment of the quality of the information provided for review (i.e., the data room) from various angles: form of presentation and accessibility, level of detail and completeness. The quality of sell-side cooperation can also be read from the level of engagement in the formal Q&A process run alongside the diligence review (the answers would not make reference to a W&I insurance covering the risk).
Manage expectations. It should not come as a surprise that insurers are unwilling to provide coverage against circumstances which the buyer knew prior to entering into a binding acquisition agreement, be it as a result of its own due diligence review or sell-side disclosure (which ideally go hand in hand). Corresponding risks are covered by way of specific (uninsured) indemnities (if negotiable), not by W&I insurance.
While typically a W&I insurer provides back-to-back coverage for a specific warranty catalogue which has been negotiated by the parties, there are also (admittedly limited) possibilities to get coverage for what is referred to as ‘synthetic’ warranties, i.e., warranties which the sell-side is not prepared to give, but which come into ‘existence’ solely for insurance purposes. This obviously is an exception from the default (back-to-back) concept, and it is a logical consequence that offering such cover requires that the buy-side gets the insurer ‘extra comfortable’ with regard to diligence and the results thereof. Synthetic insurance concepts have been implemented both regarding tax indemnities and balance sheet warranties.
Sometimes transactions depend on solutions with respect to individual known risks. If parties are unable to find a risk allocation, there are scenarios in which insurers may agree to also insure such known risks through so-called ‘special situation insurance’. Typical cases would be insurance for title risk, litigation risk and tax risk. In addition to the standard package (i.e., thorough diligence) in relation to these matters, the insurer will typically require a third-party professional legal/tax assessment of the relevant risk at hand and on this basis take a view on whether to provide cover or not. In these cases, insurance premiums will be significantly higher than for regular W&I.
In a nutshell, from a diligence standpoint, a buyer needs to convince the insurer that it conducted a proper and professional review within the corridor of what can be considered appropriate for the relevant transaction at hand. Should a certain ‘smell’ arise that the scope of review was trimmed down or the review exercise rushed, this will most likely result in a higher insurance premium or less coverage (better case) or in the complete denial of a policy (worse case).
Dr Matthias Jaletzke is a partner and Daniel Dehghanian is counsel at Hogan Lovells International LLP. Dr Jaletzke can be contacted on +49 69 962 36 651 or by email: email@example.com. Mr Dehghanian can be contacted on +49 211 13 68 498 or by email: firstname.lastname@example.org.
© Financier Worldwide
Dr Matthias Jaletzke and Daniel Dehghanian
Hogan Lovells International LLP