The effect of Buy-Side Representations and Warranties Insurance (RWI) on M&A transactions is one of the topics we’re following closely. Our 2019 Buy-Side Reps and Warranties Insurance (RWI) Deal Terms Study analyzes private-target acquisitions over a three-year period in which we provided professional and financial services to consider how transactions that use Buy-Side RWI compare to those that don’t.
Younger private equity professionals and M&A attorneys don’t know what it’s like to not have Buy-Side RWI as a key indemnification solution, especially for private, middle-market M&A transactions. Many people in the RWI industry may be content to sit back, bind more coverage, and enjoy the ride—but is it that simple? Clearly the use of RWI alters the deal structure, but is the growth of RWI affecting diligence reports, purchase agreement wording, and the M&A negotiation process in other subtle or not-so-subtle ways? How can RWI be used alongside other indemnification tools, like retention escrows and special escrows, to ensure buyers and sellers using RWI also address matters not typically covered by the insurance, such as purchase price adjustments and special indemnities for known matters? Will the pendulum swing in favor of traditional deal structures and Sell-Side RWI if, or more likely, when, the sellers’ market adjusts to middle of the road, or even beyond middle—to a buyer’s market?
The Evolving RWI Landscape
Not too long ago, RWI was in its infancy in the U.S. The now-popular M&A insurance product first appeared here rather uneventfully almost 20 years ago when a few underwriters saw an opportunity to bring a traditionally sell-side U.K. insurance product across the pond. Throughout the early and middle of the decade, RWI endured in a niche space, with moderate awareness and acceptance among M&A parties and their advisors. The product and process, including insurers’ willingness and ability to handle and pay claims, were unpolished and unproven. For example, the submission, quoting, and underwriting stages sometimes lasted several weeks; people weren’t quite sure when the “right time” during the M&A process was to approach insurers and initiate the RWI discussion; and pricing and deductibles could be double what they typically are today.
Those of us who were there at the beginning may also remember the often painful and time-consuming process of negotiating and drafting insurance policy wording for each transaction, even after reaching agreement on coverage intent and exclusions, and the difficulty convincing M&A advisors to grant insurers access to data rooms and diligence reports. Finally, let’s not forget early versions of some of today’s common RWI exclusions.
Fast forward to today: A competitive M&A market has continued to support the growing use of Buy-Side RWI for transactions of varying sizes and across many industries, and Sell-Side RWI can be a valuable tool for sellers who remain at risk after closing for breach of reps and warranties indemnification obligations in traditional transaction structures. The number of RWI underwriting shops operating in the U.S. has increased dramatically; Buy-Side RWI is often part of the negotiation for deals involving financial sponsors or their portfolio companies; and a number of strategic acquirers are learning about the pros and cons of Buy-Side RWI and considering using the coverage when circumstances require. However, questions remain regarding whether deals with RWI have different purchase agreement terms, claims experiences, quality of disclosure schedules and diligence reports, or other similar dynamics compared to deals without RWI. Some of those questions do not lend themselves very well to quantitative analysis, but SRS Acquiom has been analyzing the available data and speaking with M&A professionals to give as much insight as possible into these important questions.
RWI’s Effect on M&A Negotiations, Diligence Reports, and Purchase Agreement Wording
Our 2019 Buy-Side RWI Deal Terms Study reiterates a trend we first noticed in the 2018 Buy-Side RWI Deal Terms Study: on the whole, transactions and purchase agreements that use Buy-Side RWI do tend to differ from transactions and purchase agreements that don’t. Some of those differences are commonly known or assumed, such as the use of a small- or moderate-sized indemnification escrow when RWI is in play–often serving as all or part of the RWI retention–instead of the larger indemnification escrows typically seen in traditional (non-RWI) transactions. Other differences are less pronounced or not as easy to track with data; for example, M&A advisors sometimes comment that purchase agreement negotiations go quicker or more smoothly when a transaction is structured with RWI, which may be good from an efficiency standpoint, but it may also be something insurers need to be conscious of if they expect to insure fully negotiated transactions, and something that buyers need to consider when thinking about the quality of reps and warranties made by sellers in purchase agreements.
The data seems to support the premise that, generally speaking, whether a deal term is more buyer-favorable or seller-favorable on a transaction that involves Buy-Side RWI is closely correlated with whether the risk regarding such term will be retained by the sellers or transferred to the insurer. When RWI is used, more buyer-favorable outcomes tend to be seen with respect to risks transferred to the insurer, and more seller-favorable outcomes tend to be seen with respect to risks retained by sellers. Examples include the presence of “materiality scrapes” in the purchase agreement, which are buyer-favorable provisions that sellers appear more willing to agree to when Buy-Side RWI is in play, and the presence of “non-reliance” and “no other representations” clauses in the purchase agreement, which are seller-favorable provisions that buyers appear more willing to agree to when Buy-Side RWI is in play.
We’re also seeing certain concepts typically associated with RWI usage beginning to appear in purchase agreements even when the transaction structure does not involve RWI, such as separate purchase price adjustment (PPA) escrows, which allow the parties to ring-fence and secure a specified amount for the PPA regardless of whether RWI is used and regardless of whether an indemnification escrow is also established to address non-PPA matters (e.g., rep & warranty breaches; special indemnities for known matters). And we wonder if changes to the diligence process and the way diligence reports are prepared–diligence efforts and write-ups are sometimes geared towards the RWI insurer’s needs or preferences, especially when the buyer’s advisors are familiar with the RWI underwriting process–will soon become the new norm regardless of whether the transaction involves Buy-Side RWI. As another example, it’s possible that diligence reports will increasingly be prepared under the assumption that they will need to be shared with an outside party that could potentially impact whether such reports remain privileged.
The Fate of Buy-Side RWI and Potential Rise of Sell-Side RWI in a Shifting Market
While Buy-Side RWI is currently more popular than Sell-Side RWI in the U.S., this may change in a buyer’s market or in a moderately-paced neutral market. Certain U.S. underwriters who prefer writing Buy-Side RWI or who do not currently offer Sell-Side RWI may consider adjusting their appetite in a changing market, and underwriters who are experienced with both types of RWI may see a first-mover competitive advantage if the desire for Sell-Side RWI increases over time. M&A advisors who understand both types of RWI will be able to adjust more quickly than those who are not familiar with RWI or who are only familiar with Buy-Side RWI.
There is also a question of whether there will be a market correction if insurers and reinsurers incur greater than expected losses on RWI policies. With more RWI providers in the market, some underwriters have become increasingly aggressive on pricing and other terms, including for example retention levels and policy wording. At the same time, buyer’s and third-party advisor’s diligence efforts may have declined on some of those transactions. Some M&A professionals are questioning whether this puts the RWI market in a fragile state.
While our study cannot predict the outcome of such future changes, we believe it does illuminate how the use of RWI on a deal is impacting deal dynamics today and paying attention to trends and feedback from deal parties, underwriters, and advisors can help us prepare for what’s next.
About SRS Acquiom
SRS Acquiom offers the most comprehensive platform to help deal parties manage complex financial transactions within mergers & acquisitions and bilateral or syndicated loan deals. Our solutions include paying and escrow agent services, online stockholder solicitation and reporting, representations and warranties insurance brokerage, professional shareholder representation, and for loan and credit transactions, administrative, collateral and sub-agent services. Since 2007, we have helped businesses, investors, lenders, and advisors complete transactions as efficiently and effectively as possible, so they can focus on building strong businesses, and maximizing value.
Acquiom Insurance LLC (CA License 0K36258; operating as Acquiom Insurance Services in New York and Acquiom Insurance Solutions LLC in California) is the SRS Acquiom insurance brokerage subsidiary, specializing in Transactional Insurance placements. Our team of M&A service professionals, former corporate attorneys and experts with Transactional Insurance underwriting experience is uniquely positioned to assist Buyers, Sellers, and their advisors with a range of indemnification solutions, including Representations and Warranties Insurance, Tax Insurance and Contingent Liability Insurance.