How the Competitive Landscape and Increased Use of Reps & Warranties Insurance is Influencing M&A Deals
Emboldened by a healthy M&A market and multiple suitors, sellers are requiring higher prices and less risk. To remain competitive, buyers are completing their due diligence efforts quickly and agreeing to smaller indemnification escrows. Transactional insurance, including reps and warranties insurance, tax insurance and contingent liability insurance, especially when used creatively in conjunction with indemnification escrows, is one of the indemnification solutions buyers can use to design a competitive offer and deal structure that allows sellers to receive more of the purchase price at closing.
As familiarity with transactional insurance, especially R&W insurance, has increased in recent years, visible changes are taking place in the number of private M&A deals using these products and the way deals are structured. This paper explores how sophisticated M&A practitioners are perfecting methods of using transactional insurance in conjunction and collaboration with traditional solutions such as escrows and offers key considerations for deal parties who are evaluating indemnification solutions.
Smarter Sellers, Complimentary Indemnification Solutions
In certain contexts, especially deals involving private equity or venture capital sellers or where the sellers know there will be a competitive auction process, sellers and their M&A advisors are becoming more skilled at ensuring the term sheet or letter of intent specifies buy-side R&W insurance as the buyer’s primary source of recovery for losses resulting from breaches of the reps and warranties made by sellers and the company in the purchase agreement. As a result, the indemnification escrows historically used to secure recovery of those losses are often serving as only the deductible or retention above which the R&W insurance attaches, with specific, separate escrows used to secure sellers’ indemnification obligations for matters not covered by the R&W insurance, such as purchase price adjustment matters and known, indemnifiable matters discovered during the buyer’s diligence investigation.
An increase in the number of insurers and MGAs/MGUs offering R&W insurance over the last few years has facilitated this shift in transaction structure and escrow size. The increased competition has resulted in downward trends in R&W insurance premium rates and deductible levels, as well as narrower or fewer exclusions in the insurance policies. This has encouraged M&A practitioners and deal parties to become more accepting of R&W insurance but does leave some concerns regarding whether these more aggressive policies will pay when needed, especially with some of the new entrants.
The Buyer’s Perspective
Another apparent change contributing to the increased use of transactional insurance and the above-referenced structural changes is that as buyers and their advisors become more accepting of transactional insurance, especially R&W insurance, which is the most commonly used transactional insurance product, they are learning that it is sometimes in their interest to propose transactional insurance early during an M&A negotiation. This is partly because the sellers’ market encourages buyers to be competitive not only with respect to acquisition pricing but also with their post-closing indemnification structure. It’s also a result of buyers and their advisors learning to pair transactional insurance, especially R&W insurance, with traditional indemnification solutions such as indemnification escrows, thus allowing for consideration of a broad array of collaborative indemnification solution tools that can be deployed as needed for each M&A deal.
Two distinct examples illustrate this point, both involving situations where a buyer may propose R&W insurance instead of, or as a supplement to, a traditional escrow even if an escrow remains the buyer’s preferred method for securing sellers’ indemnification obligations. One example involves a buyer negotiating with sellers who have enough leverage to resist a traditional escrow structure altogether, or sellers who are expected to propose buy-side R&W insurance above a relatively small escrow. Even if the buyer prefers a traditional 10 to 15% escrow instead of R&W insurance, by initiating the R&W insurance discussion instead of simply reacting once the sellers propose R&W insurance, the buyer may achieve some control or influence over the indemnification discussion (e.g., desired amount of insurance; size of the insurance deductible; determination as to which party will bear the cost of the underwriting fee, the premium, and the insurance deductible).
Sophisticated buyers may suggest a combination of escrow and R&W insurance as a compromise to sellers’ preference for a “no indemnity” deal and buyer’s preference for a traditional 10 to 15% escrow arrangement. This structure may satisfy the buyer’s and insurance underwriters’ desire for the sellers to have “skin in the game” in the form of an escrow, even if sized to serve as the R&W insurance deductible instead of the buyer’s only or primary source of recovery, while also satisfying the sellers’ desire to not tie up 10 to 15% of the purchase price post-closing. Hybrid escrow/insurance arrangements are also useful in transactions where an appropriately sized escrow, separate and apart from the R&W insurance, serves as the primary or sole source of recovery to compensate a buyer for losses relating to known, indemnifiable matters discovered before signing and not typically covered by R&W insurance, such as historical environmental issues or pending or threatened lawsuits.
A second example involves a buyer who knows they are not the only party interested in acquiring the target company. To distinguish their offer and hold the sellers’ interest during a competitive bidding process, the buyer can propose buy-side R&W insurance in place of an escrow, or to supplement a smaller escrow. As with the prior example, affirmatively proposing the use of R&W insurance may provide the buyer a level of control or influence over the discussion and may enable the buyer to utilize their preferred mix of indemnification solution tools. If the buyer is familiar with R&W insurance and has strong relationships with its transactional insurance broker and one or more underwriting shops, that too may help the buyer convince the sellers that they will be able to execute smoothly and in a timely manner.
Improvements to the Underwriting Process
In addition to the structuring changes noted above and the improved R&W insurance terms and conditions resulting from increased competition, improvements to the R&W insurance underwriting processes have also contributed to increased use of both buy-side and sell-side R&W insurance.
Many transactional insurance underwriters today are former private practice M&A attorneys with experience structuring, negotiating, and drafting reps and warranties, indemnification provisions, and disclosure schedules. M&A practitioners exploring the feasibility of a traditional escrow or transactional insurance product for a particular deal appreciate the ability to work with underwriters and advisors who are commercial and who understand M&A transactions and complimentary indemnification solutions.
Also encouraging is that many of the insurers and MGAs/MGUs active in the transactional insurance space today have created streamlined, efficient procedures and template documents that allow for a smoother, quicker submission and underwriting process than that which existed in the early years of transactional insurance, further supporting the acceptance of transactional insurance by M&A attorneys, investment bankers and business professionals in the private equity, venture capital and strategic acquirer space.
Key Considerations: How Does this Affect You?
Understand the differences (both pros and cons) between escrows and R&W insurance, and the differences between buy-side R&W insurance and sell-side R&W insurance as well as the typical timeline and substance of the R&W insurance underwriting process.
Be familiar with the transactional insurance submission and underwriting process to understand how it may affect the deal’s substance and timing, and so you can advise your client if you realize sticking with (or reverting to) a more traditional escrow structure, or combining transactional insurance with an escrow, may benefit that particular deal. Transactional insurance is not available on all deals and is not always the only (or best) solution, and even when it is used, specific escrows may be needed to secure funds for purchase price adjustments or for specific, expected indemnification obligations not covered by the insurance.
Don’t view transactional insurance as the only solution or as a perfect substitute for a traditional escrow structure. Depending on the M&A deal, an escrow may be more efficient or more readily available than insurance, or a specific escrow may be advisable for certain specified indemnification obligations. Reasonable expectations go a long way to keeping the overall discussion and the insurance discussion grounded and practical.