With new regulations phasing in that will change how traditional bank escrow services are managed, alternative solutions for M&A escrows have emerged. An insurance-backed escrow investment solution is one new option. With this comes a new set of questions regarding how insurance-backed vs. bank solutions differ. These questions are addressed here.

How do the protections against loss of principal compare?

Historically, most M&A escrows have been invested either in a bank money market deposit product or an institutional money market fund. A bank money market deposit is a general obligation of the bank and gets a limited amount of FDIC insurance. This means that deal parties take the bank’s credit risk beyond the FDIC coverage. If the bank fails, merger parties are general unsecured creditors. Investments in money market funds carry no FDIC insurance, but the investors in the fund own a pro-rata interest in the assets in the fund’s portfolio. Money market funds have special rules that allowed the fund to price investments and disbursements from the fund at the same price. Although not guaranteed, the special accounting rules have ensured that money market funds were protected against principal loss except in very rare circumstances. However, that is about to change. Beginning in the fall of 2016, investments and disbursements in money market funds will be priced at that day’s net asset value of the fund, which could be more or less than the amount originally deposited into the fund. This means that the amount that will ultimately be disbursed from an escrow will be unknown at the time the initial investment into the fund is made.

When merger proceeds are placed into an insurance-backed investment product specifically designed for M&A escrows, escrow funds are invested in a portfolio of high quality liquid securities similar to what occurs in a money market fund. However, unlike the volatility that will occur with the fluctuations in the daily value of money market funds, the insurer guarantees the parties will always get a return of their principal plus accrued interest. Additionally, in contrast to what happens in a bank deposit where the investors are general obligors of the bank, money invested in an insurance company’s separate accounts are insulated from the insurance company’s other obligations. Therefore, for deal parties to lose principal, there would need to be both a loss in the separate account and a default by the insurer on its guarantee against loss.

How does liquidity compare?

Bank money market deposits, money market funds and insurance products designed specifically for M&A escrows generally provide same or next-day liquidity when required. However, beginning in 2016, money market funds may impose waiting periods and/or fees on withdrawals under certain market-downturn conditions. Insurance-backed escrow investment solutions are designed to provide liquidity when necessary under the terms of the merger agreement without fees or delays.

Is there a difference in fees charged?

When M&A proceeds are invested in a traditional bank escrow account, escrow investments and disbursements are generally processed through the escrow bank. Escrow banks typically charge administration fees, annual fees and/or payments fees. With new regulations causing deposits to be more expensive for banks to hold on their balance sheets, the amount charged for such services is likely to increase. Some banks are considering withdrawing from the escrow and payments business altogether.

Insurance-backed escrow investment solutions typically involve the engagement of a third-party payments and escrow administrator. While fees are typically charged for disbursements, third-party administrators may offer no-fee options, potentially making the insurance-backed solution the lowest-cost option.

Are new regulations affecting my existing escrow investments?

Yes. New banking regulations are being phased in currently and major financial institutions are responding by limiting new deposits, encouraging merger parties to consider investments in money market funds rather than bank deposits, lowering interest rates and charging higher fees. Because most escrow agreements allow banks to adjust pricing based on market or regulatory conditions, a bank could start to charge new fees during the escrow period or collect fees previously waived. While the new regulations affecting money market funds don’t come into effect until late 2016, parties need to be concerned about those rules now since many escrows being entered into currently will expire after such date. It is therefore important that the merger parties recognize the possibility of additional fees or mark-to-market risk in the merger and escrow agreements they sign today and specify which party will bear the risk of any such possible costs or losses.

To make an informed decision regarding the best investment option for your M&A escrow, consider whether any of the following could come into effect during the escrow period:

  • Risk of loss to principal or interest
  • Lack of liquidity when required
  • Additional fees charged
  • A need to change the investment
  • Cessation of certain services such as payments

This chart compares insurance-backed escrow investment solutions to traditional investment products distributed by escrow banks:

Insurance-Backed Escrow Investment Bank Money Market Demand Account Money Market Mutual Fund
Principal Protection Yes: Insured collateralized guarantee of return of principal Limited: General obligation of bank with FDIC insurance capped at $250K Uncertain: Moving to floating NAV with possible liquidity fees and not insured
Yields (relative to other options) Highly competitive Low and likely to go lower Highly competitive, but subject to mark to market risk.
Fees Typically escrow and payments fees, but often reduced or waivable based on the amount invested. Typically fees apply and likely to go higher Typically fees apply and likely to go higher
Liquidity on Demand Yes Yes, but limits in markets under stress Currently yes, but subject to limitations under new regulations
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