Negotiation over representations and warranties (R&W) and related indemnification provisions has always been particularly burdensome in M&A transactions, since buyers and sellers have naturally opposite incentives. Sellers typically negotiate for representations and warranties that are very limited in scope and for indemnities that are targeted to specific risks. In contrast, buyers seek comprehensive representations and warranties and a very broad indemnity package to protect against the risk of losses that may arise post-closing. Insurance coverage provides a way to reallocate the risk associated with breaches of R&W and partially align buyers’ and sellers’ interests in M&A transactions.
In today’s rapidly changing global marketplace, R&W insurance can offer both buyers and sellers in mergers and acquisitions the additional confidence often needed to close the deal. Such insurance may be especially useful in global M&A transactions, particularly in Latin America.
1. How has R&W insurance evolved in recent years?
R&W insurance has been available since the ’90s, but in the early years its use was fairly limited, due such factors as high cost of the policies, an unrealistically long underwriting process (which could take several weeks to complete) and unattractive policy terms (where liability limits were excessively low, policy periods were sometimes even shorter than indemnity survival periods and policy exclusions were very broad). Over the years, the cost of obtaining R&W insurance has fallen, and at the same time the underwriting process has improved. More insurers have entered (and are entering) the market as well. The competitive environment and maturation of the product has resulted in the availability of better terms and conditions (with higher limits and policy periods of up to six years), all contributing to a tremendous growth in this type of insurance. The number of transactional insurance policies issued in 2015 was approximately twice that from the prior year, with many new users of the product; this high growth is expected to continue.
Today, R&W insurance is being offered by a wide variety of carriers that include most global insurance companies, and covers either the buyer against the seller’s breaches of R&W or, alternatively, the seller against losses recovered from it by the buyer resulting from such breaches (third-party or seller-side coverage). First-party or “buyer-side” coverage represents approximately 80 percent to 90 percent of the total number of policies issued today; in 2008 and during the financial crisis, seller-side policies dominated the small market. The main difference between buy-side and sell-side policies is that buy-side will cover breaches due to seller fraud, whereas sell-side policies generally will not.
2. What are the main advantages of R&W insurance?
R&W insurance may benefit both sellers and buyers primarily by contributing to the successful closing of the underlying acquisitions. In addition, for deals providing for continued business relationships between sellers and buyers (e.g., where they become business partners post-closing or where sellers are retained to manage the acquired business immediately following the closing), R&W insurance may be a tool to preserve and enhance these relationships.
Seller-specific benefits include (i) reducing the risk of exposure for breaches of representations and warranties post-closing; (ii) negotiating lower deductibles and caps and shorter survival periods; (iii) permitting cleaner exits from a business, not subject to sizeable escrows, holdbacks or similar mechanisms, and permitting the distribution of a larger portion of the sale proceeds at closing; (iv) facilitating auction processes by insisting that buyers rely primarily (or sometimes entirely) on R&W insurance; (v) attracting buyers with significant R&W insurance experience that would not consider certain types of transactions otherwise; (vi) protecting passive investors that are selling their stakes in a business; and (vii) expediting the sale process and sometimes increasing the purchase price obtained.
Buyer-specific benefits include (i) supplementing or sometimes substantially replacing the indemnification provisions provided in the purchase agreement; (ii) extending the survival of certain representation and warranties from one to two years to up to six years, which allows considerably more time to detect and effectively recover for post-closing losses; (iii) distinguishing bids in a competitive auction process by providing sellers with more of the purchase price at closing and requesting a substantially more limited indemnification package from sellers − in the past few years, in an increasing number of auction processes by private equity companies, it has become a prerequisite that bidders include R&W insurance in their bids; (iv) easing collection concerns such as from funds that may distribute assets, in distressed acquisitions, from numerous sellers who can be costly to pursue, and individuals against whom collection may be difficult; and (v) reducing the risks relating to cross-border transactions, where the ability to enforce sellers’ obligation may be uncertain due to legal restrictions or the complications related to international legal proceedings.
3. What are R&W insurance’s common terms and exclusions?
In most cases, R&W insurance policies cover all of the target company/seller’s representations and warranties as they are drafted in an acquisition agreement. However, some policies may only cover certain representations and warranties or may be drafted not to completely mirror the terms of the representations and warranties.
The coverage limit is often equal to the indemnification cap in seller-side policies, while in buyer-side policies a 10 percent of purchase price limit is common. Policy premiums are deal specific and may vary among different transactions and depending on the type of industries involved; however, the premium amount typically range between 2 percent and 4 percent of the coverage amount with buyer-side policies typically being slightly more expensive than seller-side policies. Policies purchased with a United States insurer are generally a bit more expensive but generally also have better terms. Most insurers will require a “retention” (similar to a deductible), which typically ranges between 1 percent to 2 percent of the transaction value. There is an increasing use of zero-escrow and public-style deals that are buy-side insurable, though with no seller skin in the game the pricing and buyer retention are harder than with a typical placement.
The policy period usually begins at the closing of the transaction, though buy-side policies usually offer the option of cover for signing breaches that are discovered before closing. Buyer-side policies can be negotiated to survive past the expiration of the representations and warranties of the sellers in the acquisition agreement (such as, typically, six years for fundamental and tax), while seller-side policies typically have terms mirroring the survival period of the representations and warranties in the acquisition agreement.
Both in seller-side and buyer-side policies, the premium is normally paid in full at the closing of the transaction. Determining who pays the premium (i.e., buyer, seller or a combination or both) is a business issue to be negotiated among buyers and sellers.
Not all types of losses are covered by R&W insurance policies. Common exclusions include losses resulting from (i) issues related to price adjustments, working capital adjustments and their calculation; (ii) breaches of covenants; (iii) disclosed or diligenced matters of a risk level that is deemed uninsurable; (iv) forward-looking statements, including failure by the target company to meet certain financial projections; (v) matters actually known by the insured’s deal team including matters disclosed in diligence (vi) intentional and criminal acts and fraud by the insured; and (vii) in some cases, punitive or multiple damages, or equitable relief. In addition, certain risks may not be covered and may require alternative tools to protect against them. Common exclusions include (i) environmental issues; (ii) issues related to the outcome of pending or threatened litigation; (iii) product liability claims; (iv) Foreign Corrupt Practice Act (FCPA) violations; and (v) tax liabilities that a buyer or seller may incur related to the tax treatment of a transaction itself, an issue which is increasingly being addressed through the acquisition of a separate tax liability insurance policy.
4. How does the insurer selection and underwriting process work?
In the majority of transactions, the insured party, independently or through the assistance of deal counsel, will engage an insurance broker that will assist identifying the best insurer. Most often this process occurs through a formal auction process.
Once a pool of insurance companies have been contacted by the insurance broker selected, they each conduct a very high-level review of the transaction (including a review of the purchase agreement, financial statements and information memorandum) and present price range and proposed quotes to the insurance broker. At this point, the insurance broker prepares a summary of the quotes (including policy terms, exclusions and other limits, and premiums) for the insured party’s selection. For this service the insurance broker charges a fee payable if a policy is purchased, typically equal to a percentage of the insurance limit purchased (between 0.5 percent and 1 percent) or a percentage of the premium (typically 15 percent). The broker’s fee usually is part of the quoted premium, and the broker receives its compensation from the insurer with whom the policy is ultimately placed.
During the underwriting process, the insurer will conduct a review of the transaction to assess whether the process has involved sufficient negotiation among the parties, due diligence by the buyer and its counsel and disclosure by the seller and its advisors. The insurer’s review requests include a copy of the purchase agreement, the legal and financial due diligence memoranda, any ancillary transaction’s agreement and financial statements, as well as a list of follow-up diligence questions, which is typically submitted after an initial review of these materials. The insurers will often charge an underwriting fee for these services, typically ranging between $25,000 and $50,000, depending on the complexities involved.
Upon completion of the insurer’s due diligence review, the parties, assisted by legal counsel, proceed to negotiate the insurance policy. Insurance policies typically become effective upon the closing of the transaction. The entire process typically takes about two weeks to complete, though policies have been underwritten and placed in as little as three business days in exceptional circumstances.
5. What are the main issues to consider when negotiating deal documents?
With the exception of certain auctions by private equity companies (which may require insurance as a prerequisite to the transaction), the necessity of insurance maybe determined at any point in a transaction, from the initial offer to late-stage sticking points in negotiation. For example, a buyer may insist on an IP rep capped at purchase price, which could lead the seller to purchase a sell-side policy to cover that exposure and allow it to distribute funds . The R&W insurance option is often introduced by financial advisors or legal counsel on the deal.
In any case (including when insurance is required since the beginning in private equity deals), the key consideration to keep in mind is that the insurer’s due diligence will monitor closely the dynamics of each transaction to determine that the seller and buyer treated the transaction in a market reasonable manner, including the reps given and the diligence conducted.
6. Which types of deals is R&W insurance most suitable for?
R&W insurance is a product used for the most part in private, middle market M&A transactions, which can largely be defined as transactions with values ranging between $20 million and $2 billion. Transactional insurance program limits can typically easily be placed in the hundreds of millions of dollars by use of multiple insurers; 2016 will likely see higher program limits at least for tax risks.
7. How can R&W insurance be effective in cross-border transactions?
2015 was a remarkable year for global M&A activity, with deal volumes and valuations surpassing pre-crisis highs. According to Dealogic M&A Analytics, by year end, $4.7 trillion of global deals were signed, topping 2007’s previous record high for deal value.
Cross-border deals are definitely benefitting from the availability of R&W insurance. The insurance market is becoming more mature and insurers are gaining global experience, in the process becoming more sophisticated and beginning to offer global insurance policies that are very attractive in cross-border transactions involving a variety of jurisdictions.
Acquirers may lack knowledge of new geographies in which they will be operating post-closing; and cross-border transactions in today’s world also entail certain cultural, jurisdictional, legal and political risks. Given those factors, the availability of R&W insurance becomes an extremely valuable tool in seeking to successfully close M&A deals.
8. What about the use of R&W insurance in deals involving Latin American countries?
Given the current economic and political environment, the use of R&W insurance will, in all likelihood, continue to grow exponentially in Latin America during 2016.
By way of background, between 2010 and 2014, the growth in cross-border M&A activity involving at least one Latin American company as buyer, seller or target has soared, by many measures outpacing the growth of the rest of the world. Latin America has experienced and is still experiencing M&A deals focusing primarily on the energy, telecommunications and banking sectors. While lower commodities prices, an economic deceleration in major trading partners (including mainly China) and persistent political challenges among some of Latin America’s largest economies have significantly slowed M&A activity in 2015, other political and economic factors will create attractive transaction opportunities that will likely be available in 2016 and beyond.
Latin America is starting 2016 facing fundamental political changes in countries such as Argentina and Venezuela. The new Argentine presidency is moving forward with great speed to implement reforms, which, in turn, are fueling expectations of an equally fast economic turnaround. In Venezuela, the newly elected National Assembly took office on January 5, 2016, securing a two-thirds majority, which will hopefully enable a push for sweeping reforms and at the least will reignite some confidence in the Venezuelan corporate world.
Countries such as Mexico and Colombia, which have continued growing into more sophisticated markets, are benefitting from still healthy private consumption and strong growth in exports of their goods and services. Conversely, Brazil’s outlook for the next few years is bleak, and the economy is unlikely to rebound without significant reforms. However, during this transitional downturn period, the opportunity may arise in Brazil to acquire a number of interesting distressed assets − for example, in the oil and gas sectors, which have been strongly affected by low oil prices.
There is no doubt that, especially for US buyers interested in buying assets in Latin American countries, R&W insurance can provide the additional deal security that, due to economic, jurisdictional or political considerations, buyers increasingly are and should be seeking. While data and statistical evidence relating to the use of this product in M&A transactions involving Latin American geographies is not readily available, we have certainly seen its use grow exponentially and, as a matter of practice, recommend it to our clients in a large number of transactions.
Finally, it should be noted that, especially in the past few years, a significant number of insurance companies have started offering a somehow similar but separate insurance product specifically tailored to protect against political risks, which can be an important consideration for companies investing in emerging markets (e.g., Venezuela). Such policies typically may provide coverage for such risks as expropriation, forced divestitures and abandonment or deprivation. Needless to say, political risk insurance can also be extremely beneficial to M&A transactions, as it provides corporate shareholders and management with sufficient comfort that unforeseen risks in emerging country operations will be contained post-closing.