Over the last decade, as the M&A pendulum has swung from the public to the private markets, representation and warranties insurance (RWI) has emerged as an increasingly popular transaction risk management tool. By deploying RWI in an M&A deal, the buyer can be protected against losses arising from a seller’s breach of representations in the acquisition agreement. According to a study by GF Data, RWI was reported on 42% of all transactions in 2017, up from 7.7% in 2016.
The status quo for managing transaction risk has involved requiring escrow from the seller. But that can be an inconvenient and inefficient use of resources. RWI policies transfer to the insurance provider most of the risk of loss arising from breaches of the agreement. Fundamentally, RWI can offer effective protection against financial losses, including legal defense costs for breaches of the seller’s representations and warranties made in the purchase agreement—even if those infractions were unintentional.
RWI can even increase the value of the deal overall: According to the GF Data study, in 2017, transactions utilizing RWI were valued at 0.6 times more than those without.
In making RWI part of their M&A deal, sellers gain greater certainty over sales proceeds, and buyers receive a number of strategic benefits.
Advantages for Buyer and Seller
In short, RWI helps each side of the transaction mitigate uncertainty as well as:
- enhance bargaining and bid positions;
- allow a cleaner exit for the seller;
- protect the ROI of the deal;
- shorten the negotiation process.
RWI can be an important differentiator for a buyer courting a reluctant or popular target. A policy offer can help distinguish the buyer’s bid in an auction process by making the bid more attractive economically. RWI can also be read by the market as a meaningful promise of efficient negotiations over the acquisition agreement, an important factor in a competitive process.
In some cases, a buyer discovers issues after purchase, such as underfunded pension plans, accounting mishaps, disputes over patents, or consumer lawsuits. These risks can’t always be discovered in due diligence or anticipated. And, it may not always be feasible or cost-effective to pursue the seller for damages. For example, if the company leadership responsible for the flawed presentations—whether intentional or unintentional—might currently be party of the newly-formed corporation. In that case, taking legal action may not be suitable.
Without RWI, 100% of representations and warranties liability typically falls to the seller. Buyers not wanting to face the potential hassle of finding and suing a seller will likely request an escrow amount to serve as a backstop against claims. The amount of escrow is typically around in the range of 5% to 20%, and the duration averages 12 - 24 months. For a $100 million sale, that means $9 million of the seller's money will be tied up for years in a cash account (as required by law) without the benefit of earning interest.
Using RWI can significantly reduce the amount of the purchase price that would otherwise be held in escrow. And premiums for RWI are typically around or below 3% of coverage limits with 1% of deal value retained (depending on risk factors specific to the deal). The rest of the seller’s precious capital can be deployed more efficiently. After the sale, those involved in the deal can move forward with business plans without the specter of breaches hanging over their head.
And using RWI to protect the seller from liability can also serve to speed up the process of closing the deal. That's because the seller can more easily agree to the representations and warranties the buyer asks, without the extensive “materiality” and “knowledge” qualifiers typically necessary for a resolution.
Rise of New Risk Management Tool
Whereas previously, obtaining RWI coverage was cost-prohibitive for most deals, now underwriters have developed the depth of knowledge and expertise to become more efficient in their diligence review process. This has allowed them to reduce policy processing time and costs. As more carriers enter, the insurance market has thereby become more robust and experienced.
Also, policy exclusions practices that were standard only a few years ago have been modified or abandoned. A report from a major transactional insurer suggests that along with the number of transactions, deal size and aggregational limits are increasing, too. Policy limits have gone up to $1 billion. But RWI isn’t just for large deals. Better pricing and lower minimum limits have made RWI a viable risk management option for transactions as low as $20 million.
Due Diligence Is Still Key
As some risks are transferred away from the transacting parties, counterparties unfamiliar with RWI might wonder about moral hazard. In reality, RWI typically will not cover issues disclosed to the buyer at the time the policy was issued, including (but not necessarily limited to) matters included in due diligence reports. Underwriters will want to therefore ascertain that standard due diligence has been performed.
Therefore, the ideal time for negotiating RWI is generally after the standard due diligence has been performed. However, when either the buyer or the seller are aware of potential claims from the start, RWI can be introduced when negotiating the letter of intent. The maturing insurance process now incentivizes the exchange of information, keeping a deal competitive while also effectively managing risk.
RWI can be structured to the benefit of—and without detriment to—either party. At the appropriate time, the buyer and seller can negotiate towards an agreement on key parameters:
- the scope of losses included and excluded from the RWI coverage
- the payer of the underwriting fee/insurance policy premium
- escrow amounts (typically a portion of the purchase price), if any, to mitigate the retention amount of the policy
For instance, sometimes the seller will pay for the RWI policy as a deal incentive and to demonstrate good faith towards full disclosure.
How Fallback Solutions Can Come Up Short
Of course, buyers and sellers have other options for transaction risk management in lieu of RWI. After both counterparties hash out terms for the indemnification, larger escrow remains as a potential mitigation choice. However, while the seller is carrying 100% of the representation and warranties risk, anticipating 100% of those potential risks isn't always possible. And even after the costs of paying legal experts to pore over company data, sellers can be haunted by the possibility that something important can come up years after the sale. And, escrow may still not be enough to cover the buyer's hassles, should any issue arise.
The other drawback to moving forward without RWI is the loss of another precious resource—time. Sometimes, the counterparties will haggle over for extended periods over the amount of escrow required. Yet, many deals can be under pressure to close in a timely manner. Buyers may need to close acquisition transactions before their post-IPO 18 or 24 month deadline.
Added competition from private equity, venture capital, and strategic buyers has resulted in a strong seller’s market, in which buyers grasp at any opportunity to differentiate themselves from the pack of eager suitors. Indeed, a well-designed RWI policy allows a buyer to offer the same purchase price, but with minimal or no seller indemnity and with minimal or no escrow.
A New Best Practice Standard
In addition to more attractive premiums and broadened coverage, increased RWI market participation has led to new deal standards. According to the GF Data survey, RWI remains prevalent with utilization at 65%. Data also point to an overall cap in indemnification in light of increased RWI usage.
RWI is now almost a market standard in auction processes and is likely to be offered and used by the rest of the competition. Excluding RWI from its offer effectively puts a buyer at a serious disadvantage. For buyers and other counterparties under a timeline crunch, spinning their wheels in a failed auction process can present serious consequences.
For PE and VC funds, RWI can bring added advantages in line with their missions. Sellers gain the potential to sell their portfolio at the best time to maximize returns. Buyers get the ability to distribute the purchase price proceeds to investors sooner rather than later.
Seeking Out Expertise
The availability of private funds ready for deployment and looking for investment opportunities has created a very competitive M&A environment over the last few years. As a strategic banking partner for numerous transactions, Fifth Third has developed the critical expertise needed to guide clients through the journey. We have come to understand how RWI reduces the calculus of liability down to a more manageable level for transaction parties. Buyer and sellers can expect to draw upon this knowledge when choosing the best RWI process for their needs.
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