The use of insurance in M&A transactions is gaining popularity among deal professionals who are finding this tool increasingly useful to bridge the gap on one of the most fundamental deal issues in any M&A transaction: the potential post-closing erosion of value (either of the consideration received by the seller or the business acquired by the buyer). This article discusses a few of the popular types of transaction insurance available to private equity and strategic buyers and sellers to help get deals done.
Overview
The issue of post-closing erosion of value (i.e., reconciling the seller's desire to protect its sale price and exit cleanly from its investment vs. the buyer's desire to be made whole if the asset it purchases is not what was bargained for), and how buyers and sellers choose to deal with it, manifests itself in various ways throughout the M&A process. As principals and deal professionals know all too well, post-closing contingencies and credit support mechanisms with respect thereto are significant factors that can impact overall purchase price, distinguish a particular bidder in a hotly contested auction, and even be among the final negotiated business points that can make or break a deal. Today, insurance companies provide a variety of insurance options to assist deal professionals and principals in solving for this issue in a transaction. The costs of obtaining these insurance policies depend on various factors, including the scope of items covered, the survival period, and the amount of the deductible and cap. Generally, however, the typical premium for obtaining a representation and warranty insurance policy is between 2–3.5% of the liability cap under the policy. The costs for other types of insurance policies vary on a case-by-case basis.
Some of the main types of transactional insurance policies available are the following, each of which is discussed in greater detail below:
- Representations and Warranties ("R&W") Insurance;
- Tax Indemnity Insurance; and
- Contingent Liability Insurance.
R&W Insurance
The most common type of transaction insurance is R&W insurance, which can be obtained by either the buyer or seller. For a seller, a seller-side policy is typically used to backstop the seller's indemnification liabilities. By shifting the potential liability to the insurer at a fixed cost to the seller, the seller can ring-fence its exposure to ensure that the price it receives for its asset will not be eroded by post-closing claims for indemnification. In addition, a seller can often use insurance to better market its asset in a sale by either (i) providing greater indemnification coverage to the buyer than the seller would otherwise be willing or able to give (and backstopping the seller's indemnification exposure with a seller-side policy) or (ii) procuring a buyer-side policy (at seller's cost) directly for the buyer's benefit that provides for such added indemnification coverage.
Under a buyer-side policy, the insurance company pays the buyer directly for losses arising out of a breach of a representation or warranty. The policy can be used by the buyer as its sole source of recourse or can be used to supplement the seller's indemnification by providing coverage beyond the survival period and/or cap under the purchase agreement. In addition, a buyer can use an R&W insurance policy to distinguish its bid in a competitive sale process by reducing or even eliminating completely the need for a seller indemnity.
R&W insurance can also afford a buyer coverage in circumstances where indemnification traditionally has either been unavailable or impractical: for example, a buyer of assets out of bankruptcy; a buyer purchasing an asset from a private equity seller that is looking to wind down its fund or that is restricted under its fund documents from having ongoing indemnification liabilities; a buyer of assets from a distressed seller or from a seller group comprised of a large number of stakeholders; or a buyer of a public company in a going-private transaction.
Set forth below are some of the issues a deal professional who is interested in utilizing R&W insurance should consider when going through the process of obtaining and negotiating the terms of an R&W insurance policy.
Non-covered Items. Buyers and sellers should be aware that, for all of their benefits, R&W insurance policies do have certain limitations. For example, in addition to claims for injunctive, equitable or non-monetary relief, an R&W insurance policy will typically not cover claims with respect to:
- Purchase price adjustments;
- Losses arising out of breaches of covenants;
- Losses arising out of known issues, or issues stated on disclosure schedules; or
- Losses that fall within a deductible threshold (insurance deductibles are typically 1–2% of the transaction value).2
Description of Indemnifiable Losses. The insured should make sure that the indemnifiable losses under the insurance policy match the scope of the expected indemnification. This is particularly true if the seller is the insured, since any discrepancy between the seller's indemnification liability and the insurance coverage will result in dollar-for-dollar exposure to the seller. Particular drafting points to consider in this context are whether the insurance policy and/ or seller's indemnification obligations cover losses arising out of a diminution in value or based on pricing or earnings multiples, or consequential, special, indirect, etc. damages; scrape materiality on a consistent basis; and take into account the same types of indemnification adjustments for taxes, insurance proceeds, etc.
Timing. Obtaining insurance is a process that takes time, so parties need to plan ahead. Parties interested in using insurance policies for their deals should get the broker and the insurer involved as soon as possible in the process. Typically, after engaging a broker and entering into non-disclosure agreements, the broker, on behalf of the applicable insured, will submit certain materials (such as the business description of the target (information memo, if available), the most recent draft of the purchase agreement and schedules and the most recent financial statements of the target) to different insurers to obtain their pricing and coverage quotes, which usually are received within 3–4 days. Once an insurer is selected, the insurer will begin its 7–10 business day underwriting process, during which time the selected insurer will conduct its due diligence (which will typically cost approximately $10,000–$25,000, paid upfront). The due diligence investigation will entail the insurer obtaining access to the data room, reviewing transaction materials and conducting diligence calls. During this process, the policy terms will be negotiated with the applicant and its counsel.
Tax Indemnity Insurance
Another type of insurance product that is available is tax indemnity insurance, which is often designed to protect against losses arising from a historical tax position taken by the target. Even if the likelihood of liabilities arising from a particular tax position is remote, parties frequently have difficulty allocating between themselves exposure to such risk because such liabilities could have significant adverse consequences to the business. A tax indemnity policy helps bridge this gap by shifting the risk of loss to the insurer.
Tax indemnity insurance is sometimes also used to protect against losses if a transaction fails to qualify for an intended tax treatment. These policies can minimize or even eliminate liabilities that may arise from a successful challenge to the intended tax treatment of a transaction. In many deals, the tax treatment of the transaction is critical to structuring the deal and deciding whether to go forward, and in the event that a tax opinion or tax ruling is unavailable, a tax indemnity policy may give the deal participants the necessary comfort to proceed.
Contingent Liability Insurance
As previously noted, R&W insurance typically does not cover known exposures or identified contingent liabilities. Identified risks, however, are often the subject of a specific indemnity under purchase agreements, and in many cases present some of the most difficult issues for buyers and sellers to resolve. In response to these issues, many insurers now provide contingent liability insurance that may cover some or all of the exposure to those types of liabilities, subject to agreed-upon deductibles and limitations under the policy. The costs of these policies vary on a case-by-case basis due to the highly fact-specific nature of the risks being insured. Generally, the policies will be available if the risk is quantifiable, and the probability of the risk can be analyzed.
Conclusion
Private equity and strategic buyers and sellers should be aware of all of the tools available to them in the current highly competitive deal market. Transaction insurance is one such tool that, if carefully crafted and strategically used, may just provide the competitive edge that deal professionals are looking for to get deals done. Deal professionals should discuss the possibility of using insurance in their deals with their legal and financial advisors, and insurance brokers, early on in the process to determine whether insurance is right for them in the context of their deal.
Footnotes
1. Craig Schioppo, Esquire, a Managing Director with Marsh USA, Inc.'s Private Equity and M&A Services Group, contributed to this article.
2. Note that the size of the deductible is often the most important element in the cost of an R&W insurance policy.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
