United States: Deal Points Study: Representations And Warranties Insurance Continues Its Significant Influence On M&A Deal Terms

Every few years, we conduct a survey of current private M&A deal terms. Since our previous Deal Points Study was conducted in 2015, we have reviewed an additional 93 private acquisition agreements for our new survey for transactions from January 2016 to September 2018 and compared them to the terms reflected in the 139 agreements reviewed for the 2017 ABA Private Targets Mergers & Acquisitions Deal Points Study.

The acquisition agreements for most private target deals are not generally publicly available. The ABA study exclusively reviews publicly available private target agreements, which most often relate to transactions in which public companies have acquired large private targets. In contrast, the great majority of the deals that we have reviewed were middle market transactions (so most typically these deals reflected target company enterprise values ranging from $50 million to $500 million).

The headline from both surveys is that acquisition agreements continue to reflect increasingly seller-friendly terms, attributable to the strong competition among buyers with significant capital to deploy and a more limited number of targets available to purchase. We will discuss these areas of commonality in both surveys in more detail below.

One of the key differences, however, that we observed between our study and the ABA's was the greater use of buyer-side representations and warranties (R&W) insurance policies in the transactions we reviewed. Our data showed that most agreements (65%) included the use of R&W insurance policies, compared to just 29% of the agreements in the ABA study, as our survey reflected proportionately more private equity buyers (which have now almost universally accepted the use of the R&W insurance policies, especially in auctions) compared to the ABA survey, in which the buyers are most typically strategic buyers (which have increased their use of R&W insurance policies, but continue to use the product significantly less often than private equity buyers). 

We have also found that the increased use of these policies is impacting key terms — even in deals in which R&W insurance is not used (as buyers are increasingly comfortable adopting certain terms across more of their deals overall). For example:

  • Materiality scrapes: In our new survey, 61% of deals had a double materiality scrape for the indemnity (i.e., materiality/MAE is disregarded both for determining whether a breach occurred and for calculating losses), compared to 52% in our prior 2015 survey and 48% in the ABA survey.
  • Deductibles: Indemnity deductibles are increasingly replacing "tipping baskets" (where, if losses exceed a set amount, the insured recovers from first dollar). The insured is now more likely to agree to provisions where they recover for losses only in excess of the deductible (which works well in combination with the "retention" mechanism in a policy). In combination with the increased use of materiality scrapes, the deductible acts as a functional proxy for the materiality that is deemed to be read-out. In our new survey, 75% of deals used a deductible, compared to 59% in our prior 2015 survey and 70% in the ABA survey. 

The time window to assert claims is another key difference highlighted in our study, with a pronounced overall movement to shorter survival periods with respect to any seller responsibility for breaches of non-fundamental representations. Very significantly, we have also observed an increase in the number of no-survival (i.e., public-style) transactions, even in transactions (normally involving a competitive auction sale process) in the lower middle market, which we previously would very rarely encounter. In our new survey, in 19% of deals the representations did not survive, compared to 13% in our prior 2015 survey and 7% in the ABA survey. We have broken down the data as follows:

Indemnification caps are also trending significantly lower, principally due to the increased use of R&W insurance by buyers. In our new survey, 79% of deals had a general indemnity cap of 10% or less of the transaction value, compared to 61% in our prior 2015 survey and 74% in the ABA survey. In R&W insurance policy deals, our data showed that caps were usually at about 0.5% of the transaction value (when calculating both the mean and the median), whereas the ABA data found a mean cap value of 5.77% and a median of 1%. In non-policy deals, our new survey data showed that caps were usually at about 10% of the transaction value (for both the mean and the median calculations), whereas the ABA data found a mean cap value of almost 15% and a median of 10%. These non-policy higher cap numbers presumably reflect a combination of the greater proportion of strategic buyers (which have traditionally required a higher cap than financial buyers) and buyers' greater relative negotiating leverage in less robust auctions (where a R&W policy was not required).

Increasingly we have observed that escrows and holdbacks (which most typically equal the cap amount) are the exclusive remedy, so that the buyer's recovery with respect to even fundamental representations and warranties is limited to the escrow/holdback. In our new survey, 41% of deals provided for this type of exclusive remedy to the escrow/holdback, compared to 36% in our prior 2015 survey.  

The overall pro-seller trends observed in the surveys reflect the continuing effects of increased competition for limited private acquisition targets for buyers in both the middle and larger-cap markets. R&W insurance has increasingly become a mainstay in private M&A transactions, and this product is continuing its significant influence on key deal terms.

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.

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