2021 was an excellent year for mergers and acquisitions (M&A) in Europe. According to Bloomberg, the value of all pending and completed deals amounted to €1.6 trillion. That is almost double the figure for a typical year and the highest figure since 2007. Citi predicted that 2022 will be an even better year, with a growth of another 15%. Morgan Stanley optimistically points to the financial readiness of parties who have over €800 billion at their disposal for potential deals and continue to raise money. On the other hand, in recent months the M&A market has taken a turn due to the war in Ukraine and further global supply chain issues. It is yet to be seen how this will evolve in the coming months and how resilient the market will remain. In any case, each transaction consists of a tailored negotiating schedule with specific issues that have to be dealt with.
One of the most heavily negotiated matters in acquisitions are the indemnification rules. While a seller agrees to a number of representations and warranties, these cannot be relied on indefinitely. They may be time-barred, or made subject to caps, de-minimis clauses or baskets. Apart from this, certain specific indemnities may be agreed on which form an exemption to these rules. And then we are not yet talking about any general or specific disclosures of certain information which may impact the representations and warranties. Depending on each party's bargaining power and the nature of the transaction, these clauses may either favour the buyer or the seller.
As these clauses are essential to determine the risk between the parties and may have large financial consequences, negotiations about this scope and duration are often difficult. To facilitate them, parties may seek alternative solutions. One of them is to choose to enter into a warranty and indemnity insurance (W&I insurance). Such insurance covers the seller's liability in the event of a breach of its representations and warranties under the share purchase agreement (SPA), and even in some cases in the event of a specific indemnities.
Adoption in Belgium
It is clear that W&I insurance is still a novelty on the Belgian M&A market, albeit growing strongly. While in 2012-2016 the use of such insurance was only noted in 3% of all Belgian transactions, this rose to 8% in 2016-2020 (M&A Survey – Fifth Edition).
However, in 27% of all Belgian transactions with a value over 100 million euros such insurance is already adopted. It is clear that such result is achieved due to the involvement of larger and more sophisticated foreign investors and PEs in large transactions. Indeed, in 27% of all transactions involving a PE/VC firm such insurance may be found. In contrast, only 1% of small transactions (i.e., a deal value up to 10 million euros) adopt a W&I insurance, as the cost thereof may be too high. Where sellers are in a strong position (e.g. competitive auctions), the use of W&I insurance is more likely.
Interestingly in 86% of all cases the insurance is entered into by the buyer. This may also indicated that usually a buyer's policy is entered into, whereby the seller is not a party to the insurance agreement and the buyer can directly turn to the insurer to be held harmless. By contrast, in a seller's policy the buyer is not a party to the insurance agreement and can thus only issue claims based on the SPA, whereby the seller can then seek coverage from the insurer.
Almost all of these policies relate to the liability arising in respect of the representations and warranties (94%). The tax indemnity is covered in 34% of all transactions. There is still not enough data to verify to which extent (other) specific indemnities may be covered.
It is likely that W&I insurance will become more prevalent in Belgian deals as this solution becomes more and more known, resulting in the need to recalibrate the view on market norms and the balance of risk between buyer and seller.
A seller's market
The statistics show that there has been a noticeable increase in the use of W&I insurance on the Belgian M&A market in recent years. While the use of W&I insurance is already more customary in large deals, the uptick in its use in the mid-market segment is a more recent phenomenon. While the product has already proven its use in neighbouring countries, especially in the UK and the Nordics, parties on the Belgian market are just starting to truly grasp the advantages of W&I insurance. It not only offers a clean(er) exit for sellers but the insurance also improves the relationship between the buyer and seller in case of continued involvement of the seller after closing the deal. Fraught negotiations on the warranties and security mechanisms under the SPA can be bypassed, which are characterised by diverging views on duration and caps, freeing up time to focus on other discussions. This also benefits the seller in achieving more seller-friendly terms.
Sellers are especially able to impose their own favourable terms in the case of competitive auction processes, where multiple prospective buyers are allowed to bid for the target company. Sellers have the power to go as far as to impose W&I insurance alongside a € 1 cap, allowing them to walk away from the deal with hardly any remaining liabilities. Furthermore, the organization of a competitive auction may considerably aid the seller in avoiding a partial deferral of the payment of the purchase price or, if a deferred payment or the use of an escrow is agreed, in limiting the deferral amount (allowing the seller therefore the receive a larger percentage of the purchase price upon closing). The organization of an auction increases the likelihood that the amount of the deferred payments can be limited to 10% or less of the total purchase price. This is especially important to PE/VC firms seeking a fast and clean exit to be able to fully reinvest their aggregated gains.
A sweetened bid
While W&I insurance does show benefits for both parties, it is not always the most attractive option for buyers. A high de minimis, a high insurance premium and deductible, or gaps in the coverage can effectively result in many costs. A buyer requiring to keep a certain level of recourse against the seller up to the deductible or in respect of those warranties which are not covered by the policy may lose its competitive edge in a sales process or competitive auction. W&I insurance may therefore be seen as a way for buyers to differentiate themselves from other bidders and court sellers.
Why would a buyer agree to such terms? First of all, because W&I insurance gives it recourse against a surely solvable insurance company, easing the ability to claim collection. Some sellers may even be lenient to accept a lower purchase price when an insurance is available to the buyer. It may thus provide a competitive advantage for the buyer compared to other buyers. Apart from facilitating a deal, an insurance may also be useful to secure a relationship between the parties if the seller will continue to work for the target after closing.
Negotiations will be conducted with the insurer in order to align the terms and conditions of the SPA with its own policy, for instance on the duration of coverage (mostly two years) or excluding conflicting issues. Insurers who have become comfortable in the practice of W&I insurance accept the non-recourse aspect of the SPA. This was not always the case but experience has shown that there is no noticeable difference between a clean walkaway and those sellers who have retained post-closing liability to some extent.
However, it should be noted that not all warranty claims under the SPA are covered by the policy. The seller could remain liable for W&I aspects excluded from the insurer's policy such as a known issues or a warranty out of the scope of due diligence. Consequently, it is quintessential to seek legal advice from the beginning of negotiations between buyer, seller and insurer, in order to categorise claims accordingly.
The cost of the insurance will of course depend on the circumstances of the transaction. However, it is still relatively low in Belgium compared to other jurisdictions, and not so different from the UK, with averaging pricing at 1.15% of the policy limit.
A clean(er) exit and bypassing fraught negotiations whilst improving the relationship between the parties are not the only attractive benefits of the W&I insurance. Sellers want to avoid traditional mechanisms of escrow on warranty guarantees since this flattens the growth curve of the business. The W&I insurance mechanism bypasses the need block part of the purchase price as a security for potential liability claims. Escrows may of course still be appropriate where the seller retains significant liability under an SPA, for example up to the amount of the W&I insurance policy retention or in respect of known risks or other items not covered under the policy.
Other usual exclusions include known risks identified during the due diligence process, consequential losses, anti-bribery and corruption, environmental pollution, contractor employment status, certain tax liabilities, cyber risks and data protection risks of the target. Hence, in certain sectors many important risks will (in addition to a possible insurance) still have to be covered through traditional means. For instance, in the tech sector the increased risks of sham self-employment and cyber risks may have to be covered through specific indemnities that are not covered by an insurance.
The limitations of the insurance policy will be aligned with those in the SPA (including time limitations, baskets, deductibles, caps and/or de minimis thresholds.
As claim payments become more common in the W&I insurance market, clients on the buy side increasingly want to know which insurers have a good reputation for paying claims. From the start of the transaction, the buyer should consult the insurance market thoroughly to seek for insurers who offer the best coverage in light of the transaction's specifics. The most desirable insurers can be selected by the buyer and given access to the transaction documents. They may then opt to submit a non-binding indication of interest stating the insurance conditions under which they are willing to provide coverage. Upon selection, the insurer will gain access to all documents, will review the due diligence report, may request additional information and will then, based on all findings, negotiate on the risk coverage, the exclusions and the insurance premium. Hence, buyers do still maintain a certain degree of power to choose the right insurer, especially in the case of a buyer's policy.
Repeat users of W&I insurance have started pre-negotiating template policy terms with their preferred brokers and insurance markets, setting new market norms in the process. Certain insurers may also develop specialisms in certain types of transactions, thereby enabling a more tailored approach for clients.
It is also important to link the due diligence with the W&I discussions early in a transaction, as this helps to meet the expectations of the parties and can optimise the W&I cover. Insurers will after all require that the party insured and its advisors conduct a comprehensive due diligence to confirm the accuracy of the SPA's representations and warranties. The seller may also have to go through a thorough disclosure exercise in addition to prior disclosures in the data room. If the process is aligned with the insurer from the very beginning, the buyer can avoid future costs to meet the insurer's expectations.
As the market continues to be seller's friendly, the use of W&I insurance is likely to increasingly be adopted in Belgian deals. A general awareness of the existence of this alternative will also boost its use. After all, where difficulties in negotiations appear alternatives have to found be to close the deal which of course always remains the ultimate goal of all parties involved.
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.