Anyone who has participated in the acquisition or sale of a company will recognize the typical path of a deal: from flirting to tough questions to hard bargaining to—finally—handshake. Inevitably, however, the road detours, from the exhilaration of accord to the anxiety of suspicion. The buyer wants assurance that all the seller’s promises are true and that there are not going to be any nasty surprises once the acquisition is consummated.
Traditionally, the seller’s representations and warranties, as these promises are called, are backed up by an indemnity agreement that calls for a portion of the purchase price to be held in escrow for a set time. These funds are intended to cover the costs incurred by the buyer from any breaches of the seller’s representations—that customer contracts are iron-clad, that loss reserves are adequate, that employment laws have been complied with, that all liabilities have been disclosed, and so on.
Needless to say, sellers are often less than enthusiastic about waiting months or years to get their money released from escrow and the possibility of a future fight over whether the representations were breached.
Enter representation and warranty (R&W) insurance—coverage that covers some of a buyer’s loss in the event of a breach of representation and warranty made by the seller. These policies can smooth over the rough spots that get in the way of completing acquisition deals, giving sellers certainty of deal proceeds while protecting the buyer from losses due to unexpected breaches of representations.
Crystal & Company has observed the rapid adoption of R&W insurance in acquisitions of mid-sized companies and increasingly lower-middle market firms as well. Whether you are an entrepreneur thinking about selling your company or a private equity fund focused on the middle market or lower middle market, there are questions that need answering before you can know if this option is the best one—and, even if it is, how to properly structure such a policy.
How much does the policy cost, how much does it cover and for how long?
As the volume of R&W insurance increases, carriers are trying to standardize policy language. But this coverage is customized for each deal, and many of the terms are negotiable. The most common approach is to secure a policy that provides protection up to 10% or 15% of the deal’s enterprise value (typically the combination of the equity and debt of the company). In the U.S., the premiums are typically 3% to 4% of the policy limit, substantially lower than they were a few years ago. A common term is three-to-six years for breaches of nonfundamental representations--basic claims like the accuracy of financial statements and customer contracts. The limit is usually six years for breaches of fundamental representations--core issues such as whether the seller actually owns the company being acquired and that its tax returns weren’t fraudulent.
Which party pays for the premium and covers the deductible in case of a claim?
In general, these details wind up as part of the broader negotiation of the terms of the acquisition agreement. Either the buyer or seller can offer to sweeten the deal by paying for the R&W coverage.
Typically, there is a retention (similar to a deductible) that calls for the buyer to absorb the first losses related to the policy. Sometimes there is a second retention that calls for the seller to cover some of the losses as well. For example, the buyer might be responsible for the first losses up to a limit of 0.5% of the deal’s enterprise value and then the seller would cover losses of the same amount, leaving the insurance company paying claims above 1% of enterprise value up to the policy limit.
Imposing a retention on the seller might seem to be inconsistent with a transaction specifically meant to mitigate the seller’s contingent liabilities. Still, both buyers and insurance companies worry about the moral hazard of an arrangement in which sellers have little incentive to ensure their representations and warranties are accurate. This often means that the insurance is combined with a traditional escrow arrangement, albeit a smaller one than would otherwise be needed.
Indeed, if the seller has no “skin in the game,” many insurance companies will insist that the buyer has a retention of at least 1.5% of the deal’s enterprise value.
What risks does the underwriter exclude?
Now that underwriters have experience with the sort of claims that are made under R&W coverage, they are adjusting policies to avoid trouble spots, such as environmental liabilities or certain regulatory actions.
While there have been relatively few claims so far against R&W policies, those that have been made eventually turn on the exact definitions of what misrepresentations are covered. Nonetheless, acquiring companies must understand these provisions and negotiate details with carriers that ensure language fits circumstances.
Of course, traditional deals often bog down as well in fights over a buyer’s claim to the seller’s money held in escrow. Ultimately, buyers may prefer to deal with an insurance company rather than the seller in the unfortunate event of a dispute. This can head off an awkward situation if a major shareholder of the acquired company is to remain in an executive position after the purchase.
What due diligence does the underwriter expect the buyer to perform?
Using R&W insurance doesn’t relieve a buyer of having to investigate its acquisition target. The insurance company won’t conduct its own due diligence. Rather, it will verify that the buyer is following best practices and will want to understand issues identified. So any company making an acquisition that involves R&W insurance must be clear on the due diligence expected of them by the insurance carrier. In fact, as part of the underwriting process, the buyer will allow the carrier to audit its investigation, providing access to the documents collected in the due diligence process, third-party advisor reports, internal findings, and other documents.
What is the timetable for underwriting and issuing the policy?
While the process of underwriting an R&W insurance policy usually does not delay a transaction, it creates some additional milestones for a deal’s closing. It’s essential to start shopping for R&W insurance early in the process and to ensure the selected carrier understands the proposed timetable. As dealmakers get used to the unique rhythms and requirements of R&W insurance, they will find it can be part of a smooth process and diffuse the anxiety of closing a transaction.
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