Employee benefits related issues during an acquisition can cause major problems for a deal. Take for example a recent call I had with a private equity client. The client was a month away from closing an acquisition of a healthcare services firm. After thoroughly reviewing their target’s benefit plan, I had to tell them that the company they wanted to buy had violated key provisions of the Affordable Care Act and could be subject to penalties of well over half a million dollars. If they didn’t figure out what to do fast, it could scuttle a deal they had spent months putting together.
Employee Benefits aren’t just big and potentially volatile expense items. They’re heavily regulated and, as our client learned, subject to stiff penalties for noncompliance. Moreover, employee benefit-related problems can complicate the process of securing Representations and Warranty (R&W) Insurance, the financial innovation that often makes acquisitions of private companies faster and easier.
Forward-thinking private equity firms and other corporate acquirers have learned that they need more than lawyers and accountants to conduct due diligence on target companies. They need an employee benefits expert looking closely at a target’s health, welfare and retirement programs.
In the case of my client, the problem at the healthcare company wasn’t evident in a routine examination of its financial statements. The financial statements showed that the target didn’t offer benefits, and recorded $0 in benefits-related expenses on its books. But after we were hired to assist with the due diligence, our team looked closely at the company’s employment contracts and roster of workers. We found that it had been quietly reimbursing its top two executives for buying their own health insurance. Under the ACA, if a company pays for the coverage of any employees they’re required to do so on a non-discretionary basis, for all eligible workers.
Understandably, this triggered a torrent of questions from my clients. Here are a few of the questions they had that also serves as a guide for any potential acquirer:
“What is the risk?”
The liability for operating a non-compliant group health plan is $100/day/occurrence (each participant is 1 occurrence). Additionally, if they failed to distribute Summaries of Benefits and Coverage (SBCs) for this group health plan, it’d be an Employee Retirement Income Security Act violation subject to a $1,000 penalty per participant ($1,128 indexed for 2018).
“So how can we get this deal done right now?”
First, get the company to file with the IRS right away admitting the violation. Self-Reporting can mitigate the potential exposure, regardless of whether the seller retains, or the buyer inherits, this pre-close liability. The next step is to rework the acquisition agreement to specify whether buyer or seller will pay any penalty the government imposes, including the necessary indemnification and/or adjusting the purchase price accordingly.
“Will this screw up our R&W insurance?”
Probably not. R&W policies are meant to compensate the buyer in cases where the company turns out to have problems the seller didn’t disclose. Employee benefits are frequently an issue, for example, when the acquired company turns out to have an underfunded pension plan or some other undisclosed violation. That’s why many insurance companies are starting to exclude certain employee benefits from some R&W policies. (In this particular case, I assured the private equity firm that we could show the insurance company that we had done due diligence, initiated corrective action, and can get coverage for all employee benefits other than the ACA fine.)
“How do we avoid being in violation after we close the deal?”
This is always a tough question, because it would take more than a few weeks to establish a compliant group health insurance program. However, within a week, we presented a solution that is permissible by the IRS, and that offered reimbursement, up to a limit, for health policies purchased by all eligible employees. (These are called Qualified Small Employer Health Reimbursement Arrangements for companies with less than 50 employees.) While there would be some incremental expense, it would provide the buyer with a compliant program that would be in place at close and eliminate any future penalties.
Once again, this example highlights the reason companies should not rely solely on legal and accounting diligence on their target investments. Evaluating retirement and health and welfare plans requires specialized knowledge of regulations, industry trend and best practices, particularly in the ever-changing state of the insurance market.
Moreover, a broker with an integrated M&A practice can not only minimize assumption of any pre-close employee benefits liabilities, but also address all transactional risks. They can work with underwriters to make sure R&W policies offer meaningful protection without significant exclusions. And they restructure a target’s benefit programs to comply with regulations to meet the buyers’ cost projections.
Lydia Ramcharitar is a First Vice President in the Mergers & Acquisitions practice at Crystal & Company .
Sign up to get the latest Viewpoints articles by Crystal & Company experts sent directly to your inbox