For the acquisition of private companies, reps and warranties insurance can be a powerful bargaining chip for both buyers and sellers. In this guest post, my colleague Emily Maier, who leads the M&A practice here at Woodruff Sawyer, discusses the ways this type of insurance can sweeten a deal. — Priya
Maybe you’re a corporation or private equity house competing with your peers and strategic buyers for a highly attractive acquisition target. Maybe you’re a seller hoping to make the cleanest exit with the lowest escrow you can. Either way, a fast-growing and very valuable tool you can both make use of is representations and warranties (R&W) insurance.
R&W insurance provides coverage for potential financial loss resulting from a breach of the representations and warranties given by sellers in an acquisition or merger agreement of private companies. I’ve written about its benefits previously here, and my colleague Priya has discussed how to use it as a negotiation tool, here.
This product has been around for more than 20 years and is used extensively in Europe (where at least a quarter of deals involve its use) and Australia (where the majority of deals utilize it). In the United States, however, it’s only in the last couple of years that we have seen a growing adoption.
This has to do in large part with the willingness of insurance underwriters to remove standard exclusions for multiple and consequential damages (for a price). It also has to do with the expanded use of R&W insurance by sophisticated U.S.-based M&A lawyers, as well as the hire into insurance underwriting teams of experienced M&A lawyers.
Critical mass in terms of policies written and claims made has also allowed a more uniform approach to premiums, making it easier to factor R&W insurance into deals from the beginning. This critical mass has also allowed for a greater understanding of the wide variety of industries that can benefit from using this type of coverage.
Why Reps and Warranties Insurance Makes Offers More Attractive
Initially, private equity firms were a major contributor to the use of R&W insurance because they found value in using it to distinguish their bid in competitive auction situations. Now we are also seeing growth in its use by private equity when it comes times to sell those companies that they used R&W insurance to buy – sometimes even rolling the policy on as an additional asset.
From the seller’s perspective, R&W insurance has become such an attractive option that a growing number of sellers are building R&W insurance into their auction preparation documents, with the intention of making use of insurance as a pivotal piece of the discussion on indemnity and escrow limitations from the very beginning.
While sell-side policies are available, we are increasingly seeing a desire from all parties – including the insurance underwriter – for the insured to be the buyer. The advantage of a “buy-side” policy is more robust coverage: the policy can provide higher limits and a longer survival term than what sellers are obligated to provide under the acquisition agreement, and the policy doesn’t contain an exclusion for seller fraud.
From the underwriter’s perspective, access to the buyer’s due diligence makes them a very attractive insured.
How Reps and Warranties Insurance is Structured
Structures where the seller can walk away without any kind of indemnity or escrow are very attractive from the seller’s perspective, but are considered the most risky from the insurer’s point of view and are priced accordingly.
Additionally for the buyer, if the seller has no “skin in the game,” then the buyer will have to accept a retention (like a deductible) on the policy that the buyer will need to fund in the event of a claim.
As a result, both buyers and underwriters often prefer a structure that requires the seller to have a little money at risk. A comfortable example would be a seller indemnity of 1 percent to 2 percent of the transaction value held in escrow for a couple of years.
The insurance is then used to provide buy-side coverage in excess of that indemnity in terms of both time and money; perhaps 10 percent to 20 percent of the purchase price for six years in excess of that 1 percent to 2 percent for 24 months.
Premiums for Reps and Warranties Insurance
Premiums for reps and warranties insurance are calculated as a percentage of the limit of insurance coverage purchased.
Currently we are seeing rates in the U.S. market between 2.5 percent and 4.25 percent of the limit of coverage purchased. In the right circumstances, paying between $250,000 to $425,000 for $10 million of coverage will be the right move to get a deal done.
The policy retention is based on the size of the overall transaction. Minimums are 1 percent, but underwriters get more comfortable and pricing more attractive when we are in the 2 percent to 5 percent arena.
So in conclusion, R&W insurance is not only a useful tool in M&A, but also an increasingly popular one. We have seen a shift of emphasis from sell side policies to buy side, driven both by private equity and by the insurance underwriters themselves.
Pricing remains constant, but with new markets coming in on a seemingly weekly basis, it will be interesting to see if those hold or if competition starts to work its magic on pricing and retentions.