Zero Seller Indemnity: The New Normal in M&A?

This post by colleague Emily Chapple, who leads Woodruff Sawyer’s mergers and acquisitions practice, discusses a new development in use cases for reps and warranties insurance during M&A.

Reps and warranties insurance is a transaction facilitation insurance product. New developments in the buyer’s side of the policy would allow the seller a clean exit from the company if the buyer elects to have his or her own retention with no requirement on the seller to provide indemnity.

In this post, Emily discusses a recent case where a client leveraged this type of policy to successfully win an acquisition auction. This is not the first time reps and warranties insurance has come in handy to move the sale of a company to a close, as discussed here in a previous post.

Now, let’s hear directly from M&A insurance products expert Emily Chapple…

In the brisk M&A market of 2014, how can a buyer distinguish his or her bid for a hot company? Seller auctions are back, and our most successful clients have found that a willingness to limit indemnity for the seller is a strong weapon in the bid process. In fact, a client of ours recently won an auction using a relatively new structure that the market is offering in reps and warranties insurance.

First, some background. Traditionally, reps and warranties insurance has been used to reduce, rather than eliminate, an escrow. The insurance market has historically wanted to see “skin in the game,” the idea being if the insured had nothing to lose, then there would be an “inherent moral hazard” in placing the coverage.

In transactions where the seller was the insured party, policies would usually have a minimum retention. Let’s say you have a $100m transaction with a $10m cap on reps and a $1m escrow. In that case, the insurance market traditionally was only willing to drop down and cover part of that escrow. The best you could expect was $9.5m of insurance coverage over a $500k retention. On the sell side, this situation has not changed.

Where we have seen the change is with a buyer policy. Previously, like the sell side, insurers were only willing to offer coverage above a certain retention point. Traditionally, the insurance carriers still wanted the seller to be at risk. However, this is no longer the case.

In an exciting development, the insurance market evolved on this point. Now a buyer can elect to have his or her own retention with no requirement on the seller to provide indemnity.

This is the latest in a long line of improvements in the type of coverage available when it comes to reps and warranties insurance. First, we saw the potential to cover consequential damages, an idea initially resisted by the market, then the concept of multiples in damages were also accepted. Now, finally, we see the introduction of a structure allowing a seller an entirely free exit.

This change is meaningful. Consider the case of one of our clients a private equity firm, that was looking to acquire a company where the seller was nearing retirement and nothing could induce him to give warranties. Luckily for that seller, several parties were interested in acquiring his company, so he could hold off for the bidder most willing to come close to his ideal.

Our challenge was to provide our private equity client with comfort that if he made this bid, we would be able to back it up with coverage despite only being at the auction stage. This meant getting a feel for the deal when we only knew the industry, the players and a little bit about the target.

Despite having only a relatively sparse amount of information, we were able to obtain several indications for a premium of around 2 percent of the limit. While the buyer would have a retention of around 2 percent of deal size, there was zero indemnification obligation on the part of the seller.

With this structure in his pocket, our private equity client was able to put his best foot forward, and won the deal.

Not every buyer will find it acceptable for the seller to have zero indemnification obligation, but this is something in which sellers will surely have an interest. So, while we doubt zero seller indemnity will become the new normal, as competition continues to be fierce, we definitely expect to see more deals like this.

If you’re interested in the topic of reps and warranties insurance, you may also be interested in this pdf that goes into more detail on the coverage.