How Transactional Risk Insurance Makes Sense for Many M&A Deals

This article first appeared in Smart Business Magazine's July 2015 edition.

As merger and acquisition activity has increased recently, it has become in vogue for buyers and sellers alike to secure representations and warranties insurance to cover risks.

Sales of these policies have gone up exponentially. About 1,000 reps and warranties policies were sold in the U.S. last year probably more than the last five years combined.

This insurance protects against breaches in the reps and warranties made in a sale and purchase agreement. It is especially growing in use by private equity firms, which have been on a buying spree of companies in the past two years.

What is reps and warranties insurance?

Should a loss occur as a result of a misrepresentation or breach in an agreement, this insurance provides protection against the loss.

Buyers in the M&A transaction are the ones who most frequently purchase the insurance, but it is available to either sellers or buyers. If a buyer agrees to purchase a company based on the reps and warranties given, and then those reps and warranties turn out to be false, the buyer has the right to take action against the seller. Similarly, should the seller purchase the insurance and the buyer file a dispute, the seller can expect the insurance to cover the matter.

Is reps and warranties insurance useful in all M&A deals?

It isnt necessary in all transactions. It mostly works when large differences occur during negotiations between the buyer and seller. For instance, if the buyer and seller differ on the amount of escrow, or if the seller only wants warranties to last for a certain number of months post-transaction and the buyer wants them to last several years, insurance can cover that gap.

What are some of the latest trends?

M&A activity has been so brisk that competitive auction situations may arise. In response, insurance coverage has evolved to include a zero seller indemnity structure, which has enabled private equity firms to use such coverage as an enticement and win auctions.

Under this structure, the seller has an entirely free exit from liability should issues arise with regard to providing true and accurate reps and warranties.

How else has reps and warranties insurance evolved?

Until a couple of years ago, there were certain aspects that underwriters were unwilling to cover, including consequential and multiple damages. With consequential damages, for example, the buyer could claim that a breach of inventory representation meant not only that the inventory promised wasnt there, but that the buyer lost ongoing operating revenue because it was unable to fulfill a contract.

This type of loss used to be specifically excluded from policies it no longer is. The purchase price is often based on a multiple of the companys earnings before interest, taxes, depreciation and amortization (EBITDA). In the event of a breach, the argument could be made that any loss suffered should be subject to the same multiple. In other words, I paid you 10 times EBITDA for your company so, when a contract you said was valid turned out not to be, I want 10 times the value of that contract as my loss. Previously, looking at loss in this way was a standard exclusion, but again, underwriters are now willing to offer this form of coverage.

How does a company choose a qualified reps and warranties insurance broker?

An organization that is or may be involved in M&A should find a broker with experience, a long-term view and well-established relationships with the underwriters to get the best results.

A broker without the right experience may likely get in the way, and can potentially create more difficulties. Using a broker who has a proven track record in covering the risks associated with M&As is worth the cost of engagement; you wouldnt want to entrust an amateur with these risks because the stakes are high and can be exponentially more costly.