Deal teams are fundamentally changing how they view and consider risk when it comes to private equity and mergers and acquisitions (M&A) insurance. In our latest Private Equity and M&A Looking Ahead Guide for 2023, Woodruff Sawyer experts provide predictions and advice on private equity risk management, including insurance due diligence, the rate environment, and transactional risk insurance. This year, we analyze topics such as market upheaval in the private equity space, the soft market for transactional insurance, and due diligence for middle market private equity transactions.
Private Equity Is Facing Turbulent Times in 2022
Public and private markets experienced a record year in 2021, but the macroeconomic and geopolitical backdrop has caused significant market upheaval in 2022.
|Factors that have caused the market upheaval include:|
This market upheaval has decreased deal volume, with activity slowing down into the second half of 2022 and the first quarter(s) of 2023. Pitchbook predicts “deal activity will likely pick up as GPs feel pressure to deploy capital, but this eventuality may be several quarters out.”
A potential recession could also fuel the slowdown.
Expect More Competition for Private Equity Deals
For private equity insurance market, this signals three things:
- While there may be fewer deals in the market, competition for those deals among private equity firms will likely increase.
- The private equity firms that do get deals under a letter of intent and move forward will need to work with significantly more speed and certainty to close the deals as quickly as possible.
- If a recession does arise and stick around for several quarters, private equity firms will likely be highly focused on managing current investments’ earnings before interest, taxes, depreciation, and amortization (EBITDA) margin and growth to weather the storm.
Having an expert team of insurance advisors will help deal teams act with more speed and certainty regarding the key protector and mitigator of EBITDA risk for companies: insurance.
The Hard Market is Behind Us for Transactional Insurance
Lasting just over three months, the first-ever hard market to hit the transactional insurance space was over by the end of the first quarter.
The entire domestic market for reps and warranties insurance consists of 25 separate underwriting groups, which makes it a very small world by insurance standards. What this means is that the market adapts very quickly to changing circumstances, which were characterized by:
- Slowdown of M&A activity across the board
- Increased underwriting capacity both in terms of capital to deploy and underwriters to underwrite because of the increased activity last year
- Increased capital deployment by underwriters
All the above resulted in a quick dropping of the pricing we saw toward the end of 2021, an increase in the number of quotes each risk received, and a return to more friendly underwriting terms and speed of execution.
Trend 1: Secondaries Are on the Rise
Traditionally, use of secondaries has not been covered by reps and warranties insurance, but certain underwriters have overcome the challenges by producing a product that requires far less diligence and at a cheaper price. In certain circumstances, they can even offer coverage for excluded obligations.
Trend 2: The Soft Market Will Continue Into 2023
The number of deals and the size of those deals have been decreasing since the end of 2020. For example, below is a snapshot of deals submitted to Euclid, one of the major players in the market.
While we see a path to a more robust end of the year, we do not expect pricing to reach the previous fourth-quarter levels for last year.
Trend 3: New Products Are Being Developed
Carriers are developing niche products for new music rights portfolios, as well as two new products for very small-scale policies for sellers.
Trend 4: Expect Increased Underwriting Scrutiny in Key Areas Such as Insurance and Cyber
More frequently, underwriters will want to see fulsome due diligence around the underlying target’s insurance program. Depending on the industry class, they may also want to see a more detailed IT and cybersecurity diligence report or memo. If a deal team does not perform diligence in these key areas, they should expect additional questions and/or exclusionary language related to things like management liability, cyber liability, and professional/E&O liability.
Trend 5: Insurers Are Responding to Increased Claims Activity
As insurers bind more reps and warranties insurance policies, they’re seeing a corresponding influx of claims being noticed. In the past few years, the rapid growth of the industry and the number of insurers that offer products for M&A transactions have led to unprecedented competition, including a desire by carriers to position themselves as superior on the claims side. Carriers are eager to be perceived as easy to deal with when it comes to claims, reasonable in their scope of requests, and willing to pay out what is owed to their insureds.
Trends in Insurance Due Diligence for Middle Market Private Equity Transactions
Based on our work on hundreds of middle-market private equity and growth equity transactions over the last 24 months, we believe the following trends will continue to have an impact on transactions in Q4 2022 and moving into 2023.
Trend 1: Target Companies Need More Sophisticated Insurance Programs
Oftentimes, we find that the target company needs to professionalize its insurance program. When the company is sold to a private equity firm, the new owner will want to ensure the insurance and benefits programs are state-of-the-art in terms of coverage terms, conditions, and pricing, as well as offerings to employees (for employee benefits).
Trend 2: Cyber Liability Continues to be a Key and Constantly Evolving Risk
The cyber liability landscape is continuing to evolve as a key exposure for middle-market companies. We believe this trend of increasing underwriting scrutiny surrounding cyber liability is here to stay for the foreseeable future. Key exposure areas are network security/hacking, ransomware attacks, cyber extortion, and social engineering/funds transfer fraud. As claims continue to increase in both frequency and severity across the lower and core middle market, rates and underwriting scrutiny will both continue to increase.
|Controls such as multifactor authentication across various network platforms, VPN utilization, segmentation, and encryption are becoming standard controls that underwriters expect companies to have in place before quoting.|
Trend 3: Portfolio Companies Are Rethinking Insurance as a Mechanism to Improve EBITDA Margin
Insurance has traditionally been seen as a drag on EBITDA. Many private equity firms are now using the operating partner approach to managing the broader portfolio. A key role for the operations team within a private equity firm is to help the portfolio company maximize EBITDA margin growth and improvement over time. Insurance has typically not been included in this discussion, but firms are now realizing that insurance can be used to not only protect EBITDA and mitigate losses but also improve EBITDA margin over the short and long term. By adjusting the structure of an insurance program and thinking more strategically about risk, portfolio companies can increase EBITDA margin year over year.
Trend 4: Macroeconomic Conditions Are Affecting Insurance and Risk Management Decisions
In our deals throughout 2022, we’ve also noticed that the overall macroeconomic environment is negatively affecting the underlying insurance program decision-making process for target private equity firm transactions. Inflation and general macroeconomic business conditions are forcing risk managers and CFOs to reconsider insurance coverages, limits, retentions/deductibles, and overall risk tolerance.
Trend 5: Take-Privates and Corporate Divestitures Are Gaining Momentum
There have been 18 take-private deals in the US during the first half of the year, and this number is expected to increase during the latter part of the year and into 2023 as public companies look to boost profits. In addition, we have seen the number of carve-outs/divestitures increase.
The carve-out or take-private transaction structure is unique and challenging from an insurance perspective. This challenge is because a new property, casualty, management liability, employee benefits, and 401(k)/retirement plan must be established for the new stand-alone entity.
We believe it is critical to work alongside an insurance advisory team that not only has experience working on carve-out or take-private transactions but that uses the same team for both due diligence and servicing the company post-close. With myriad tasks to complete pre-closing as well as TSA requirements for post-closing, there is simply no time for any type of hand-off between a centralized diligence team and a local broker team.
For deeper insight, advice, and our predictions for the mergers and acquisitions and private equity landscapes in 2022, read the full interactive Guide below or download the PDF.