In 2022, we saw a higher percentage of minority investments from our strategic company and private equity clients. We expect this trend to continue in 2023. Investing less in an individual company lessens the potential downside of a poor merger and acquisition (M&A) choice, but it also comes with less control.
When buying reps and warranties insurance (RWI), there are specific issues to consider that come with a minority investment placement. We will look at the bifurcation of risk between the investor and target levels, the impact on limit selection, and the overall market appetite for deals at different levels of ownership.
For many deals, if the buyer is acquiring only a portion of the target, the underwriter may insist on:
- Differentiating between target-level loss and investor-level loss
- Prorating target-level loss and only paying 100% loss for investor-level losses
The concern from an underwriter’s perspective is that if 100% of a loss is covered, a mechanism exists whereby the seller or seller entity can benefit from their failure or fraud. Like most issues in the market, real-life risk and the likely potential downside are perceived differently by different markets. Some underwriters are much more conservative, and some won’t quote minority deals.
What Is Prorated Loss?
Pro-rated loss is merely tying any potential payout to the same percentage of ownership investment. For example, an insured is paying $30 million for 30% of a company valued at $100 million. Once the deal closes, the buyer discovers a breach that leads to a $1 million loss. Further, it is determined that this is a target-level loss, not an investor-level loss; the underwriter will only pay $300,000 of that loss and not the full $1 million.
Investor-Level Losses versus Target-Level Losses
It has been argued that every loss is a potential “investor-level loss” because it affects the insured’s investment value. This is not an argument underwriters agree with, and the wording underwriters use is becoming increasingly clear, so it would not be wise to rely on that argument when making decisions.
Prorated losses are those felt at the target level and would affect all the equity holders of the target, in line with their proportion of ownership, and not merely the investors. A good example of a target-level loss that underwriters would seek to prorate might be an inventory valuation claim or a third-party product liability claim. In these cases, while overall company valuation could be affected, the seller or other equity holders are just as affected as the buyer.
On the other hand, investor-level losses are only felt directly by an individual equity holder and not experienced by the other equity holders; in this case, they are felt by the investor and not those already holding equity in the company. An example of this might be a breach of the rep that the seller was authorized to consummate the transaction. In this scenario, the investor has potentially lost their entire investment, and it is only correct that they receive 100% of that loss.
Picking an RWI Limit
Whether you are potentially receiving only 30% of any loss or the full amount is an important distinction when judging limits. Picking a limit can be an art as much as it is a science.
|Historically, the statistical average is that insureds insure around 10% of the enterprise value, so the buyer insures a $100 million deal for $10 million.
The statistical average, in this case, is just a statistical average. It does not necessarily reflect the amount of risk. Reps and warranties insurance was first used as a replacement for the traditional escrow style, and 10% has always been considered a standard amount, so this has become the norm. We sometimes see higher percentage amounts in very small deals, which provides a big enough dollar amount in the event of a breach, and smaller percentages in very large deals, as even smaller percentages provide a very healthy cushion.
If the insured is only going to receive a portion of that amount for target- or company-level losses, then is 10% the right number? Might a smaller amount make more sense?
|Over the last year, we have noted that in these situations, insureds tend to seek less than 10%—closer to 7.5% on average—for a minority investment deal.
Attitudes Vary Around Minority Investments
As with everything else in the reps and warranties insurance market, no two underwriters offer precisely the same coverage, and no two deals are the same. We see a wide range of attitudes around minority investments.
Suppose the seller keeps less than 25% of the equity in the target or receives 25% or less rollover into the new entity. In that case, underwriters are generally happy to offer 100% coverage on the transaction.
If that amount grows to 30% or more, then underwriters expect the seller to complete a no-claims declaration at signing and again at closing to get 100% coverage. A no-claims declaration is a statement saying the seller doesn’t know of any potential breaches of the reps and warranties they are giving at the time of signing and closing. The buyer gives this in all cases.
Suppose seller ownership is between 30% and 51%. In that case, there is a wide variety of responses, with some underwriters offering 100% coverage with a seller’s no claims certification (NCD) for up to 49% of seller ownership, and some only offering a prorated loss option.
Claim Outcomes Depend on Your Policy’s Language
It is important to understand precisely what is on offer when placing reps and warranties insurance policies on minority investment deals. The outcome of a claim can depend materially on this understanding and the specifics of the policy’s language. Carriers are becoming more uniform in how language is used, but there is still enough variety to make an impact. We expect the market to continue to change over time, depending on market forces and claims experience specific to this issue.
This is another reason you need a highly experienced broker when discussing your options and working through differing quotes at the earliest stage.
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Learn about the key policy sections that impact claims, including what is included in a loss, as well as standard exclusions to many R&W policies.