As 2020 swings into gear, more companies are utilizing reps and warranties insurance on middle-market private equity, strategic, and M&A transactions. As we noted in our 2020 Private Equity and Transactional Risk Insurance Trend Report, we believe this trend will continue through 2020 and beyond. Among the trends we identified in our report is the notable trend of relative newcomers to the marketplace implementing R&W insurance—specifically lower middle-market private equity funds, growth equity funds, and strategic investors. As the R&W insurers move downstream and new insurance buyers seek expertise and options for their deals, it is critical to understand the ways in which a process can go south—and how to keep things on track.
We have identified five general pitfalls common to R&W deals, informed by our work on hundreds of lower, core, and upper middle market transactions ranging in size from $30.0 million growth investments to $1.5 billion LBOs.
#1) Insufficient Due Diligence
Simply put, if the due diligence is insufficient, coverage will be very limited. A lack of due diligence creates anxiety for underwriters and the main question they will ask is, “Why would the Buyer willingly choose to not perform due diligence in this area?” From the underwriter’s perspective, a lack of due diligence in a key area raises the cardinal concern that the R&W policy is being procured as a substitute for diligence and not a safety net against failings in diligence.
One of the biggest hurdles to overcome is a lack of financial diligence. Breach of financial reps is the biggest single source of claims. We have seen much greater scrutiny in this area. It used to be the rule that if you had audited accounts you didn’t need a separate QOE, but that is not always the case now. It is no surprise, then, that underwriters would want prospective buyers to undertake fulsome due diligence on the financials and tax related to a Target acquisition.
Many strategic acquirers have extremely sophisticated in-house diligence teams, however, these teams may not be used to memorializing and categorising diligence in a way that underwriters can easily understand. Strategic acquirer diligence teams may also look at certain areas that are key to them but less at areas that are a concern for underwriters. We can help first time strategic clients prepare for this level of due diligence, but it can cause tremendous disappointment if the underwriters’ needs are not kept in mind from the beginning of the process.
Key to Success #1
Perform due diligence on the areas that are relevant to the representations and warranties under the agreement, and memorialize the findings in a written red flags memo, general memo, or formal written report. The diligence needs to be properly memorialized for the underwriter and outside counsel to gain comfort that the buyer has adequately performed diligence on the areas that matter to the business. That is not to say a buyer has performed unnecessary diligence in areas that are not mission critical. For example, there is no need to perform a full environmental due diligence analysis if the target is a software company that leases all of its locations. On the flipside, if the target is a manufacturer using solvents and owns three manufacturing locations, R&W underwriters will certainly look to review a full environmental due diligence report.
An expert R&W insurance broker should be able to advise the buyer on the extent to which diligence will need to be done after negotiating the quotes with the marketplace.
#2) Failure to engage the right advisors at the right time, and getting them to review the right aspects of the deal
Understanding what due diligence the underwriters are going to want to see specific to your deal is essential. Unfortunately, we see this on a daily basis among first-time buyers who have not had to engage diligence providers on a routine basis. .
For example, if the financials are unaudited, the underwriter will expect a buy-side QofE to be performed in order to provide coverage for the financial statements under the agreement. If a QofE is not going to be performed, the buyer should be prepared for a list of follow-ups and deal-specific exclusions related to any financial-related reps and warranties.
Key to Success #2
As part of the marketing process, your broker needs to get the greatest clarity possible from each carrier about exactly what level of diligence is going to be required in key areas.
#3) Unrealistic Expectations
Whether a buyer is going through the process for the first time or working on their 25th transaction in the last two years, one thing is certain: the R&W insurance market is constantly changing. This is typical in the insurance world—new entrants to the marketplace drive prices down and expand terms/conditions, while at the same time claims analysis and trends force others to add new exclusions, increase retentions, etc. Having unrealistic expectations of coverage enhancements, general terms/conditions, or pricing is a pitfall we see frequently with new buyers or buyers who have not gone through the procurement process recently.
Key to Success #3
It is critical at the outset of a process to understand what’s “market” versus what is unrealistic. A competent broker should advise a prospective buyer during initial discussions on the expectations they should have for a process. For example, here are several questions where level-setting on expectations will help immensely as a process moves forward:
- How will the marketplace treat multiplied damages under the policy if there is explicit language in the SPA pertaining to multiplied damages?
- How will the underwriters respond to deals where a majority of revenue is attributable to Medicare/Medicaid?
- How will the premium change if we (the buyer) offer a No-Seller-Indemnity structure versus the traditional escrow?
- What can we (buyer) expect in terms of pricing, retention structure, etc., on this specific deal?
#4) Engaging an R&W insurance broker late in the process
Another pitfall we see is when a buyer that has the notion that if they take a fully negotiated, all-but-signed agreement to an R&W insurer, the underwriter will simply accept the deal as-is. The reason this is problematic is the R&W policy attempts to mirror the SPA as closely as possible so there are no gaps in understanding of how coverage will apply to each rep and warranty under the agreement. When clients attempt to gain coverage with a pre-negotiated agreement, the underwriters will frequently add deal-specific exclusions. And any last minute material changes to the agreement can result in proposed exclusions with little time for negotiation.
Key to Success #4
The earlier the broker is engaged, the smoother the process will be. Our preference at Woodruff Sawyer, after negotiating several hundred transactions, is to get involved either pre-LOI or immediately following execution of the term sheet as the deal moves forward. This allows the underwriter to see how the negotiation unfolds and each turn of the agreement throughout the process. It also enables the buyer to avoid #1, #2, and #3 above by firming up the expectations noted in #4. Nothing is more frustrating or unfortunate to both a buyer and broker than to have a buyer approach the broker at the last minute with a fully negotiated agreement and have deal-specific exclusions added, diligence requests for areas that were not reviewed, or worst of all, blanket declinations from the market.
#5) Approaching the R&W insurance marketplace with an overly seller-friendly agreement
Contrasting with #4 slightly, there are times when it is too early to approach the R&W insurance marketplace. In our opinion, if the only version of an agreement that’s available is an initial, seller-friendly draft of the purchase agreement, it’s too early. This is obviously unless the seller is the one approaching the marketplace to get a sense of market terms, conditions, and pricing (we see this frequently at Woodruff Sawyer).
Key to Success #5
We like to approach the marketplace with the most buyer-friendly agreement. Typically, this will be the first mark-up of the initial agreement. Why would this make the most sense when both buyer and seller know for a fact neither of those agreements will be where the deal ends up signing? Simply put, if the R&W underwriters accept a deal and provide an NBIL when the agreement is as broad as it possibly could be (i.e., includes everything the buyer could possibly want in the deal), the underwriters will certainly be comfortable when the negotiation leads somewhere back to the middle. The potential issue with approaching the marketplace with a seller-friendly draft is the underwriting community is largely aware that the terms/conditions of the deal will change in a material (and potentially adverse) way. This gives them consternation when considering whether or not they will accept the deal. A buyer markup, however, provides them with the other end of the spectrum.