Middle-market private equity or growth equity transactions have specific implications on risk management and insurance programs pre-close, at close, and post-close.
It is a fundamental mistake for members of a deal team to believe all transactions will simply require an updated name to the current insurance policies. This incorrect understanding of how insurance works can lead to problems post-close in the event of a loss or claim.
In Part 1 of this three-part series, we review the insurance implications associated with asset versus stock transactions, so deal teams have a better understanding of the due diligence process and pre-close general requirements for each transaction structure.
Types of Transactions and Insurance: A Visual Guide
Here’s a quick reference guide for deal teams to understand whether a new property, casualty, management liability, or benefits program needs to be implemented at close or if the existing program can remain in place.
Knowing this can help you better prepare, because it can take several weeks and effort to put in place correctly.
|Transaction Type||Property and Casualty||Management Liability||Employee Benefits||Effect on Total Cost|
|Minority Control, Stock||No||Depends||No||Depends|
|Majority Control, Stock||No||Yes||No||Increase|
|Majority Control, Asset||Yes||Yes||No||Increase|
|Merger||Yes||Yes||Yes||Decrease / Neutral|
|Carve-Out / Divestiture||Yes||Yes||Yes||Depends|
Every middle market transaction is complex in various ways. When considering insurance implications for the deal, the first and most basic question that should be answered is: Is this an asset or stock transaction? The answer to this fundamental question will create the framework for interacting with the insurance advisor for the rest of the transaction. Based on that answer, a Buyer’s advisor with either (1) perform due diligence with no major implementation changes necessary at close, subject to any applicable run-off provisions; or (2) simultaneously perform due diligence of the current program and solicit options for a new go-forward Property, Casualty, and Management Liability program to be implemented at close.
In Part 2 of this 3-part series devoted to transaction structures and their corresponding insurance implications, we’ll look at Majority versus Minority control transactions. Finally, in Part 3, we’ll take a look at the insurance implications associated with Mergers, Carve Outs, and Corporate Roll-ups.
Asset Versus Stock Transactions
The first question an insurance advisor should ask at the outset of a new transaction should be: Is this an asset or stock transaction? The answer to this question will set the framework for the due diligence and insurance implementation process pre- and post-close.
In an asset transaction, a new property, casualty, and management liability program needs to be implemented at close, whereas in a stock transaction, the existing program can remain in place, subject to any change in control provisions (more on that below) or new coverages needed.
In a stock transaction, a buyer is acquiring both the assets and liabilities of the selling entity. As a result, the existing insurance program can remain in place. The buyer inherits the existing program and may not be able to make significant changes until the renewal date of the program as opposed to at closing.
There are three key reasons a new property, casualty, and management liability program needs to be implemented in an asset transaction:
1. Assets Versus Liabilities
The insurance program is a current liability on the balance sheet because the policies are annual policies to be paid off during any given year. In an asset transaction, the buyer is acquiring the assets of the selling organization, not the liabilities. A new company will be established at close, which will buy the assets from the seller. The new insurance program will need to cover the new entity as opposed to the old company.
2. Clean and Clear Separation from Old Company to New Company
The buyer is only acquiring the assets of the old company and is not intended to be responsible for any pre-close liabilities. If the existing program remains in place, ambiguity could arise if a claim arises. A new insurance program creates a clean break and separation between who is responsible for what and as of what date (i.e. the close date).
3. Assets Not Included in the Transaction
Some assets may not be included in the sale. The existing insurance program in place at the time of sale will protect the exposure related to those assets, and the new program will provide coverage for the go-forward exposures.
For example, real estate or building ownership may remain with the seller post-close. If the buyer simply changes the name on the existing program (which is an incorrect strategy buyers are sometimes advised to take), the assets remaining behind have no coverage.
How Due Diligence Is Impacted
From an insurance perspective, asset transactions involve several extra steps pre-close as compared to stock transactions.
There are two simultaneous workstreams for asset transactions:
- Due diligence of the current, in-force program; and
- Solicitation and implementation of the new go-forward program at close
Phase 1 due diligence of the existing program will enable the buyer to understand the current Property, Casualty, Management Liability, and Employee Benefits insurance program structure and any deficiencies within the program. It is during Phase 1 that the diligence team can identify, understand, and convey what the pre-close insurance and risk management strategy has been. How has the Seller viewed insurance up to the point of selling the business? How has the pre-close management team approached financing that program? Are there any exposures that are uncovered, under-covered, or over-covered by insurance? What benchmarking has been done to date, and how does the Target acquisition’s program compare to its industry peers of similar size? These are all questions to which answers should be identified during the due diligence process.
Phase 2 will allow a new Property, Casualty, and Management Liability program to be solicited and negotiated, fixing any of the deficiencies uncovered during Phase 1. Missing coverages identified in Phase I should also be implemented. For example, here are a few deficiencies we typically uncover and rationale:
- No Cyber Liability is purchased: “we do not believe we have a Cyber exposure.”
- No Product Recall is purchased, and the Target company is in the consumer goods space: “It’s cost prohibitive and we have good quality controls in place.”
- No existing Management Liability coverage in place: “I have a good relationship with all of the shareholders and they would never bring a lawsuit against us.”
- Low Excess Liability or Umbrella Liability limits purchased: “We buy some coverage but don’t think our size warrants any more limit than we have.”
- Employee Benefit offering: “We offer the standard coverage for Medical but historically have not wanted to pay for anything else to offer employees.”
As the transaction process moves forward, Phase 2 allows the Buyer to fix deficiencies like those noted above. It’s worth mentioning that experience matters here. Especially with asset transactions, it is important to consult an experienced broker advisor. As a key example, the “deficiencies” noted above may not be deficiencies at all from the perspective of the Seller. If the company is a lower to core middle-market company that has been family owned and operated for several decades with no insurance issues and there has been a conscious strategy that brought the Seller to the in-force program, that is completely acceptable. However, the strategy for a private equity firm is fundamentally different. Long term asset appreciation and value creation for an ultimate sale of the asset is critical for the private equity Buyer. From that lens, the above examples are very real deficiencies that could impact the short and long-term EBITDA protection of the go-forward entity and thus the long term value. These deficiencies carry real risk that can and should be mitigated or transferred via insurance at close.
Taking it one step further, the Buyer is potentially spending hundreds of millions of dollars to acquire these assets. On top of that, there are several other stakeholders at play that will have issues should there be a significant decrease in the company’s value due to a loss that should have or could have been covered by insurance.
Due Diligence for Asset and Stock Transactions
Performing due diligence on the existing program, putting together applications and solicitation materials for the new company, marketing and obtaining options for the new company, and efficiently implementing a new program at close requires specific expertise and deal experience.
A typical insurance broker or advisor who is not accustomed to working on transactions may encounter issues along the way, which could ultimately lead to timing problems and/or mistakes within the new program.
Important note regarding Employee Benefits: Typically, it does not matter if the transaction is a stock versus asset transaction from the perspective of Employee Benefits implementation and administration. The existing program can remain in place as-is both pre and post-close. All that needs to be done for the Benefits program is working alongside the insurers to ensure the proper transition is implemented at close.