According to Pitchbook, 2021 was an unprecedented year for dealmaking, with middle-market private equity firms closing 4,121 deals, for a total deal value of over $602.6 billion in the US—roughly 50% over prior historical highs for both deal count and value set in 2019. One reason for the increased activity was that some 2020 deals were pushed forward into 2021, while other potential 2022 transactions were pushed to close sooner due to anticipated tax hikes. Add in COVID-19, regulatory headwinds, and a burgeoning SPAC/de-SPAC marketplace, and it’s no wonder the US private equity marketplace was so intense last year.
In this blog post, we’ll talk about the state of the M&A and Private Equity market, issues we came across in deals for which we conducted insurance due diligence, and why insurance due diligence is more important than ever in helping to close deals.
Sellers Looking to Close Deals Faster in 2022
In 2021 and into 2022, we’ve found that sellers place a high priority on closing as quickly as possible. All else being equal, a seller will typically want to close a deal sooner rather than later. Therefore, one way in which firms differentiate themselves is through certainty and speed to closing. What can help private equity firms close deals faster is having a deep and expert bench of third-party advisors ready to go for new transactions, both at the platform and add-on level.
Ironically, we at Woodruff Sawyer heard from many clients throughout 2021 that third-party advisors were stretched thin, and capacity was low considering the high volume of deal flow. This limited bandwidth occurred across all advisors, including insurance, and had an impact on the representations and warranties insurance (RWI) marketplace as well.
During the hold phase, a broker who is fluent in portfolio company insurance programs and the dealmaking world will help maximize EBITDA margin improvement and protect the asset for the private equity firm. At the time of exit, the advisor can help prepare the company for sale and ensure no lingering or long-tail liabilities are associated with the exit. This scrutiny is especially valuable in the de-SPAC process, which we will discuss later in this post.
Representations and Warranties Insurance Market in 2022
The market is cooling after an overheated third quarter in 2021. A theme for this year is going to be how fast premiums will return to early 2021 levels (if at all); several new entrants have started up, which will push competition, helping us get back to those prices more quickly.
The impact of Russia’s invasion of Ukraine is already being felt, both in terms of diligence and emerging exclusionary language.
Cyber coverage continues to be a primary concern when underwriters evaluate underlying insurances of a target; backdated coverage is becoming increasingly hard to get when a target has no existing coverage, leading to the potential for separate retentions and exclusions.
The Importance of Insurance Due Diligence
Part of every transaction’s due diligence process is the insurance and risk management workstream. Though they often take a backseat to operational, legal, financial, or accounting diligence, insurance and employee benefits due diligence are becoming more and more important.
Private equity firms have a particular investment in these types of due diligence as they look to protect EBITDA of their new platform investment and efficiently and effectively integrate new add-ons to existing platforms. If executed poorly, acquirers and investors alike may leave themselves exposed to increased risks that could negatively impact EBITDA in the short term and diminish value of the asset in the long term.
One oversight many deal teams make is involving the insurance advisor too late in the process. We have found that insurance due diligence advisors are not typically engaged until a Letter of Intent (LOI) has been executed. We recommend including a fully vetted RWI proposal when a private equity firm nears completion of the LOI and looks toward submitting a second or final round bid for a target. This step demonstrates to a seller that the prospective buyer is not only committed to procuring an RWI policy as part of the transaction but that the buyer has also engaged with a broker and has gone through the initial stages of obtaining quotes and vetting out initial terms, conditions, and pricing. This move also sends a clear signal of the bidder’s intent.
The pre-LOI stage is a good time to get the administrative work on the due diligence side completed, such as mutual NDA execution, formalized engagement letters, initial diligence information checklists, data room access, etc. At this stage, the team can also get familiar with the target company by reviewing the Confidential Information Memorandum, financials, management presentations, and initial insurance-related information located within the data room. With this step complete, the insurance advisory team can hit the ground running as soon as the LOI has been executed and a definitive closing timeline is established.
Our Guide to Transactional Risk covers what you need to know to plan for insurance due diligence at each phase of the deal process, from pre-LOI to the period of exclusivity, to deal close and post-close and implementation.
Key Insurance Due Diligence Findings for 2022
Here are key issues that Woodruff Sawyer is seeing in middle-market private and growth equity transactions:
- No comprehensive, strategic approach to insurance and risk management. While a foundation of coverage has been established, no long-term insurance strategy for EBITDA protection has been developed or implemented. The insurance advisor should recommend ways to both professionalize the program and raise the level of sophistication of the insurance program post-close to maximize EBITDA protection over the lifecycle of the investment.
- Key coverages are missing. For many target acquisitions, the deal represents the first time the company has accepted institutional investors or considered a buy-out from a private equity sponsor. This situation means new board members and potentially a new approach to insurance. What may have been treated as low priority pre-close (due to cost, for example) may be treated differently with a new private equity owner or growth equity investment because the buyer or investor will always seek to protect their investment.
- Examples of missing coverages include Management Liability (Directors and Officers Liability), Commercial Crime, Cyber Liability, or Product Recall Liability
- Limits are inadequate. Like the above point, a company pre-close will choose a limit for a variety of reasons. We have found the company typically has not performed any benchmarking analysis around limit adequacy. As an institutional investor becomes involved, there should be greater thought around limit adequacy to protect the short- and long-term EBITDA of the company.
- Examples include Cyber Liability, Business Income and Extra Expense, Contingent Business Income, and Products Liability
- RWI continues to be utilized on most transactions that are greater than $50 million total. Two new entrants have come into the market in the six months ending 2021, and the market volatility we saw in the last quarter of 2021 is beginning to calm down.
- While smaller deals continue to be underserved, we have seen a new entrant focused specifically on very small deals with non-negotiable wording and a very streamlined diligence process, and we think this change has the potential to broaden the market even further.
- Currently Cyber Liability is an underwriter’s greatest concern when looking at insurance diligence and is worth exploring early in the quoting process.
- Property, Casualty, and Management Liability rates are rising across industries and lines of coverage. Management teams should be prepared for continued rising rates throughout 2022. Broadly speaking, the insurance marketplace is in a ‘hard’ market as compared to 2018–2020, which means rates are generally increasing across Property, Casualty, and Management Liability coverage lines.
Insurance Due Diligence is Important Because You Will:
- Understand how EBITDA is being protected at the company level.
- Understand the foundation of insurance, general risk management strategy, and approach to employee benefit offerings that have been implemented historically to protect the business and employees prior to investment.
- Identify potential new program needs. A new Property, Casualty, Management Liability, or Employee Benefits program may need to be implemented at close depending on the transaction structure and agreement language.
- Avoid exclusions or issues with the Representations and Warranties Insurance (RWI) process.
- Respond to lender requests. When new lenders are being added to the financial structure, they will require certificates naming them as additional insured or lender’s loss payable on the insurance program. Like RWI insurance underwriters, lenders will require a base review of the insurance program. There will be certificates required for closing.
Check out our full Guide for 10 key reasons to perform insurance due diligence and to get a roadmap of the process at each phase of the deal process.
Rise of the SPAC and Implications for Insurance Due Diligence
Although new regulations and the public markets have put a severe headwind in the face of new SPACs pricing this year, there are 500+ SPACs currently priced and in search mode. Many of these SPAC clients are turning to the diligence phase of their investment life cycle, known as the de-SPAC phase.
This phase includes identifying a target acquisition, gaining shareholder approval, acquiring the target, and then the combined company beginning life as an operating company with publicly traded shares. The de-SPAC diligence process from an insurance perspective is nuanced and a critical part of the due diligence process. Because of the similarity to a general M&A process, diligence for a de-SPAC can be like a traditional private equity transaction.
Key Findings During SPAC Due Diligence for 2022
Our main finding across most transactions is the target’s underlying insurance program—while adequate—is not as sophisticated or professionalized as needed for a publicly traded company. Also, both the management team and insurance broker have not developed or implemented a comprehensive approach to risk management and EBITDA protection for the target company.
Below are other key findings that Woodruff Sawyer is seeing on de-SPAC transactions:
- The target has not implemented an adequate insurance foundation. With some de-SPAC targets, the company is pre-revenue and/or the company has not established a foundation of Property, Casualty, or Management Liability insurance.
- An adequate foundation is set, and the core exposures are acceptably covered. Typically, the target does have a form of foundational insurance in place covering key exposures. Oftentimes, more nuanced coverages (such as Cyber Liability and Product Recall) have been overlooked or simply not purchased due to budgetary constraints.
- The strategic approach to insurance and risk management is missing. While a foundation has been established, the target does not appear to have a long-term insurance strategy for EBITDA protection.
- There is little (or no) Management Liability coverage in place. If the target has obtained Management Liability coverage, it will typically be a small, private company D&O, EPL, Fiduciary, and Crime policy. This lack will be problematic if not tackled sooner rather than later in the transaction process.
- Examine limit adequacy of various coverages. In most cases, the decisions behind limits for various coverages on the underlying insurance program are driven by total annual cost. For example, if the exposure for Cyber Liability is $5 million, but the policy is three times what a $1 million limit costs, the insurance buyer may accept the risk and opt for the $1 million limit. As the SPAC seeks to close the transaction, limit adequacy should be evaluated, and the program improved to state-of-the-art terms, conditions, and pricing.
Insurance Due Diligence for De-SPAC Transactions
A solid insurance advisory team should be on any de-SPAC transaction deal team. With the recent proliferation of SPACs over the past 24 months and the increased number of SPACs now in search mode for a target to begin a de-SPAC process, insurance due diligence and an expert broker-partner team to help the management team navigate the de-SPAC process are necessary.
There are critical nuances from an insurance perspective that must be implemented at close when the business combination completes, and a new publicly traded company is formed through the merger. Once the SPAC identifies a target acquisition, several workstreams should commence simultaneously on the insurance side of the equation: (1) RWI solicitation for the transaction; (2) customary due diligence for the Target company’s insurance program; and (3) go-forward and tail Management Liability solicitation. When managed appropriately, these work streams work in tandem with one another with a single advisory team handling all aspects of insurance. Read more about insurance due diligence for de-SPACs in our full Guide to Transactional Risk.
Whether you’ll be engaging in a private equity, strategic merger or acquisition, or de-SPAC transaction, there are myriad priorities during the hectic deal process. A comprehensive risk management and insurance strategy can bolster a company’s EBITDA and protect against long-term issues.
For a more in-depth overview of the insurance due diligence process during the various phases of a transaction and to understand how this due diligence can help you close deals faster and with more certainty, view or download your copy of the Guide to Transactional Risk.
Find out more about war exclusions, where they may apply in light of the invasion of Ukraine, and how to prepare your organization.
Related Blog Posts
Read more for our analysis of the updated data and emerging trends in RWI.