Leading insurance brokers and risk consultants have been quick to recognise that international private equity can be a major driver of their revenue streams. As private equity has evolved into a more and more common source of M&A financing, so too have the industry's practitioners come to recognise the critical importance of insurance related issues in the acquisition process.
Until relatively recently, private equity practitioners were not at all accustomed to giving much consideration to insurance problems, but this has changed dramatically. As Hazel Mack, a due diligence specialist in the London-based M&A division of Willis Risk Solutions, observes: ?When we set up the team six years ago, insurance due diligence and insurance risk were just totally ignored. Now private equity firms come to specialists straight away and ask about headline issues that might be deal or price sensitive.?
Private equity related insurance due diligence is a global business, and the dominant service providers in the field such as Aon, Marsh and Willis have all built global networks of professionals deploying a wide range of skills to service the market. Europe is key to all of them, not only because of its relative immaturity for buyout operators, but also because the crossborder nature of many transactions means that risk due diligence requires a much more sophisticated, and deeper, level of analysis in the buyout process.
The value proposition brought to private equity firms is simple. ?Private equity is under substantial pressure to create value under a very difficult set of circumstances,? says Mark Roberts, chairman of Aon Mergers and Acquisitions Group (AMAG) Europe. ?We can help make sure that perhaps not the entrepreneurial risks, but at least some of the more finite and calculable risks they are running are covered.?
This is precisely what LBO firms are looking for when seeking risk-related advice. Dave Novak, of Clayton Dubilier & Rice (CD&R) in London, says that because his firm satisfies its appetite for risk by taking on a leveraged balance sheet as well as operational types of risk, it wants absolute clarity on the insurance side. ?Prior to doing a deal, you've got to understand a lot of risk that is not intuitive to you. You need to make sure that the relevant allocations are visible on both the balance sheet and the P&L of a target company,? he says. Equally importantly, the buyer needs to ensure that the provisions that are in place are the right ones for the business he is looking to acquire. In the case of a carve-out deal for instance, CD&R's favourite kind of transaction, a target business will have cover in place that will have suited its needs as a subsidiary of a larger parent, but may not work for it in its new guise as a stand-alone operation. ?We always change the cover of a new acquisition post-deal,? notes Novak.
Roberts: making sure calculable risks are covered
To be sure there are no skeletons hidden in the closets before any commitments are made, private equity firms are calling in the insurance experts to carry out what can be described as forensic auditing. Once the data room is set up, these specialists look for holes in a company's insurance programme. They also look for liabilities that a business may have assumed but are not included in the offering memorandum and initial due diligence reports. ?We come in to check whether a target company, perhaps so as to make its balance sheet look a little better, may have knocked down its product liabilities or underplay any reserves they have set,? says Craig Simon, a director in Willis' Casualty Marketing Practice. ?It's detective work.?
Enelow: different mentality in the market
Identifying potential problem areas pre-deal is one thing, addressing them another. ?There is no point in making a red flag report highlighting areas that really need addressing and then forgetting about the measures that have to be put in place,? Roberts insists. AMAG and its peers are therefore looking to work with clients on a partnership basis and stay close to an investment throughout its life cycle.
They also help clients, pre-acquisition, to procure the various products they require in the insurance market, thereby often facing tight deadlines that are determined by the dynamic of the bidding process. Underwriters in the insurance market looking to do business in this field are generally acknowledged to be highly sophisticated in their approach to the process. Their specialist teams are often staffed with former corporate security lawyers and investment bankers that have a high level of understanding of what is required. According to Bruce Batzer, senior vice president of M&A at Willis, ?the challenge is to educate clients as to the availability of insurance products to resolve issues.?
Part of this challenge is also to ensure private equity firms understand the tremendous impact that September 11 has had on the insurance market. Most observers agree that underwriters remain open for business, but that the rules have changed significantly. James Enelow, European practice leader at Marsh Private Equity and M&A Services, says ?there is now a totally different mentality in the insurance market with regard to quantity and quality of the risk-related data that it needs to analyse.? Carriers are taking a lot more time to work through an underwriting proposal, and by all accounts will happily let a buyer run into a wall if approached at too short notice. And they are asking clients to pay steep fees for the due diligence that they do.
Nick Maher, managing director of Aon's Global Risks division, expects private equity firms to find a way to respond to the changed realities and provide carriers on time with the right data. He also believes that there is pressure on sellers of businesses to help underwriters get comfortable with a deal: ?Perhaps we need to look at who actually accepts responsibility for arranging insurance in the first place. The people with the information are the vendors.?
Using insurance capital strategically
To a first time buyer optimising insurance cover for a target company and understanding its cost implications may look like a major headache, but savvy purchasers know that the right approach can in fact yield significant upside. Andrew Hunt, a due diligence specialist at Marsh in London, says: ?Private equity firms are increasingly keen to use insurance capital strategically to gain an edge in their negotiating stance. In an auction, rather than hammer down on the seller to get them to give high warranty caps, they will look to buy insurance cover in the market.? This helps to accommodate the vendor's requirements, whilst also giving the buyer more room for manoeuvre regarding the price it is prepared to pay.
Although some may still regard private equity dealmaking more art than science, many more private equity firms are realising that a more technical approach to closing a deal pays. In this context, undertaking rigorous insurance due diligence not only delivers you negotiating room but also ensures that there are no liabilities lurking in a target company set to render that plum investment into an albatross around your fund's neck.
Insurance Due Diligence ? Issues & Solutions Checklist
When a private equity firm is undertaking due diligence on a prospective acquisition, it is critical to include insurance related liabilities in the mix. Here Aon Mergers & Acquisitions Group lists some of the common insurance issues that arise when assessing a target company and their solutions.
1. Issue: Target company has high levels of excess and/or alternative structures of self-insured retention (particularly on long tail liability classes).
Solution: Adviser should obtain fully itemised electronic historic claims data and undertake full analysis including calculation of incurred but not reported (so-called IBNR) claims, review of reserving practices and accuracy of reserves, cause code analysis and disputed claims, with a view to delivering valuations to the client for use in negotiations.
2. Issue: Target company has low level current total cost of insurance risk expenditure (on an annualised basis) versus expected pro forma annualised total cost of risk post completion.
Solution: Adviser should understand the construction of the current premium/allocation expenditure and establish pro forma budgetary figures of the total cost of risk on a stand-alone basis including premiums, expected self insurance expenditure, and third party administration fees, with acquirer utilising the difference for negotiations.
3. Issue: Target company has history of long tail industrial disease with a number of past insurers either untraceable or insolvent. This means that there is an uninsured exposure from claims relating to this period for IBNR claims as either insurers can not be found or are unable to pay.
Solution: Risk needs to be negotiated out through vendor indemnity in the Sales and Purchase Agreement (SPA) although there is limited appetite in the insurance market for the provision of retroactive cover, dependent on the level of information available. Insurance consultant must liaise closely with the legal advisers to ensure that the SPA reflects the required position on all assumption and retention of insurance liabilities.
4. Issue: Target company has problematic contract conditions. An example of this is where a landlord can give a six month notice of termination of a lease. This would lead to potential loss of profit due to relocation and start up in another location. As a result the banks would be reluctant to provide debt as this loss of profit would upset the funding model.
Solution: An insurance policy is arranged to respond for loss of profit in the event the lease termination clause was activated. This policy provided the bank with the necessary comfort to enable it to provide the finance.
5. Issue: Financiers to transaction insist on stringent insurer risk management/improvement requirements.
Solution: Review requirements and help acquirer understand thought process behind their imposition. Provide budgetary capital expenditure estimates for inclusion in financial model.
6. Issue: There are concerns over the disclosures provided, security of warrantor, and there is an inability on the vendor's part to provide warranties and indemnities required by their acquirer.
Solution: Investigate the arrangement of Warranty & Indemnity insurance programme, with either the vendor as the insured or the purchaser.
7. Issue: What about credit insurance?
Solution: This cover is ?transaction sensitive? as insurers grant policy to management, not the company. So if management change then policy can be voided. The insurers must be fully involved in any transaction where there will be a change in the management pre completion, bound, of course, by a Confidentiality Agreement. Other credit insurance solutions can also be used to enhance the transaction.
8. Issue: Vendor tax liability concerns
Solution: Investigate the potential application of Tax Opinion Liability insurance.
9. Issue: Understated reinstatement sums insured, leaving target open to underinsured loss.
Solution: Arrange for a revaluation or uplift using pre agreed indices. However debt providers often have commercial property survey undertaken for security purposes. Insured values are not usually obtained but if management request that the survey includes the valuation the request is usually agreed to.
10. Issue: Awareness of any Bonds (Completion/Duty&Vat).
Solution: The surety market is very cautious about businesses post completion and there is a time line to obtaining quotes resulting from a requirement to refer the project to a credit committee taking a minimum of 10 days. Choice of insurers and realistic planning for this eventuality can avoid delays.
11. Issue: Directors and Officers liability continues for prior acts, post completion.
Solution: New management teams should be aware that protection must be arranged by way of a ?retro? coverage arrangement, or by insisting that the previous directors and officers provide an indemnity ? immediate past directors and officers will normally have an option to purchase a run-off cover attaching to their own insurance for between three and six years.
12. Issue: Ensure Statutory compliance
Solution: Confirmation of compliance with statutory insurance requirements in individual countries. E.g. third party auto liability, UK employers liability, Plant inspection etc.
Source: Aon Mergers & Acquisitions Group