Not so long ago, few private equity firms spent much time worrying about insurance when buying companies. On their long list of due diligence items, insurance usually sat somewhere near the bottom. But today things are different. For example, insurance against potential losses under the warranties provided in a sale and purchase agreement, so-called warranty and indemnity policies, now rank higher up on the agenda of financial sponsors.
“Historically, only sellers of businesses have bought warranty and indemnity insurance to cover their exposure under the sale and purchase agreement,” observes Andrew Hunt, a London-based insurance specialist at broker and consultant Marsh's Private Equity/M&A practice. “In the last six months, however, we have seen a real pick-up in interest from private equity in risk transfer concerns, and the insurance market is increasingly interested in, and capable of, addressing these. Insurance is now being used strategically, to aid the bidding process and a fund's position in it.” In other words, more and more buyers are considering the use of warranty and indemnity insurance to improve or protect their position and concomitantly, that of their investors.
Dealing with warranty gaps
One trend that has led to private equity professionals paying more attention to the insurance-related aspects of a transaction is the increase of secondary buyouts in the industry. In this type of transaction, the warranties and indemnities that are part of the sales contract, usually provided by the seller but also often by the management team involved in the buyout process, are central to the negotiation process, and usually make for emotional discussions among those involved.
Warranties are essentially promises that require those making them to provide some kind of recompense to a buyer in the event that what the buyer thinks he has acquired turns out to be something different. To take a straightforward example, a seller may warrant that the company being acquired owns all the assets necessary to carry on its business. If it is established by the purchaser that in fact such a warranty has been breached, then the purchaser may be entitled to damages as compensation for losses suffered, in effect a retrospective reduction in the purchase price.
In this context, secondary buyouts constitute a special case because, by definition, the private equity firm selling an asset is not a corporate entity with enough financial substance to be able to back any warranties that may be agreed. In the past, the absence of warranties would typically have led to lengthy negotiations about a portion of the sale proceeds being placed in an escrow account for a period of time, or for a portion of the consideration to be deferred in some way. The variations on such structures were endless, and sometimes quite imaginative so as to accommodate the specific circumstances of a deal.
Today, however, such warranty gaps, as they are known, can be bridged through the purchase of insurance. This does not, of course, mean that the private equity buyer will accept a ‘warranty-free’ proposition, but it does mean that a W&I insurance product can be purchased by either the seller or the buyer that transfers economic risk in the event of a breach of the warranties contained in the sale and purchase agreement.
Insurance is now being used strategically, to aid the bidding process and a fund's position in it
“The most appealing feature of warranty and indemnity insurance products is that they enable us to get deals done which might otherwise have been extraordinarily difficult or even impossible to get done,” says Rob Myers of Barclays Private Equity, the European mid-market investor. The use of such structures can also influence the price paid, as a portion of the vendor's potential future liabilities are transferred to the insurance market.
Naturally, it is the possible reduction of the purchase price resulting from the strategic use of insurance that private equity buyers are especially attracted to. Today most transactions are the end result of a competitive auction process that often involves numerous financial buyers, whose thinking goes like this: “What if the seller can reduce its exposure to the contingent risk of a breach of the sale and purchase agreement warranties? Would this make our bid more digestible from the seller's perspective? Would it mean we could offer a lower price?” Part of why vendors may find this an appealing approach is that financial buyers generally have a reputation for being ‘difficult’ parties to negotiate with due to their often heavy due diligence and warranties requirements. They may respond favourably to equity sponsors who differentiate themselves by not conforming to the stereotype.
Insurance remains a subject worth pondering for private equity investors even after an asset has been acquired. Because buying a business is often a highly competitive process, and because selling it can be problematic, especially in the current environment, financial buyers are also paying closer attention to the day-to-day management of companies in their charge. This is another area where insurers are also able to help.
One example is in managing environmental liabilities. Let us say that a business was acquired with specifically identified environmental rectification issues at one of its sites of operation. The work is anticipated to cost €5m and to take two years to complete. This has been factored into the acquirer's bid price. The seller has warranted that if the problem costs more than €5m to put right, it will pay the difference, up to a maximum of €2m. But what happens if the total costs are €10m? And, more insidiously, what happens if there is no cost overrun, but the work takes three years to complete, leading to a loss in productive capacity for longer than anticipated? It is likely that the warranty may not cover the latter eventuality, but it may be possible to insure against some or all of such potential exposure, thereby creating less of a headache for the owner and, importantly, underpinning the cash flow of the business.
But how easy is it to arrange such, often very specific, insurance cover? In reality, there are still relatively few insurance providers who are willing to consider such risks, but the number is growing and more and more brokers too are setting up specialist M&A or private equity practices in an effort to satisfy increasing interest.
Litigation and environmental issues for example are, today, comparatively easy to cover due to the insurance market's familiarity with them. In contrast, taxation issues are more difficult to deal with through insurance as they tend to be more slippery by nature.
As the chart on this page illustrates, there have been recent examples of sizeable warranty claims. UK insurance professionals estimate that somewhere in the region of 60 claims have been made on insurers over the past five years under such policies. So far the market has not seen any restrictions on the provision of cover to private equity firms as a result of these claims, but it is possible that capacity may be more cyclical in the future if such trends continue.
As a result, costs of cover can vary. “There is some competition between insurance carriers, but you cannot really tender this type of business,” says Hunt. Fees typically range from 2 to 6 per cent of the insurance limit provided. Such costs clearly reflect not only the nature of the risk, but also the restricted ability of the carrier to lay-off significant amounts of the cover provided. Naturally some practitioners view this as expensive and are unwilling to entertain taking out such cover. Nevertheless, an equity sponsor's ability to put together a bid with a difference is likely to be more, not less, important in the foreseeable future. Insurance looks set to play an increasingly important role in this.