Over the last several years, transactional insurance, or representation and warranties insurance (“R&W Insurance”), has become a more prominent part of the M&A landscape. For example, private equity and venture capital firms are increasingly using R&W Insurance to obtain a “clean break”—relatively speaking—when exiting their portfolio company investments. In this brief article, we thought we would provide a high-level overview of these policies, and our observations regarding trends and key considerations.
R&W Insurance policies provide a number of key advantages to sellers and buyers. Key advantages to sellers include: increased deal proceeds at closing (since the policy will be used in lieu of a typical indemnity escrow); and, for private equity and venture capital firms, the ability to distribute proceeds to their limited partners promptly after receipt (without the need to escrow a material portion of the proceeds for future indemnification claims). While buyers have shied away from this product historically, in the current M&A climate (where sellers typically have a significant amount of leverage), buyers are using R&W Insurance to advantage their bids and win deals, particularly when acquiring businesses from private equity and venture capital firms. In addition to helping them win deals, buyers also expect that these policies will have other advantages for them as well, including a creditworthy insurer as a source of recovery and enhanced recovery terms as compared to what they could typically negotiate in a market M&A agreement.
Generally speaking, an R&W Insurance policy insures buyers for breaches of the seller’s representations and warranties up to a specific “limit.” In most transactions, the amount of the limit tends to be equal to the amount that a buyer would expect to place into escrow in a traditional deal not involving R&W Insurance. Additionally, there is typically a retention (or deductible) on the order of 1% of the transaction value, which is typically funded in part by the buyer and in part by means of a seller escrow (usually 0.5% of the transaction value). It is this difference—the difference between the 0.5% seller escrow in a transaction with R&W Insurance and the traditional escrow (e.g. 10% of the transaction value)—that provides the seller with increased deal proceeds at closing.
With that as a backdrop, we thought it would be useful to highlight current trends and a few key points to consider when considering R&W Insurance.
- Introduce R&W insurance early in the process. Our clients have been most successful with R&W Insurance, when they have introduced it very early in the process. In a competitive sales process, we recommend that sellers include the concept as a condition to the bid—or, at minimum, as a material factor in the bidding process. We encourage our clients to work with their advisors to ensure that it is included in the bid solicitation process as early as possible.
- Structure as a “seller-flip.” While not universal, when we see R&W Insurance policies used, we typically see them structured so that the buyer (and not the seller) is the insured. There are several reasons for this. Most notably, from the seller’s perspective, it is preferable to have the buyer deal directly with the insurer (and not the seller) on any post-closing claims. We typically advise sellers to engage with an insurance broker to scope the coverage, identify any potential gaps in coverage (see below) and then bring a proposed policy to the buyer early in the negotiations. If done correctly, and particularly as part of the competitive sales process, we have found that sellers can utilize these policies very effectively to achieve a relatively “clean break” from their investment post-transaction.
- Be proactive about identifying “gaps” in coverage.One of the bigger points of contention when negotiating transactions with R&W insurance is the scope of the insurance coverage. In recent years, the scope of R&W insurance has broadened to the point that many buyers are comfortable with it as their primary source of recovery for indemnification claims. And some buyers have even become comfortable with an R&W Insurance policy as their sole source of recovery (subject to the limited seller escrow described above). However, for many buyers considering an R&W Insurance policy, they will be very focused on ensuring that the policy, itself, when combined with the seller indemnification obligations, provides them with the same protection that they could otherwise negotiate in a market M&A agreement. For general representations and warranties, there is not usually much difference. However, when it comes to specific indemnities, insurance exclusions, and some specific fundamental matters (such as intellectual property), there can be a “gap”—and sometimes a significant gap—in coverage when comparing R&W Insurance to standard market M&A terms.In this regard, it is extremely important for transaction participants to fully understand as soon as possible in the process the proposed scope of the R&W Insurance coverage. For many insurers, typical “exclusions” from coverage include: matters of which the insured (typically the buyer) is aware, matters that are subject to price or working capital adjustments, certain regulatory matters (such as those relating to healthcare laws, unfunded benefit plans and FCPA compliance).As noted above, for sellers that are likely to be subject to a number of exclusions, the utility of R&W Insurance can be greatly compromised, because (among other things) the seller will then be forced to reserve proceeds to cover the exclusions. So, we recommend that our clients speak with their brokers early in the process to identify any potential known gaps in an effort to ensure that they are addressed early in the process. If there are gaps in coverage, then sellers may want to consider ways to proactively close the gap as part of the sale dynamic. This could include a limited agreement to indemnify for the gap items up to some intermediate cap. But, of course, the broader the scope of this gap indemnity, the less valuable the R&W Insurance policy is in actually obtaining a clean break. In general, we have found that a little advanced planning and strategizing can go a long way in improving the effectiveness of the product.
- Other policy terms. In addition to the exclusions, several other policy terms are important in understanding the scope of coverage available to the buyer and any gap coverage for which a seller may have exposure. Key terms of R&W Insurance policies for buyers and sellers to consider generally include the following:
- Eliminating the right of subrogation against the seller
- Limiting the number and scope of exclusions
- The definition of “Covered Losses”—in many cases, buyers will be able to achieve better protection with respect to coverage for diminution in value and recoveries based on multiples of damages than they might otherwise receive in a standard, “market” purchase and sale agreement
- The term of the policy, which frequently lasts for six years (even for general representations and warranties)
- The amount of the premium—frequently between 2–5% of the policy limit
- The amount of the policy “retention”—frequently 1% of the transaction value (but subject to a step-down after a period of time)
- Coverage for specific/special indemnities—this may be difficult if there is known liability, but should otherwise be something that the insurer will cover depending on the nature of the matter
- Negligent misrepresentation and fraud coverage—One of the advantages of the “seller-flip” structure is that the buyer should be able to obtain coverage for negligent misrepresentation and fraud by the seller of which the buyer is unaware
- Loss payee coverage and the right to assign—This will be important for leveraged and other transactions where the buyer may need to collateralize or otherwise assign the policy coverage
- The definition of “covered costs”—buyers should try to obtain coverage for defense costs related to third party claims as well as all costs of claim prosecution
R&W insurance going forward
Although we have seen increased use of R&W Insurance policies in transactions over the last several years, there is still a fair amount of uncertainty as to whether or not the recent growth in usage of these policies will continue; or whether, the recent trend will be fleeting. The answer to this question will depend, almost exclusively, on whether or not R&W Insurance achieves the key objectives identified above: a clean break for sellers and the same (or better) representation and warranty coverage for buyers. With very little insurance claims history to date, it is hard to know for certain one way or the other whether R&W Insurance will actually satisfy these key objectives over the long term. However, in the short term, in light of the increased interest in placing R&W Insurance shown by insurers and the current seller-favorable M&A climate, we expect to see these policies with increasing frequency in private M&A transactions.