So far this year, deal parties are approaching M&A with cautious optimism. This series of Cooley M&A blog posts include some brief observations that offer some M&A highlights over the past year and our thoughts for the year to come.
Rep & Warranty (R&W) Insurance is Here
Previously, transaction insurance (or R&W insurance) was used sparingly and predominantly by East Coast private equity funds. PE funds have historically found R&W insurance to be attractive on the buy-side to enable them to make more competitive buyout bids for private targets by foregoing large escrows and significant post-closing indemnifications from targets. At the same time, when the PE fund is on the sell-side, it will insist that the buyer purchase R&W insurance to protect the fund’s risk exposure to breaches of representations and warranties by its portfolio company in the sale. Outside of the US, R&W insurance has already become widely used in private M&A deals in Europe by both PE funds and strategic buyers alike.
As the underwriting process has streamlined, and premiums have come down in the US, R&W insurance has secured a significant position in the M&A toolbox for middle-market M&A nationwide (outside of the PE context). Most financial buyers and now many strategic buyers increasingly use these policies as a means to manage risk and to help facilitate a deal. We note, however, that R&W insurance has not gained significant market share in private life sciences transactions. This may be due to the strategic nature of most life sciences deals (which makes it harder for buyers to offer R&W insurance as a price differentiator in a competitive auction) and also due to the potential exclusions from coverage that make it less attractive to buyers.
In its typical use, a buyer agrees to purchase R&W insurance for breaches by the target of any of its representations and warranties in the purchase contract up to a policy cap equal to what a seller would otherwise deposit into an escrow fund or cap an indemnity. Premiums have ranged between 3-4% of the policy limit for a multi-year policy that expires, generally speaking, a little later than the expiration of the survival period for the respective representations and warranties in a typical purchase agreement that does not have R&W insurance. The purchaser generally agrees to pay for the first layer of liability, in an amount typically equal to an indemnity deductible and then the seller agrees to pay for the next layer of liability (which may be funded through an escrow), with the policy kicking in thereafter for the seller’s exposure up to the policy amount. Increasingly, we are seeing deals structured with no seller contribution for an increased premium. With the underwriting process now shortened to about a week and policy negotiations standardizing, R&W insurance is poised to become more mainstream in non-private equity deals.
Although it is too early to tell whether the volume of claims will make these policies sustainable – or whether strategic buyers will agree to buy R&W insurance considering their relative leverage in most transactions – targets and buyers alike should be prepared to discuss insurance as a component of any private deal.