M&A: Mind the gap!
Risk & Insurance in Private Equity and M&A
Warren Buffett of Berkshire Hathaway once said: "Risk comes from not knowing what you're doing".
Even if you know what you're doing, there can still be risk, of course, but, at least, in theory that risk should be more manageable. Mergers and acquisitions ("M&A") activity is an area of risk particularly if it is not managed properly.
In the more risk averse world in which we now find ourselves, it is perhaps no wonder that M&A activity levels have been down.
However, the flip side of risk is opportunity – and M&A does present real opportunities for businesses. Indeed, there seems to have been a recent uptick in M&A activity. There is a sense now that businesses, which have been focussed to date on balance sheet management and stripping out costs from their businesses, are looking for ways to grow or better deploy scarce capital, and M&A is one way of doing just that.
Current M&A activity
It is fair to say that M&A activity in the UK and elsewhere has been patchy over the past few years. There are a number of reasons for this.
For a start, confidence in the global and local economies generally remains quite low. There is also uncertainty over the future direction of regulation in certain parts of the world which breeds a lack of confidence. Confidence is an important ingredient in the deal-making mix.
There is also a price gap between sellers and buyers. As far as buyers are concerned, sellers are still expecting too much for their businesses. As far as sellers are concerned, buyers are undervaluing their businesses. This gap might have narrowed recently, but it is still there.
In addition, sellers are concerned to ensure buyer deliverability - that is, that a buyer will be good for its money and can generally deliver on the deal. The lack of readily available bank funding has not helped alleviate this concern. Nor has the tendency of buyers to include a number of conditions to completion, such as conditions relating to there being no material adverse change in the target business between signing of a deal and its completion. The risk for a seller is that if any of these conditions is not met, then the buyer has the right to walk away from the deal.
For their part, buyers are concerned at the covenant strength of sellers. If a successful warranty or indemnity claim is brought, will a seller be good for the claim? Buyers are investing more time and effort in due diligence, and are concerned about what skeletons may lurk in the target business' cupboard. Buyers are also concerned to ensure that material issues are, where possible, resolved before completion. As a consequence, execution risk (that is, the risk that a deal will not complete) has increased.
So, how can the gap between sellers and buyers be bridged? Well, there are a number of solutions, many of which will involve careful negotiation and will depend in part on the relevant parties' respective bargaining strength.
For instance, to minimise concerns over covenant strength, a parent guarantee could be offered, assuming the parent has the requisite covenant strength. If a claim is subsequently made, this may require the parent to make a provision in its accounts which may not be ideal. An alternative is to lodge monies in an escrow account, but this has the disadvantage of tying up money potentially for some time which cannot then be put to work elsewhere.
There has also been an increase in the use of earn-out provisions, with part of the purchase price being dependant on the target business meeting certain performance or other criteria. However, this is not ideal from a seller's point of view because following completion the seller no longer has any control over the business it has sold.
The purchase price may also be subject to adjustment depending on the outcome of a completion accounts process. This process has become more robust in the recent past. One compromise is a "locked box" mechanism which involves agreeing the financial position of the business to be sold at a particular date prior to signing. This enables the buyer to price the deal accordingly. Thereafter, the financial position is locked up, with no further adjustment being made to the purchase price which is good news from the seller's point of view. However, in order to provide comfort to the buyer, the seller does provide certain undertakings to the buyer that it will run the business in the ordinary course from that date until completion and will, for instance, not incur any material expenditure.
Insurance as a solution
As seen, there are a number of tools in the proverbial toolkit to help bridge the gap between sellers and buyers. Another such tool, which has seen a recent increase in popularity against a backdrop of reduced M&A activity, is warranty & indemnity ("W&I") insurance.
This product was once quite a clunky, expensive product but it has developed a long way over recent years. Indeed, it can now be fairly bespoke, delivered in a short time-frame, and is competitively priced.
If a seller has capped its liability, W&I insurance may be used to top it up. If there is concern over the seller's covenant strength to meet W&I claims, then again cover may be bought to protect against this. Also, if a buyer's due diligence has uncovered particular issues, which could result in a liability arising at some point in the future, a W&I insurer may be willing to underwrite some or all of this risk.
As the insurance market itself has generally shown over the past few years, it has, by and large, generally withstood the untoward financial and economic winds which have blown its way. A big part of the reason for this is that the insurance market deals in risk every day – it is in the business of understanding risk and dealing with it appropriately as part of its core competency.
As one US writer one wrote: "There is only one risk you should avoid at all costs and that is the risk of doing nothing". I think all M&A lawyers would agree with this sentiment!