13 August 2012
It is no secret that M&A activity in the UK (and elsewhere) has been variable over the past few years. Confidence in global and local economies remains relatively low, with the uncertainty over the Euro and the future direction of regulation in certain parts of the world doing little to improve this mood. A general lack of confidence does not inspire deal flow.
Set against this backdrop, M&A deals are hard to do at the best of times. The interests and objectives of sellers and buyers are generally discordant. Sellers want the highest price for little residual risk and liability, whereas buyers want the lowest price with maximum recovery channels. Risk allocation is always a tricky negotiation area, often influenced by market conditions and the respective bargaining strength of the parties. Recent trends have seen cash ready buyers re-emerging but with more risk adverse attitudes, often seeking walk away rights for events occurring between exchange and completion (e.g. those which cause a material effect on the target business). In addition, buyers are generally unwilling to enter into transactions if the warranty package being offered is too limited or there are concerns over the enforceability of those warranties. These challenges are of course not insurmountable and deals still get done, either with the use of well-known escrow accounts and retentions or increased liability thresholds. However, these tools are not attractive to all sellers and the last few years has seen an increase in the use of warranty and indemnity insurance as a means of bridging the gap. So what is the appeal?
W&I insurance is certainly not a new product, but its cost, complexity and coverage is radically different to the first contracts pioneered in the 1970s. W&I insurance has developed into a popular and sophisticated product which can provide cover for losses arising from a breach of warranty under an SPA and for claims under a tax covenant. Historically, sell-side policies featured prominently in the market and indemnified vendors for losses arising from a buyer bringing a valid warranty claim, as well as defence costs. Sellers remain primary liable to the buyer, but they are indemnified by the policy responding. However, buyers are now also benefiting from W&I insurance and buy-side policies are becoming increasingly more common-place. These policies also respond to damages following insured breaches of the SPA and tax deed (including fraud) as well as defence costs, and are often used where the buyer cannot recover from the vendors due to limitations or caps in the SPA. In an environment of global economic challenges, buy-side policies help ease concerns to concluding transactions by enabling a buyer to "top up" a seller's capped liability. By offering more protection against downside risk, they also negate the requirement for the use of escrows or indemnities, providing certainty and finality to the parties.
Trends and features
Before the financial crisis, sellers were in a strong position and were able to offer less protection to buyers. The change in market conditions has given buyers more power, but sellers still aim to set their liability low. The M&A insurance market has therefore grown in popularity and W&I insurance policies have developed into bespoke contracts which can be delivered in a relatively short-time frame and (given the number of underwriters now offering the product) is competitively priced. The capacity for individual transactions has also increased which has resulted in greater up take.
Whether the beneficiary is the seller or the buyer, the level of cover is broadly the same. The limit on policy coverage will, however, depend on the negotiations between the parties. A sell-side policy can insure the full amount of the seller's liability under the SPA and tax covenant, or a lower amount. Buy-side policies can cover the full amount of the consideration, but in broad terms up to 50% is covered. Premiums are calculated on the total limit of insurance and are usually in the region of 1% to 2% of limits purchased in the UK, subject to the specifics of the deal. Underwriters will also require an "excess" or "attachment point" before the policy responds. Recent trends have shown these to be between 0.5% to 1.5% of the policy coverage in the UK. Additional costs will comprise the broker's fees or commission and the underwriter's due diligence fees. Depending on the underwriter, these fees may be waived or be included within the premium when the policy is purchased.
To be able to provide an adequate level of cover, an underwriter will require information about the nature of the transaction, details of the negotiation of the warranties and comfort that a sufficient disclosure and due diligence process has been undertaken. However, the requirements of the underwriter are not onerous, intrusive or disruptive, and early access to the underlying transaction documents and short telephone discussions with the seller or buyer will suffice. An insurance broker should be engaged at an early stage in the transaction so that they can examine the deal in detail, seek indications from appropriate insurers and obtain competitive pricing.
- Advisers should give early consideration to the use of W&I insurance in the deal timetable. The engagement of a broker at an early stage of the deal will allow plenty of time to negotiate an appropriate level of cover. W&I insurance is generally available globally, and therefore can be used on a variety of transactions of differing size and complexity.
- W&I insurance should not be seen as a replacement to a thorough due diligence or disclosure process. It remains important that material issues can, where possible, be dealt with upfront rather than by a subsequent warranty claim.
- Advisers should ensure that the W&I insurance policy exclusions are properly understood. These policies generally exclude fraud (on the sell-side), purchase price adjustments and forward-looking warranties. On the buy-side, if the policy does not respond due to its terms and conditions, the buyer will have no recourse to its loss if it has exhausted its recovery channels against the seller. Importantly, therefore, the SPA and the policy coverage should be reviewed together in order to identify any gaps before completion.
- Sellers and buyers should aim to negotiate with insurers so that the policy excess will be eroded by both insured and uninsured losses. This is particularly important for a buy-side policy which has been structured to "top up" to a seller's cap.
The insurance market has withstood the effects of the global financial crisis and is able to offer practical solutions to parties' risk profile in M&A transactions. The developments over the last few years deservedly puts W&I insurance high on the agenda, and this product should be considered as a normal part of an M&A transaction rather than the exception.