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Amid the “Sellers’ Market,” PE Sponsors Use RWI to Transfer Risk and Gain a Competitive Edge
Introduction
A robust economy combined with record amounts of dry powder (cash reserves kept on hand by investment firms or available for call, to be used for acquisitions) are two key factors contributing to an active and extremely competitive M&A market. This competitive landscape is empowering sellers to insist not only on higher pricing multiples but also less risk. To compete, buyers must complete their due diligence efforts quickly and rely on smaller post-closing escrows to secure purchase price adjustments and other indemnification obligations.
RWI, especially when used creatively in conjunction with escrows, is one of the tools that can help PE-sponsored buyers put forth more competitive offers for companies in which they seek to invest by shifting certain post-closing risks to an insurer and allowing sellers to receive a greater proportion of the purchase price at closing. With the use of RWI continuing to increase, it is important for PE firms and their advisors to understand RWI and select an experienced, knowledgeable transactional insurance broker who can help explain how various types of RWI can be used in conjunction and collaboration with traditional indemnification solutions such as escrows.
What is Reps and Warranties Insurance and How Is It Used in M&A Deals?
RWI covers losses that result from breaches of the sellers’ representations and warranties in an acquisition agreement. When the buyer is the insured party under “buy-side RWI” coverage, the insurance can reduce or eliminate the need for a general indemnification escrow. However, specific escrows are often used to fund all or part of the RWI deductible and to secure the sellers’ obligations regarding purchase price adjustments and certain identified or known matters, such as existing or expected lawsuits or environmental issues.
When the sellers are the insured parties under “sell-side RWI” coverage, they remain liable to the buyer pursuant to the underlying acquisition agreement. The insurance serves to protect the sellers when the buyer seeks indemnification from them with respect to breaches of their representations and warranties, regardless of whether or not the buyer’s indemnification rights are secured by an escrow.
RWI is flexible and can be used in a number of ways depending on the deal’s structure and the parties’ needs. For example, buy-side RWI coverage can provide a buyer with additional protection above a traditional escrow when a buyer is not able to negotiate for the preferred amount of escrow, or it can serve as the buyer’s backup source of protection if the sellers’ indemnification obligations are unsecured. It can also be used to give the buyer an avenue for recovery in “no seller indemnity” deals, such as when distressed sellers need to arrange for the entire purchase price to go to their lenders to repay existing debt. Sell-side RWI can be used to protect sellers against the risk that the buyer will make a claim against an escrow, and it can also be used to protect against the risk that a buyer may seek indemnification from the sellers in excess of an escrow.
Why is Reps and Warranties Insurance so popular right now?
Because of the hotly contested M&A environment noted above, buyers who understand how to use RWI in conjunction with escrows can attain a competitive advantage when bidding on acquisition targets. And, many sophisticated sellers insert buy-side RWI requirements in their auction documents or other offering materials, thus making RWI part of the overall deal structure.
The competition created in the RWI market as more insurers entered the space over the last 2 to 3 years has also resulted in downward trends in RWI premium rates and deductible levels, as well as narrower or fewer exclusions in RWI policies. Improvements in the underwriting process that allow for quicker and more efficient underwriting have further facilitated the acceptability of RWI as an alternative or supplement to traditional indemnification solutions.
What Insurers Know that You Don’t Know
With pricing and coverage trends in flux and new insurers entering the RWI space, data regarding what constitutes profitable premium levels and appropriate deductible levels is dispersed among a large number of insurers and transactional insurance brokers. And, the recent popularity and increased awareness regarding RWI has resulted in not only more repeat users of the insurance but also more first-time users, all of which contributes to the changing trends and disparate information.
Insurers who have been active in the RWI market for long periods of time and who track their historical data may insist on different coverage terms than newer entrants that don’t have as much historical data, not only with respect to premium levels but also with respect to things like deductibles and exclusions. This may result in tighter terms and conditions (when an insurer believes its data indicates market terms are too loose) or more expansive terms and conditions (when an insurer believes its data indicates market terms are too tight). In either scenario, the insurers likely have more data than the insurance purchaser, further reinforcing the need for an experienced, knowledgeable transactional insurance broker who can help the insured review and analyze competing quotes from multiple insurers and who can work together with the insured’s attorneys if they are experienced with using RWI across many M&A transactions.
Conclusion
RWI is an increasingly popular indemnification solution that can be used by buyers or sellers in a number of ways depending on the circumstances of each M&A transaction. Buyers, sellers and M&A advisors who understand how to use RWI and escrows collaboratively and who work with an experienced transactional insurance broker who can help select an efficient indemnification solution for any given transaction, whether it be escrows, RWI or a combination of both, should continue to see a competitive advantage when acting on the buy-side and will be able to shift risk to the insurer and receive more deal proceeds at closing when acting on the sell-side.