Unexpected Drains on Private Equity Productivity

Here's a common scenario you have likely encountered - and if you haven't, you probably will. You've got a hot company in your portfolio that you are selling. The term sheet is done and the merger agreement is being actively negotiated by both sides, including the representations and warranties section and the working capital adjustment provision. However, what's often overlooked during these negotiations is the additional work those provisions create downstream. Many of our private equity clients come to us asking “I have a lean staff and we’re buried with so many other pressing things, how can I outsource all of this work without sacrificing results?”

For sake of discussion, let's assume that representations and warranties insurance (RWI) is agreed-upon by the deal parties as the way to backstop the seller’s representation and warranties in the merger agreement. In this deal, let’s assume the policy is either sell-side or involves a “seller flip” scenario. (While RWI policies can be a great indemnification tool, here's a quick article on the advantages and disadvantages of Escrow vs. Representations and Warranties.) Let's also assume that, like many deals, there's a purchase price adjustment built into the merger agreement that will need to be dealt with 60–90 days after closing. Simple enough.

Now, fast forward to the time when you're faced with dealing with all of this. With this common deal structure, at least 3 service providers are now in play for you to recruit, hire, educate and manage, each of whom works independently of one another.

First, an RWI broker will take this deal to insurance carriers and procure proposals for coverage. The premium cost is important to you of course, but perhaps more important is being armed with relevant data with which you can evaluate exclusions from coverage that will invariably come back in the proposal. Wouldn't it be useful to have actual indemnification-claim data across hundreds of deals to know whether those exclusions are real risks? Unfortunately, most brokers don't have broad industry information on M&A indemnification claims to inform the policy-purchase process. Not to mention, if you need to make a claim under your policy, most RWI brokers have limited experience in handling actual claims. Anyway, RWI broker, engagement #1, check.

Second, as expected, the RWI proposals all require a retention (or deductible). Sometimes the sellers are on the hook, sometimes the buyer is on the hook, and sometimes they split it. Regardless, when the sellers have some responsibility for covering a part of the retention, buyers often require an escrow to cover that obligation to eliminate the credit risk of the sellers, not to mention the administrative nightmare of ”passing the hat” amongst the sellers in the absence of an escrow. Further, Since RWI policies never cover purchase price adjustments in favor of the buyer (i.e., additional money owed by the sellers), it's common that an escrow is established at the closing to cover this, too. The same escrow account could be used to cover the seller’s portion of the retention amounts noted above, so that's nice. However, establishing an escrow means calling a bank, filling out a bunch of paperwork, and setting up the account. This can be tedious and is getting ever more complicated with tighter review and regulation by the banks. It's a lot of work for a small amount of money. But...it's still needed. Escrow bank, engagement #2, check.

Third, you may decide to retain your accounting firm to handle the details of the purchase price adjustment (“PPA”) once the buyer delivers the PPA statement after closing. We hear all the time from our friends in private equity that they don't like to handle the details of the PPA process in-house. Too much of a time-sink for most folks on staff at the fund. So, they hire their outside accounting firm. Accounting firm, engagement #3, check.

Three engagements—RWI broker, escrow bank, and accounting firm. None of them work together; they each do only what they’re hired to do. What seemed straightforward is now a lot of work for you. At least three series of calls to educate the providers about the transaction and explain what you need, not to mention keeping them all up-to-date as the deal progresses.

While thinking about downstream work during deal negotiations is tedious, it is important. Finding ways to mitigate the potential work early in the process—for example, by engaging a single provider who can potentially provide all three services—can reduce overhead down the road, for you, your team and your deal.