What You Need To Know About Representation and Warranty Insurance
The allocation of post-transaction risk is a key area where bids for assets can differentiate themselves. And representation and warranty insurance is a great arrow to have in your quiver, whether you are a seasoned acquirer who has used it many times, a strategic that has traditionally relied on escrows for risk allocation, or a founder selling your business. Let's talk about this.
Erica Villanueva: Hi, everyone, I'm Erica Villanueva, an insurance recovery partner at Farella Braun + Martel. I'm here with my colleague, Greg LeSaint.
Greg represents and advises private investment funds, venture capitalists, operating companies, entrepreneurs, and private clients in complex business transactions, including buy-side and sell-side acquisitions, joint ventures, and control investments.
He regularly advises clients on securities laws and the regulation of investment advisors in general corporate governance, and he works across multiple industries including tech and software and consumer products. He has an extensive history working with private equity firms on both management issues and portfolio investments.
Welcome, Greg. Looking forward to today's discussion.
Greg LeSaint: Thanks Erica.
Erica Villanueva: So we're talking about rep and warranty insurance today, first what is representation and warranty insurance, and how is it used in mergers and acquisitions?
Greg LeSaint: Sure. So representation and warranty insurance is an insurance product that's been around for about 20 years. It's used in mergers and acquisitions to provide the parties with an additional source of recovery for losses that result from breaches of the seller's representations and warranties in the purchase agreement.
So it operates similarly to many other insurance products. It has premiums, retention amounts, limits and exclusions. It's a tailored product that deals with a key risk that arises in any acquisition.
So in every acquisition, the buyer and the seller share to some extent the risk that one or more of the seller's representations and warranties is not in fact true. So traditionally, the liabilities from breaches of seller's representations are satisfied either by buyer's retention of that loss, so the buyer just accepts the cost if it happens to arise, or through recourse portions of the seller's consideration.
So that's done through the use of escrows, hold backs, offsets to earn outs, and then there's also recourse through litigation directly against selling stockholders.
A representation and warranty policy adds an additional recovery source that can be used to satisfy liabilities from sellers' breaches of its representations, either as a supplement to the traditional sources that I just mentioned, or as a full replacement for those.
Erica Villanueva: You said that rep warranty insurance has been around for about 20 years. How is it currently being used in the M&A market?
Yeah, so 2021 was a seller's market. There was simply a lot of money chasing a limited number of deals. And it's not clear just yet how that trend is going to continue into 2022 with the anticipated Fed rate increases and the expected increase in the cost of capital.
But just looking at 2021, the market circumstances gave sellers a lot of leverage to negotiate deal terms that would otherwise be highly unusual in previous markets. So whenever there's competition among buyers for a particular target, setting aside the fit of the companies and synergies for strategic acquisitions, there are generally three areas where bidders can really differentiate themselves from one another and that's price, conditionality, and post-transaction risk.
Sophisticated bidders are often looking at and analyzing the same financial information, and they'll each come to their own conclusions about the right price for the deal. Assuming that price and conditionality are relatively constant across the bids, which isn't necessarily the case, then the allocation of post-transaction risk is an area where bids for assets can really differentiate themselves.
So quite simply, if a buyer has recourse to a representation and warranty policy, then more cash can be paid to the sellers at closing, and less of the consideration being paid to the sellers is at risk of being clawed back for breaches of those representations.
For private equity acquisitions, the use of representation and warranty insurance has become fairly standard, and strategic acquirers are more often using it as well, although they've been much lower to adopt it. But a strategic acquirer buying another company, the product doesn't always make economic sense in that situation since there's typically a lower cost of capital between strategics. They have reserves while private equity acquirers rely on their capital commitments and ability to access debt markets for their capital.
Erica Villanueva: How could our clients benefit from using rep and warranty insurance and their deals?
Greg LeSaint: So I would say for founders that are interested in selling to either a private equity acquirer or a strategic acquirer, know how this can be used to maximize the amount of consideration retained by your shareholders after the acquisition. That's going to create a lot of value for your shareholders.
If by freeing up the consideration to be received by sellers so that it's not available to satisfy those potential liabilities from breaches of representations, the selling shareholders get greater comfort as to what their take-home consideration will actually be once the settles.
For strategic and private equity acquirers, one key benefit to using a representation and warranty policy arises in the context where there is a continuing working relationship with the sellers. So if issues come up with the acquired company, the strategic acquirer needs to decide if and to what extent it might go after the founders, some of whom may still be working for the company. So this can put the acquirer in a tough spot from a fiduciary perspective.
In that instance, having a separate pool of resources as a source of recovery can eliminate some of that tension. For buyers that want to retain the management team, that's hard to manage if you have claims against those people.
Erica Villanueva: I would say so. What's the process for obtaining a representation of warranty policy?
Greg LeSaint: If the parties to a transaction have decided that representation of warranty insurance is right for their deal, the buyer will typically start working with a major insurance broker to solicit quotes from insurers for the policy. And that's assuming that the buyer is footing the bill for that policy, which is largely the trend with current M&A markets.
The buyer will typically evaluate the quotes from the insurers and move forward with a single insurer, pay an underwriting fee so that the insurer can conduct its due diligence and work on writing the policy. In the deal context, it's important to keep in mind that this is an additional process that needs to happen alongside the negotiation of the underlying agreement. And the process needs to be managed effectively in order to meet deal closing timelines. Although you can add a representation of warranty insurance policy after a deal is signed, starting as early as possible is always the best approach.
I would say, keep in mind that the insurer also has its own process to manage. The insurer is going to rely on the diligence report of the acquirer, which means that the acquirer will need to advance its own legal due diligence as quickly and efficiently as possible, keeping in mind also that the ultimate due diligence report is going to be used to price the risk on the deal. So that's an important caveat for the attorneys that are drafting that due diligence report and the people that are tasking that operation.
From a process perspective, the buyer will need to make sure that it has someone driving that diligence process, scheduling the appropriate calls, meeting with specialists, experts, and target representatives. And remember that if things are left out of buyers' due diligence report, then they're more likely to be excluded from the policy. The insurers are not going to be able to get comfortable with something that they just have no knowledge of.
Erica Villanueva: Speaking of limitations on the coverage, what kind of limits does a typical representation and warranty policy have?
Greg LeSaint: Well, the first one and this came up a lot in 2021, is can you even get one? And then can you get one for a price that actually works for your risk analysis?
The market for rep and warranty insurance, just like every other market, is subject to supply and demand. There used to be only a few insurers that were in the space. Now there are close to about two dozen carriers that are underwriting policies.
And the increase in carriers has led to some downward pressure and pricing, but in 2021, the level of activity in the M&A market meant that demand for the product just outstrips supply. And once carriers hit their annual underwriting limits, they either can't bind an additional policy, or need to go to reinsurers and backup insurers in order to do so.
So that spike is temporary and those limits reset at the beginning of the year. Now that we're into 2022, you can might see a decrease in that pressure.
The deal size also plays a role here too. And since the policy premium is going to be based on the amount of the risk insured, the deal size has to be in a range where it's going to make sense to underwrite a policy for 10% of the purchase price. It's important for an acquirer to get a sense as quickly as possible of whether or not it's even going to be able to bind a policy since this covers a critical deal piece.
In negotiation, this risk management is fundamental even at the letter of intent stage. If the parties are basing their assumptions on the buyer obtaining a rep and warranty policy, and it ends up unable to do so, the parties will have to pivot to negotiating a traditional indemnity structure, which could create significant deal friction and come as a disappointment to the sellers.
And then second, I would say just like any other insurance policy, there are going to be exclusions. The rep and warranty insurer is not going to want to become a primary insurer of the business of the target. They're really there just to satisfy the risk around those reps and warranties. And generally it's the issues that come up in diligence that are either excluded or they get addressed as a separate line item for insurance. Things like cyber security, privacy, wages and taxes are often specifically excluded from the policy.
And then keep in mind also that knowledge qualifiers that are drafted into the contract are generally disregarded for representation and warranty purposes. So when you're negotiating that contract, it's more important for insurance purposes to focus on materiality qualifiers.
Third, a rep and warranty policy will not cover things like a purchase price, adjustment, damages for breaches of fundamental representations, or covenants, or losses from risks that the buyer was well aware of. In this regard, a representation and warranty policy is not a full substitute for a traditional indemnity package. And that's a pretty important point to be aware of when negotiating these deals.
So ideally, buyers would like to have guaranteed recovery for indemnifiable losses, but a rep warranty policy is not necessarily going to provide that. Like any other insurance product, if you make the claim, the insurer is going to conduct its investigation into the claim and make a determination to see if the policy actually covers that loss. That said, each insurer is going to have its own claims history which informs the market. So there's an incentive for carriers to not get a bad reputation by never paying out on claims.
Erica Villanueva: Yeah. And as you know, Greg, I'm an insurance practitioner, and you always hear that claims payment on these policies is very good, as long as it's within the core risk that the carrier agreed to insure. On that note, what would you say are the key takeaways for our clients about rep and warranty insurance?
Greg LeSaint: Most of our private equity clients are pretty well versed in this area. And so for them, I think it's really a matter of staying up-to-date on where the market is for the product, talking to a number of different insurers, and maintaining your network of brokers, just so you can keep an eye on where the product's moving. What you can expect in terms of timeline, what you can expect in terms of just general ability to underwrite these processes so that you can always meet the timeline for your transactions.
If you're a strategic acquirer that is considering using a rep and warranty policy in your next deal, I would also get familiar with the process early on in your negotiations with the target. Have some preliminary conversations with insurance brokers, and get a sense if the terms of your deal and the character of your target might make representation and warranty insurance a good option. If used strategically, it can really make you a more competitive bidder.
Now, for founders or key shareholders that are selling their companies, if you're in that boat, then I would say you should have a conversation early on with your deal broker about whether requiring representation of warranty insurance from the buyer could potentially help you retain more value in the transaction, and just what the appetite for the product is in the market at that time.
In a seller's market, buyers are more often taking on 100% of the cost of the policy, while either splitting or also taking on 100% of loss retention, which is typically at least 1% of the deal value. So there's a lot of value to be gained by sellers who are able to get their buyers to cover all of the costs and losses under the rep of warranty policy.
But the dynamics of the M&A market, as I've talked about, those might shift and with it the willingness of buyers to take on most, if not all, of the costs of the policies. In any event, incorporating it into your acquisition from the buy-side or sell-side can have tremendous benefits in dealing with post-transaction risk allocation. If the process is handled efficiently, it may eliminate the need for more contentious negotiations around certain allocations, and that can also increase transaction efficiency overall, which benefits all the parties.
Erica Villanueva: Great. Well, thanks so much, Greg. That's it for today. I'm Erica Villanueva. I've been here with my colleague, Greg LeSaint. You've been listening to Upside brought to you by the private equity and venture capital team at Farella Braun + Martel. If you have any questions about what we've talked about today, or suggestions for topics you would like for us to discuss, please email us at [email protected]. Thanks for joining us.
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