Overview of recent trends in warranty insurance in M&A transactions
By Andreas Stilcken and John Cunningham
In the current economic climate, the appetite of buyers to take on risk in an M&A transaction has greatly decreased. At the same time, sellers remain under intense pressure to minimise outstanding liabilities, and achieve a “clean exit” from the business they are selling. This article looks at the use of warranty and indemnity insurance (“warranty insurance”) as an innovative way to “bridge the gap” between buyer and seller in negotiations and as a means to help close transactions where the risk gap between them would otherwise mean that an agreement could not be reached.
What is warranty insurance?
Warranty insurance is a risk management tool for M&A transactions. For sellers, it can be a strategic tool to increase their rate of return and to achieve a clean exit from the business they are selling. For buyers, warranty insurance can increase their financial protection where there are concerns over recoverability from a seller, or afford them a powerful opportunity to differentiate their bid in a competitive auction process. The warranties continue to play a key role in the underlying M&A transaction, both in flushing-out disclosures and in clarifying contractual liabilities. However, the dichotomy between the buyer’s desire for maximum protection on a warranty breach and the seller’s intent to accelerate receipt of sale proceeds can be eased or even removed through the use of warranty insurance. Warranty insurance can be used to (a) extend the period of warranty coverage (allowing the seller’s liability to end at, or soon after, completion, and the warranty insurance coverage to extend the period of warranty protection for the buyer) and/or (b) increase the warranty coverage through a “top-up” policy (where, for example, the seller would be liable for the first portion of the liability under the SPA, and the warranty insurance coverage would apply for amounts sought by the buyer above the aggregate cap under the SPA).
Why take out warranty insurance?
Warranty insurance is commonly used where financial sponsor investors are exiting a business and not willing to give commercial warranties. For example, private equity firms usually cannot close their funds or make distributions to their limited partners where warranties remain outstanding. Notwithstanding its reputation as a private equity seller tool, warranty insurance should be treated just as much a tool for assisting buyers more generally (private equity or otherwise, and including corporate bidders competing with private equity bidders). It gives buyers a chance to enhance the attractiveness of their bid by taking a lower cap on the seller’s liability or a shorter warranty period, and then obtaining top-up insurance to extend the cap and time limits. An effective strategy for a seller (in particular in an auction process) can be to “staple” warranty policies to bid documents in much the same way as vendor due diligence reports, giving rise to a new auction seller control device tool. In such cases, the seller typically instructs an insurance broker early on in the transaction process, and negotiates an appropriate draft insurance policy on the back of a draft SPA with an insurer before distributing the SPA to bidders. The related process letter makes it clear that the seller is not prepared to accept liability for the business warranties, intending instead to help the buyer procure warranty insurance to cover such liability for the benefit of the buyer (and has already commenced discussions with insurers regarding such coverage). Even if the stapled warranty insurance is not used by a buyer, it can be a powerful negotiation tool for a seller to reduce escrow amounts or escrow periods, and/ or warranty thresholds or periods.
The key development is that premium levels on buyer and seller policies are now substantially the same, being between 1% and 2% of the insured limit on European deals (commonly 1% to 1.5% in the UK), which has greatly increased the viability of buy-side warranty insurance products. We note, however, that for certain transactions where the insurers perceive the risk to be higher for a variety of reasons (for example as a result of inadequate disclosure or issues raised through due diligence), the premia for warranty insurance could be higher (although rarely exceeding 2.5% to 3% of the insured limit on European deals). A seller’s residual warranty liability will in practice usually be at least 1% of the deal value, as insurers and buyers will otherwise be sceptical about the quality of disclosure. It has also become commensurately easier to obtain warranty insurance on deals in emerging markets, increasing its usage on international transactions and the benefits it can afford when measuring cost against the opportunities it brings to manage risk. We note that there are currently at least 13 insurance carriers offering warranty insurance, many of whom are Lloyd’s syndicates. A buyer can choose the desired level of cover under a buyer policy. Factors affecting premium levels include: the insurance limit as a percentage of deal value; excess and de minimis levels; the amount of the warrantors’ residual liability; and the scope of the warranties and seller limitations. Brokers’ fees are usually payable by the insurer, although in certain cases a break fee may be required if the policy is not taken out. Insurers often require the payment of a non-refundable fee to cover due diligence costs in assessing the target and whether or not to provide the warranty insurance with respect to a transaction. This fee is normally deducted from the premium payable if the warranty insurance is secured.
Detailed consideration will need to be given to the insurance policy, to ensure it mirrors so far as possible equivalent aspects of the SPA. Ideally the policy cover should match the warranty period in the SPA, along with the de minimis and any other seller limitations. Key issues to consider will include: whether the excess will be eroded by excluded losses (important in the case of a buyer top-up policy); interaction with conduct of third party claims clauses and seller limitations on losses recovered under insurance in the SPA; and exclusions from cover (such as known matters identified from the buyer’s due diligence or the seller’s disclosures; the insured’s fraud; forward-looking warranties and purchase price adjustments). Careful consideration will need to be given to the buyer’s knowledge exclusion, to ensure that this is limited to the knowledge of relevant identified individuals who are members of the “deal team” and reflected in the signing/closing no claims declarations required by the insurer.
Warranty insurance (as with any insurance) is secured through brokers who act as the interface between the insured and the insurers. Before going out to the market, the brokers will raise a series of questions with the proposed insured, designed to assess insurability of the transaction. In practice brokers do not approach insurers until they receive the buyer’s mark-up of the SPA. On the basis of the draft SPA and other the preliminary information, insurers who are willing to write the insurance will issue non-binding indications of their proposed cover. The broker will then summarise these offers in a report for the client so that the client may select its preferred insurer. Once selected, the chosen insurer will then conduct underwriting due diligence. An important part of this due diligence is an underwriting call with the client and its legal and financial advisers. The parties will then negotiate final policy terms. It usually takes two to three weeks from when the broker is first instructed to negotiate the policy. Any proposed transaction timeframe should take into account the fact that insurers will need to review the transaction and due diligence documents, meaning that confidentiality agreements will be needed and due diligence reports will need to be released (on a non-reliance basis) to the insurer.
Warranty insurance on M&A transactions is more accessible now than ever before. Its value should be judged in the context of the pressure on sellers in the current economic climate to achieve a clean exit and the benefits that insurance products may afford compared to other warranty security devices. Parties would be well advised to give serious consideration to using warranty insurance may provide to facilitate M&A deals on satisfactory terms.