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Mergers and Acquistions

Representations and Warranty Insurance

M & A experts worldwide are using an insurance policy known as a Representation and Warranty (R&W) to transfer risk from the parties in the transaction to an insurance company. R&W policies are designed to "step in the shoes" of a seller to pay indemnification claims made by the buyer for the inaccuracies of the representations and warranties outlined in the purchase/sale agreement. Due to the low cost of R&W insurance, sellers are driving the demand for these policies rather than accept large, lengthy escrow or withhold terms. Buyers are discovering how R&W insurance can enhance their bid without having to raise their offer.
 
For The Seller:  
 
  • An R&W policy replaces the indemnification provision and reduces the escrow to 1% or less of the purchase amount. 
  • Enables early and final distribution of proceeds to investors.
  • Locks in the return and provides a clean exit as contingent liabilities are covered.
  • Expedites the sale by getting the indemnification issue "off the table"

For The Buyer:

  • Distinguishes bid in a competitive auction, without raising the offer price. 
  • Eases concerns about collecting on seller's indemnification
  • Preserves relationship with seller. In the event the seller is remaining with the company, the buyer pursues the R&W insurer, NOT the seller in the event of a breach.

Underwriting & Placement Process:

Secure information for underwriters: 

  • Acquisition agreement (draft version is acceptable) 
  • Seller's audited financials
  • Seller's disclosure statements (if available)
  • Offering memo

Within 3 to 5 business days, a no cost, no obligation, non-binding indication (NBI) is provided.

Due diligence process is commenced with selected market - requires payment of non-refundable underwriting fee

Conference call is arranged between the underwriters and the applicant's attorneys. 

Final terms are issued within two (2) business days of the final conference call. 

 Policy Basics: 

Limit Capacity - Up to $100MM on a single policy. Excess capacity up to an additional $400MM available as needed. 

Retentions - commonly 3% to 4% of the purchase price. Reduces over time.

Premium - 3% to 4% of the limits purchased (including taxes and fees). Minimum premium is $300,000. 

Underwriting Fee - From $25,000 to $35,000 in additiion to the premium. Covers the cost of the Insurer's attorney's fees and due diligence costs to review and manuscript a policy. Non-Refundable. 

  • Sellers Policy - checks how the seller developed R/W
  • Buyer's Policy - checks how the buyer vetted the Seller's R/W 

Terms - designed to match the survival period. Post survival extensions available upon request.

How much does the policy cost, how much does it cover and for how long? 

As the volume of R&W insurance increased, carriers are trying to standardize policy language. But this coverage is customized for each deal, and many of terms are negotiable. The most common approach is to secure a policy that provides protection up to 10% or 15% of the deal's enterprise value (typically the combination of the equity and debt of the company). In the U.S. the premiums are typically 3% to 4% of the policy limit, substantially lower than were a few years ago. A common term is three-to-six years for breaches of nonfundamental representations--basic claims like the accuracy of financial statements and customer contracts. The limit is usually six years for breaches of nondamental representations--core issues such as whether the seller actually owns the company being acquired and that it's tax returns weren't fraudulent. 

Which party pays for the premium and covers the deductible in case of a claim? 

In general, these details wind up as part of the broader negotiation of the terms of the acquisition agreement. Either the buyer or seller can offer to sweeten the deal by paying for the R&W coverage.

Typically, there is a retentiion (similar to a deductible) that calls for the buyer to absorb  the first losses related to the policy. Sometimes there is a second retention that calls for the seller to cover some of the losses as well. For example, the buyer might be responsible for the first losses up to a limit of 0.5% of the deal's enterprise value and then the seller would cover losses of the same amount, leaving the insurance company paying claims above 1% of the enterprise value up to the policy limit.

Imposing a retention on the seller might seem to be inconsistent with a transaction specifically meant to mitigate the seller's contingent liabilities. Still, both buyers and insurance companies worry about the moral hazard of an arrangement in which sellers have little incentive to ensure their representations and warranties are accurate. This often means that the insurance is combined with a traditional escrow arrangement, albeit a smaller one than would otherwise be needed.

Indeed, if the seller has no "skin in the game" many insurance companies will insist that the buyer has a retention of at least 1.5% of the deal's enterprise value. 

What is the timetable for underwriting and issuing the policy? 

While the process of underwriting a R&W insurance policy usually does not delay a transaction, it crerates some additional milestones for the deal's closing. It's essential to start shopping for R&W insurance early in the process and to ensure the selected carrier understands the proposed timetable. As dealmakers get used to the unique rhythms and requirements of R&W insurance they will find it can be a part of a smooth process and diffuse the anxiety of closing a transaction.