If you are looking to buy or sell a business in 2018, chances are you are thinking about representations and warranties insurance. It became enormously popular a few years ago, but its complexities are starting to reveal themselves. To cover that and other topics, we sat down with Michael Shaw, the chairman of the business and finance group at Chicago-based law firm Much Shelist, where he focuses on M&A and private equity.
Axial: As someone who sees a lot of middle market deals, what is a new pattern you are seeing?
Michael: We’re starting to see representations and warranties insurance shake out a bit. When it first came out, it was treated like the greatest invention ever, but while useful, it has not proven to be a perfect solution.
Axial: What’s a short description of reps and warranties insurance for those unfamiliar?
Michael: In a typical purchase agreement, the seller makes a lot of representations and warranties about their business. If something comes up after the deal that breaches one of those representations and warranties, the buyer is indemnified and can get value back. This has always led to tough negotiations and fights between the two sides. With reps and warranties insurance, the buyer collects from the insurance company, not the seller. Sellers like it because their downside risk is mitigated and buyers like it because they can go after a well-capitalized insurance company rather than an infidel seller.
Axial: What is happening with reps and warranties now?
Michael: Good deals are very competitive right now. From the buyer’s perspective that means there is pressure to be able to move fast and close but the high valuations are increasing pressure to run careful due diligence. People are winning deals by promising to close in 45 days or less.
Reps and warranties insurance has recently become a very popular way to try to speed through some of the trickier parts of a negotiation, but there’s been a bit of a pullback recently. In theory, everyone loves the idea of having an insurance company on the hook, but the reality is that insurance companies will fight to not pay out a claim, and they have more resources to do that compared to an individual seller.
Private equity firms are also becoming more reluctant to make claims because of the reputation risk. A private equity firm is typically buying a company from an individual only once, but it is dealing with insurance companies on a repeated basis. PE firms are worried that making a claim will hurt their ability to get new policies on good terms. They don’t want underwriters to consider them “difficult.”
I just saw a situation where the PE firm decided to collect the deductible from the seller as its only recourse rather than go to the insurance company for the full amount. The amount of money they would have collected wasn’t worth the reputational risk.
Essentially, while reps and warranties insurance is still a useful tool, people are becoming more gun-shy.
Axial: What’s another frequent topic of advice right now between you and your clients?
Michael: We’ve spent a lot of time examining the ramifications of the new tax bill. One of the biggest is the change in how capital expenditures are expensed. Historically, a company had to expense them over the useful life of the asset, but now it can expense the full amount right away. It creates really strong tax advantages for the company. We’ve tried to make sure that our clients are aware of this, and we’ve seen a lot more companies strategically invest excess capital in capex right now for this reason.
Axial: There is a lot of capital out there right now. Are you worried about excess risk and over-leverage?
Michael: The short answer is yes. A lot of banks said that they would never get back to the 2006/2007 days, but a lot of similar things are happening. Lenders are giving out a lot of money at high EBITDA multiples and low rates. PE firms are leveraging up their businesses. Fortunately, the economy has stayed strong, so there haven’t been serious negative repercussions, but there are a lot of similarities to a decade ago.