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The Evolution of Reps and Warranties Insurance in M&A

Matthew Unterlack SRS Acquiom | June 20, 2018

A robust economy and record amounts of dry powder are contributing to an active and extremely competitive M&A market. This landscape is empowering sellers to insist not only on higher pricing multiples, but also less risk. To compete, many buyers are attempting to complete their due diligence efforts quickly and some are relying on smaller post-closing escrows. Representations and Warranties Insurance (RWI), especially when used creatively in conjunction with escrows, can help PE buyers put forth competitive offers while allowing sellers to receive a greater proportion of the purchase price at closing. However, as familiarity with RWI has increased in recent years, its use in private M&A deals is changing.

On some deals, especially those with private equity sellers or where the sellers know there will be a competitive auction process, sellers and their counsel are becoming more adept at proposing buy-side RWI early during M&A negotiations as the buyer’s primary source of recovery for losses resulting from breaches of the sellers’ representations and warranties. Conversely, buyers are learning that it is sometimes in their interest to propose RWI early during an M&A negotiation. This is partly because the sellers’ market encourages buyers to be competitive not only with respect to acquisition pricing but also with their post-closing indemnification structure.

While RWI would generally reduce the exposure sellers have to post-closing indemnification claims, in our experience it does not reduce the level of post-closing work involved for the sellers. Since claims against an entire traditional escrow are rare, most claims are less than the applicable deductible amount regardless of whether RWI is used. Since shareholders retain exposure for these smaller claims even with an RWI policy in place, they generally end up spending a comparable amount of time after closing on these matters regardless of whether the deal uses an escrow, insurance, or a combination of the two.

In certain situations, the buyer may suggest a combination of escrow and RWI as a compromise between an “all or nothing” seller indemnification obligation. This structure may satisfy the preference of each of the buyer and the insurer (or the MGA/MGU) for the sellers to have skin in the game in the form of an escrow — even if sized to serve as the RWI deductible instead of the buyer’s only or primary source of recovery. This structure can also be seen in transactions where an escrow, separate and apart from RWI, secures the buyer’s indemnification rights with respect to known, indemnifiable matters discovered before signing, such as historical environmental issues or pending or threatened lawsuits.

It’s important for deal parties to understand the differences (both pros and cons) between escrows and RWI and the differences between buy-side RWI and sell-side RWI, as well as the typical timeline and substance of the RWI underwriting process. Also be familiar with the transactional insurance submission and underwriting process to understand how it may affect the deal’s substance and timing. In some cases, sticking with (or reverting to) a more traditional escrow structure, or combining RWI with an escrow, may benefit that particular deal. Insurance is not available on all deals, and is not always the only (or best) solution. Even when RWI is used, specific escrows may be needed to secure funds for purchase price adjustments or for certain expected indemnification obligations not covered by RWI.

Despite the competitive environment, buyers and sellers alike should not view transactional insurance as the “only” solution or as a perfect substitute for a traditional escrow structure. Depending on the M&A deal, an escrow may be more efficient or more readily available than RWI, or a specific escrow may be advisable for certain specified indemnification obligations. Reasonable expectations go a long way to keeping the overall discussion — and the insurance discussion — grounded and practical.

Transactional risk insurance products or services may not be available in all states, and coverage is subject to actual policy language. Non-insurance products and services may be provided by affiliated companies or unaffiliated third parties. Insurance products placed by Acquiom Insurance LLC, an affiliate of SRS Acquiom Inc.

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