Representations and warranties insurance (RWI) — a tool used in an M&A deal to cover for breaches in a seller’s reps and warranties — is gaining ground as these products get more sophisticated and the risks involved are better understood by the market.
“The use of RWI is becoming more and more prevalent in lower mid-market deals,” says Howard Berkower, a partner at McCarter & English, LLP.
But it wasn’t always smooth sailing. “There were a couple of issues when insurance firms started providing this product. People were skeptical about whether they would pay out,” he says.
In time, skeptics have been proven wrong. “Time and experience with the product have given confidence to the transaction marketplace and transaction professionals are no longer concerned about payout issues,” Berkower says.
It was not only the attitudes toward RWI that evolved. The product itself also underwent a transformation. According to Berkower, as insurance companies gained underwriting experience with the product, they have been able to reduce its cost, making RWI available at lower transaction levels.
The advantages go beyond the cost benefit. “Definitely more people are using RWI given that there are more sophisticated insurers and coverage types,” says Blake Cooper, a corporate attorney with Barnes & Thornburg. “More and more policies are tailored according to changes in underwriting procedures.”
These advances have resulted in a growing percentage of mid-market deals that carry RWI—now at roughly 20%, Cooper says.
RWI’s real emergence in the US only came about around 2010, though there were a few companies using it before then. Initially, the product was more popular in Europe. US buyers started to become more acquainted with the product in cross-border transactions.
It took time for the US market to embrace RWI, in part since it is hard to understand. “The risks that M&A insurance has to cover are broad,” Cooper says. “Before the use of this type of insurance, negotiations revolved around the allocation of risk. Instead of a negotiation involving risk allocation between the parties, RWI allows insurers to be paid to assume these risks.”
But the perks have outweighed the learning curve. “Buyers never really know everything about the business before the sale, so RWI can help them cover for unknown risks,” Cooper says. “Sellers can tell buyers that they are in a position to ask questions, do their due diligence, etc., but do not want any contingent liabilities hanging over them.”
Buyer’s or Seller’s Burden?
George Wang, a partner at Barton LLP, explains that either buyer or seller can pay for the insurance – or they can negotiate to buy it jointly in a certain proportion.
Regardless of who pays, it is desirable to have the RWI policy issued to the buyer rather than the seller since policies issued to sellers will not protect against fraud of the seller.
In today’s seller’s market, buyers can sweeten the terms of their bid by footing the bill for insurance. “The buyer can use RWI as leverage in an auction to make their bid more attractive to sellers,” Wang says. He adds that, in some auctions conducted by private equity funds, the PE fund will pre-clear a RWI package and request potential bidders to bid on the basis of RWI providing the indemnity package. In those cases, the buyer can factor in the cost of RWI in its offer.
James Epstein, a partner at Pepper Hamilton LLP, explains that there are two kinds of policies: a buyer’s and a seller’s policy. A seller’s policy is a backstop against its obligations to pay an indemnity claim to a buyer.
A buyer’s policy is obtained with the assistance of the seller. Often a seller pays a portion of the premium and a portion of the retention amount is put in escrow to support the indemnification in a transaction. Insurance companies often want to see sellers have skin in the game — while there is a range, usually about 1% of the enterprise value is the retention or deductible under the policy.
Since it’s a known entity, and typically a small amount of money in the context of the overall transaction, Epstein says that this is one of the reasons why RWI is becoming more popular in the US.
Popularity with PE Firms
When selling their portfolio companies, PE funds want to make as clean a break as possible and distribute cash proceeds quickly to their limited partners. “RWI gives PE funds the opportunity to do so and [avoid the need for an] escrow or holdback of cash proceeds,” McCarter’s Berkower says.
It is not surprising then that PE firms are one of the biggest users of this product currently, especially for those that are closing down a fund and liquidating their last portfolio investment.
This becomes a problem because if there is a significant amount in escrow, the limited partners cannot get paid in full. “The returns that the private equity sellers realize will be lower if 10% of their investment is in a low or non-interest bearing escrow account,” Barton’s Wang says. “These firms often can show a higher return just by buying a policy and paying the 2% to 4% premium plus the cost of closing the deal. They can then use the 10% they were supposed to put in escrow toward another investment.”
RWI isn’t a cure-all. Not every deal can be covered. Pepper Hamilton’s Epstein says that those buying the insurance need to realize that it does not cover all claims including certain employee and healthcare matters, and certain tax claims.
There’s another warning too. “Although there’s a growing acceptance of the use this type of a tool, it’s not a substitute for buyers doing their due diligence,” Epstein says. “What they want to buy are good companies and not buy claims.”