This article is an extract from GTDT Private M&A 2024. Click here for the full guide.
What a difference a year makes! Twelve months ago buyers had reasons to be cheerful, as valuation froth started to evaporate and those with capital to deploy licked their lips. Fast forward to now, halfway through the third quarter of 2023, and continued monetary tightening has played a key part in dampening the deal mood in response to stubborn inflationary pressures.
Bloomberg data indicates M&A deal volume for the first two quarters of 2023 was the lowest since 2017 (excluding the second quarter of 2020, as the grip of the covid-19 pandemic took hold). So far this year, even the most ardent optimist would struggle to find comfort in what has been only marginal quarter-on-quarter improvement. Against this backdrop, a McKinsey assessment sees the M&A market as looking to move on from its experience of ‘successive waves of what it likes least: uncertainty’.
Managing uncertainty, however, is the raison d’être of the insurance market, especially when it comes to M&A where risk capital can help facilitate deals by bridging gaps between buyer and seller to improve deal efficiency and support value creation.
Despite the deal doldrums, M&A insurers have continued apace over the past year to offer structuring, coverage and pricing of risk capital in response to the more challenging transaction environment. Unsurprisingly, the reality is that the flight of capital into the market over recent years has meant that dozens of insurers with significant budget targets have had to work harder to allocate capital and, with supply outstripping demand, current rates for warranty and indemnity (W&I) insurance in Europe are generally among the lowest we have seen. Necessity has also driven innovation, as insurer risk appetite continues to evolve.
Key developments of note for practitioners in this respect reflect – to varying degrees – structural adaptations, pricing and coverage improvements, as the use of insurance capital to support M&A deals continues to change and expand in response to prevailing deal execution challenges.
Private equity secondaries
One such example is private equity (PE) secondaries transactions (essentially, the trading of primary PE fund investor interests), which experienced record growth in 2021. While macro-economic challenges over the past year have helped curtail the scope for the traditional PE investor exit (via private M&A sale or public market listing), PE secondaries can, depending on how they are structured, offer a third way that not only brings liquidity options for a fund’s limited partner (LP) investors but also flexibility for the fund’s general partner (GP) to retain its interest in a high-quality asset.
This is especially the case with ‘GP-led’ continuation deals, where a GP orchestrates the transfer of one or more assets or portfolio companies from an existing fund to a successor vehicle, typically involving a monetisation opportunity for its existing LPs. With the current downward pressure on asset valuations, not only does this structure provide existing investors with an exit or rollover option into the continuation vehicle and the opportunity for new LPs to invest in the assets being contributed, it also buys additional time for the GP to weather this downward pressure, hold onto promising assets for longer and, potentially, realise greater returns through the value-creation plan.
W&I insurance has been used to support PE secondaries in the past, but the recent increase in the deal volume of PE secondaries has prompted insurers to push the envelope and consider covering ‘excluded obligations’, those liabilities typically retained by the GP in these deals that relate to withholding taxes, certain other seller taxes and LP or GP claw-back risks. Previously, excluded obligations were considered out of scope (compromising the ‘clean’ exit that a PE seller can expect in a conventional M&A disposal).
Insurers are also now prepared to cover a broader set of transactions – multi-asset as well as single-asset situations, LP to LP deals as well as GP-led transactions – across a variety of wide-ranging asset classes, such as real estate, healthcare, energy, infrastructure, credit and venture capital.
Deal execution has also improved, due to better insurer understanding of the nature and risks of these deals and, as such, alignment of their diligence expectations and underwriting process. That said, PE secondaries require special attention and knowledge given their inherent features, in particular the deal dynamics between a GP and both existing and new LPs, with – among other things – special attention being required around the application of ‘knowledge’ between the relevant parties to ensure the W&I policy responds appropriately to a reimbursable event.
Synthetic W&I structures
Another notable development is the ‘synthetic’ W&I structure, which involves the insured and insurer agreeing on a suite of warranties in the W&I policy directly between themselves, rather than the buyer and seller or management agreeing on a set of warranties (which are then separately insured by the buyer) following a process of negotiation with, and disclosure by, the seller or management under the sale documentation.
The concept is not new: insurers have already been prepared to consider this approach on deals involving non-operational (lower risk) businesses, such as real estate investment vehicles, where deal dynamics and sector allow.
Yet, in the prevailing economic environment synthetic W&I structures in the context of operational deals are more frequently discussed, as the market anticipates a rise in distressed M&A sales and the prospect of insolvency practitioners, who would neither be in a position nor prepared to provide warranties, using them to ‘bridge the gap’ with buyers to support the asset disposal and maximise sale proceeds for the benefit of creditors.
In other contexts, such as a competitive auction process or perhaps even a UK public takeover, the synthetic W&I structure can – potentially – also be used by a buyer looking to differentiate its bid or navigate the applicable Takeover Code restrictions on offer-related inducements. However, it’s fair to say that the application of such a structure to this type of situation remains more theoretical than actual.
Synthetic W&I structures also feature in other parts of the deal size spectrum, with several new W&I insurers identifying the small and medium-sized enterprise (SME) segment of the market as being historically under-served due to insurers’ minimum premium levels and diligence expectations, with the underwriting process being perceived as too cumbersome for the smaller size of deal. These newer entrants take a variety of approaches, from pricing deals more competitively and bringing efficiencies to conventional underwriting models, to fully synthetic solutions that automate some of the more process-driven parts of underwriting. We expect this trend to accelerate over the coming years, as insurers and brokers look to refine the proposition and perhaps even develop insurance as the default warranty protection solution for SME deals.
Minority stake and phased acquisitions
As deal execution in the current climate remains challenging, especially on larger transactions requiring bank finance, some clients have preferred to focus on minority investments or, in certain cases, stagger an acquisition via a combination of a minority investment plus an option to acquire a controlling interest in the target company. W&I insurance supports both approaches but, particularly with respect to the latter structure and with W&I pricing currently at such competitively low levels, clients have been looking to lock in favourable terms and insurers have been prepared to structure W&I insurance cover to accommodate such a phased approach.
These arrangements may range from a commitment by the insurer to extend cover in future (without the need for further diligence, where appropriate) to a variety of innovative upfront structures, including one that adjusts the claims waterfall pro rata to the insured’s investment in the target.
Improved pricing, cover and deal efficiency
Isolated pockets of market commentary in early 2023 appeared to suggest a tendency by W&I insurers to pare back cover, with one or two advisers appearing to question the value of W&I insurance in a slower M&A market as the deal dynamic tilts to the buy-side and allows greater opportunity for diligence and negotiation.
Our experience has been the opposite, with deal parties still keen (often, more so) to de-risk using insurance, while taking advantage of extended deal timetables to optimise the W&I insurance cover available. Indeed, given a thirsty M&A insurance market, insurers have shown greater willingness to offer broader coverage at the non-binding indication (NBI) stage. While the devil remains in the diligence detail, we have seen underwriters show coverage flexibility in areas traditionally out of scope, like capital adequacy, secondary tax liabilities and condition of assets (in the US, condition of assets is generally not excluded from cover although, conversely, we anticipate this could be viewed more strictly by underwriters there before long).
Similarly, the underwriting approach in particular areas, such as real estate and tax, has increased in efficiency, given insurers’ greater sector expertise and familiarity with the substantive risks (in part due to claims experience), although the broader, evolving tax environment keeps transfer-pricing exclusions sticky.
A couple of recent examples serve to illustrate ways in which W&I insurers have competed with one another to show greater flexibility on coverage – although very much on a case-by-case basis and with results where the actual value-add to the insured requires careful assessment. Firstly, while W&I insurance is not traditionally seen as a potential plug for gaps in the target’s operational insurance cover, insurers are occasionally prepared to sit ‘in excess’ of the target’s operational insurance, for example in relation to product liability. However, an insured’s ability to manage a claim effectively through two differently structured insurance policies remains untested (for instance, whether loss paid out under a standalone product liability policy that did not constitute a breach of a covered warranty in the sale and purchase agreement (SPA) would constitute erosion of the retention in the W&I policy). Secondly, some insurers at the NBI stage may look to accommodate a US client’s request to remove from the W&I policy the European-standard general disclosure of the data room against the warranties, in order to align more closely with the US approach. Such an offer, however, is highly likely only to be made at the NBI stage on the proviso that this will reflect a revised approach to disclosure in the SPA as formally adopted by the parties, such that the seller will not seek to rely on general data room disclosures to discharge its disclosure obligations. In other words, simply removing the data room disclosure from the SPA for the purposes of securing an ‘enhanced’ position in the W&I policy will not be sufficient, as far as the W&I insurer is concerned, to be comfortable with the overall risk.
As a still relatively new class of insurance, W&I insurance is probably in its adolescence – although, as alluded to above, its application continues to mature. To become a sustainable client solution for the long-term, however, the insurance market appreciates the need to stay responsive to client priorities and continue to provide value in terms of capital and process efficiency, as well as outcome. This can be illustrated by three recent market developments – introduced by Aon – designed to improve pricing, enhance cover and create deal efficiency.
Interim breach coverage
Despite evolving according to client demand over time, one gap in W&I coverage has remained largely beyond the appetite of the conventional market – ‘interim breach’ cover, which becomes relevant on deals with split signing and completion dates and where warranties are repeated at completion. A standard W&I policy will exclude losses arising from warranty breaches that both occur and are discovered in the interim period between signing and completion, leaving buyers exposed in the absence of reliable material adverse change or equivalent protection. To address this, the exclusive interim breach coverage (IBEX) solution was launched in North America earlier this year, which operates as both a conventional ‘excess layer’ to the primary coverage but also includes a drop-down feature to cover interim breaches for a period of 60 days post-signing. IBEX cover operates in conjunction with a conventional W&I placement but without the requirement for additional underwriting. We expect IBEX for the UK market to be launched later in 2023.
WinXS ‘excess’ facility
Launched last year, WinXS is an exclusive W&I ‘excess’ facility that offers clients dedicated ‘follow form’ London market W&I insurance capacity of up to 60 million (in British pounds, euros or US dollars) above a minimum primary layer of 25 million. By streamlining the structure and cost of cover for deals through a pre-selected insurer syndicate, clients can access the insurance market on a more competitive and cost-effective basis.
Aon’s Real Estate Solution
Although this was launched a few years ago, Aon’s Real Estate Solution (ARES) will shortly be revamped. Currently, ARES integrates into one policy W&I and broader sector-specific cover to a higher limit (closer to a level more commonly found in standalone title policies). This approach seeks to eliminate the cover, cost and process dis-synergies that arise when separate policies are placed to cover these risks and allows faster client access to funds through any W&I claims process. The new and improved version will include a combined policy form that adopts a ‘best of both’ approach to W&I and title insurance concepts and seeks to remedy the disjointed approach to cover in real estate transactions that commonly frustrates both clients and advisers.
Proof of the W&I pudding…in the eating?
It is rare for a W&I insurance claim to go to court. The recent High Court judgment in Finsbury Foods Plc v Axis Corporate Capital Ltd & Ors [2023] was only the second reported case on W&I insurance and, naturally, piqued interest from the M&A insurance community.
It is important to note that the specific facts of the case and the detailed drafting of the warranties were highly relevant in the court’s conclusion that a warranty had not been breached and the insured was, therefore, ultimately unsuccessful. Even if a breach had been determined, the court found that contemporaneous documents established relevant individuals were aware of key facts, which meant that the customary ‘knowledge’ exclusion (ie, matters known to the insured before signing) in the policy would have applied.
Although the claim could not have succeeded without a finding of breach, guidance was provided on causation and loss. The judge considered that loss should be assessed by the price and valuation methodology applied at the time of purchase, rather than attempting to reverse-engineer a valuation methodology not used at the time (and in circumstances where the insured would have proceeded in any event).
This judgment underscores the point that W&I insurance is not designed to remedy a bad bargain nor cover losses arising from matters where insufficient diligence was conducted. Although this claim was unsuccessful, it is important to remember that W&I insurance will pay out on valid claims – indeed, Aon’s 2023 Transaction Solutions Global Claims Study shows increasing claims pay-outs for W&I, tax and other contingent insurance (M&A insurance) claims in the past year alone, and more than US$1 billion paid in M&A insurance claims globally over the past decade for Aon clients.
This case may perhaps serve as a reminder of how important pre-claim review and preparation, involving specialist W&I claims advocacy, can be in helping to advise clients on the merits of a case. An insurance broker with a dedicated, experienced M&A claims team – able to draw on relationships at all senior levels within the insurance market – can help manage client expectations on success in similar situations and can even, potentially, save claimants considerable wasted time and costs.
Conclusion
From a shiny new toy in the deal-maker’s toolbox in the early years, to responding to unprecedented demand fuelled by the surge of post-pandemic activity, M&A insurance’s inherent ability to adapt, develop and enhance has continued, even in the more uncertain deal landscape of late.
More recently, we’ve seen a notable uptick in client deal activity, which, coupled with ongoing discussions with bankers and lawyers, points to a gathering consensus on a busy year-end. This could prove to be short-lived if the warning signs implied by inverted bond yields this year do in fact lead to recession rather than a soft landing.
In any event, the versatility of M&A insurance, and its ability to meet new challenges, is not in doubt. Netherite pickaxe, anyone?
* The authors gratefully acknowledge input from Aon colleagues for the purposes of this article, including Carol Clarke, Claire Fleetwood, Harriet Healy-Clarke, Simon Tesselment, Federica Titon, Annabelle Trotter and Matt Wiener.
