By August Felker
In today’s active M&A environment, we have seen a significant uptick in search fund interest around Reps and Warranties insurance. In the below FAQs, we hope to address most of the common questions we are hearing in the search fund community regarding this evolving insurance product.
What is Reps and Warranties Insurance?
Representation and Warranties Insurance (RWI) provides protection against financial losses, including costs associated with defending claims, for certain unintentional and unknown breaches of a seller’s representation and warranties made in the purchase agreement. In an M&A transaction, the majority (>90%) of RWI policies are purchased by the buyer.
There are several major benefits to purchasing an RWI policy:
RWI offers additional protection to the buyer beyond the negotiated indemnity cap and survival provisions in the purchase agreement.
It protects against the collectability or solvency risk of an unsecured indemnity provided by a seller (e.g., a financially distressed or non-U.S. seller or multiple sellers).
It can distinguish a buyer’s bid in a competitive auction process by enabling a seller to secure short survival periods, modest liability caps and reduced escrow amounts for breaches of representations and warranties.
It helps preserve key seller relationships by mitigating the need for a buyer to pursue claims against management and/or sellers working for a buyer. 1
Does it make sense for my search deal?
The demand for RWI has skyrocketed in recent years, which in turn has led to a significant increase in the number of insurance companies now offering the product. The competition has pushed minimums lower, broadened coverage terms, and allowed capacity for mega deals.
RWI in the search fund community, however, has not been nearly as popular as it is on traditional private equity transactions. This is mostly since high premiums and larger retentions can be a financial barrier on the typical search fund deal.
Andy Lock, a Partner at Goodwin Procter’s Search Fund and Private Equity practice, notes, “RWI has become increasingly popular for private-target M&A deals in recent years, particularly when private equity sponsors are involved. Searchers should become familiar with RWI, because even if they don’t purchase it for their initial acquisitions, there’s a good chance they will use it when they exit. For deals where RWI makes sense, it can be a great product for both buyers and sellers.”
In our experience, the typical characteristics of a deal that might be great candidate for RWI are as follows:
Enterprise value is greater than $10m.
The searcher is seeking an indemnity number from a breach in reps and warranties that exceeds $3m.
The searcher is seeking a longer indemnity period than what the seller is willing to offer.
The seller has expressed that maximizing cash at close is a key deal consideration.
The target company is an auction process.
There are multiple owners/sellers and/or the searcher has concerns about the collectability of indemnity amount that exceeds the escrow/holdback.
Sandro Mina, Managing Member at Relay Investments, who’s been investing in search funds for nearly 20 years, shares, “In the past couple of years at Relay Investments, we have seen RWI policies increasingly discussed or employed in two scenarios: at exit, when search fund operating companies sell to PE and/or PE-backed companies and at entry, when a PE or financial firm is a majority shareholder of a target search fund operating company. In the first case, RWI is an important negotiation point for this new buyer. The second creates a multiple-owner situation, one of whom is a very sophisticated seller.”
How much does Reps and Warranties Insurance cost?
RWI premiums range in pricing from ~2.5% to 3% of the limit of insurance purchased. So, for example, the buyer of a $10m policy can expect to pay between $250k to $300k. Pricing breaks are generally awarded for larger policies, whereas smaller polices (the floor in today’s market is a $3m policy) typically have minimum premiums of around $100k. 100% of the premium – which can be financed – is due at closing.
RWI policies are structured with a retention – an amount borne by either the buyer in full (no seller indemnity) or a combination of the buyer and seller (buyer basket/seller escrow). Retentions are typically 1% of the total enterprise value, with minimums around $200k.
In addition to the policy premium, there is a one-time, non-refundable underwriting fee payable to the insurance carrier to formally kickoff the underwriting process. This fee ranges between $25k to $40k, depending upon the size and complexity of the transaction.
The good news is that unlike traditional insurance, the one-time payment of premium can afford coverage for up to three years for general representations and six years for fundamental and tax representations.
Which reps and warranties are insurable?
Each RWI policy is customized by the insurance company based on the reps and warranties outlined in the purchase agreement. In general, however, RWI can insure general, fundamental and tax reps, including:
Organization and Standing
Brokers and Finders Fees
Power and Authority
Titles to Securities
Titles to Assets
Accuracy and completeness of financial statements
Disclosure of material contracts
Compliance with laws
There are several common policy exclusions with RWI, these include:
Purchase price adjustments (such as working capital adjustments, earn-outs, etc.)
Breaches of which the buyer had “actual knowledge of”
Some tax-related issues, such as pre-closing tax liabilities, transfer taxes, availability to the buyer of net operating losses, and R&D tax credits. (Note: Specific Tax Indemnity policies can be purchased for these exposures.)
Liabilities around asbestos, PCBs and CFCs
Forward looking revenue projections
Pension underfunding/under accruals
Amounts specifically reserved for on a Balance Sheet
I am interested in moving forward with RWI, what are the next steps?
If you plan to utilize RWI for your deal, we would highly recommend raising the topic during pre-LOI negotiations with the seller. It is common for RWI language to be included in the LOI, so you’ll want to loop in your attorney too. We would also recommend letting your seller know that the process of procuring RWI will require additional due diligence requests prior to closing.
It’s not uncommon for the seller and their representatives to bring up RWI proactively since the coverage allows a seller to maximize the cash at close and limits their downside. This is especially prevalent for larger, brokered deals. Like anything, the terms around RWI are negotiable in terms of who pays the premium and who bears the deductible (although underwriters always prefer both the buyer and seller to have skin in the game).
Following the LOI, the next step is to secure pricing indications. You’ll need to provide the following items in order to procure pricing:
Copy of the LOI
Draft of the purchase agreement
Audited financials or a QoE
Once the indications are in, we recommend evaluating the various options with your insurance broker and attorney – on a joint call – to select the carrier that makes the most sense for your transaction. Each indication will have different pricing, deductibles, and most importantly, coverage terms. You’ll want to weigh the pros and cons of each option carefully before moving forward.
Unlike other insurance, you select one insurance carrier to partner with through due diligence. As soon as you greenlight the insurance carrier, their underwriting fee will be due in full. The carrier will request access to all deal documents (data room, purchase agreement, disclosure schedule and any third-party reports). Upon receipt, they will host a diligence call with you and your advisors. Your insurance broker and legal counsel will work on policy language throughout the diligence process, finalizing the policy after the diligence call, during which deal-specific exclusions are determined.
Be prepared to allocate time to the underwriting process. Although it is a thorough and time-consuming process, many buyers benefit from the “second look” their deal receives from the due diligence professionals hired by the RWI company.
The entire process typically takes about two to three weeks from start to finish, but we recommend starting early to avoid last-minute stress or exclusions.
Please feel free to reach out to firstname.lastname@example.org if you have any questions or are seeking additional information. Our team at Oberle specializes in providing insurance solutions to the search fund community.