by Jean Harrington & Michael Sweeney | Sellers in private M&A transactions often express fear of post-closing disputes which may cause them to give back their proceeds. Representation and Warranty Insurance policies (RWI) can help maximize and protect overall deal value by increasing the cash payment to sellers at closing while alleviating post-closing risk and anxiety.
RWI covers unknown breaches of representations and warranties in a purchase agreement; however, it does not cover covenant breaches or provide coverage for any known risk (which should be properly disclosed/identified in due diligence).
RWI policies lessen or eliminate the exposure to unknown breaches of representations and warranties that could lead to claims or litigation … allowing sellers to sleep better at night. RWI basically shifts these unknown risks to a third-party insurer and can result in a “win win:” cash effective solution for sellers and buyers.
Prior to the 1990s, there was no formal RWI market to speak of in the United States. RWI policies gained acceptance in the U.S. in the late 1990s, having been available in UK transactions a decade earlier. As insurers have become more comfortable with the RWI market and have issued more policies, RWI has become more affordable and is now economically feasible for transactions as low as $35mm. Global insurance agency AON estimates that, in 2018, 34% of North American transactions used RWI.
In transactions without RWI, parties often spend an enormous amount of time and resources negotiating escrows, indemnification caps, survival periods and deductibles for a seller’s breach of a representation or warranty. Cash escrows are generally required to secure a portion of the seller’s post-closing indemnity obligations, thus reducing cash paid to seller at closing.
In fact, the recent 2019 ABA Private Target Mergers & Acquisitions Deal Points Study indicates that the median indemnity cap as a percentage of transaction value was 10% with a deductible mean of .65%. Escrow amounts can also range up to 10% of the transaction value.
RWI can either fully replace a seller indemnity (except for fraud) or serve as a supplement/back-stop to a more limited retention of liability. Both buyer and seller policies are available, however, buyer-side policies are more prevalent. In a competitive M&A market, like we have seen the last seven (7) years, buyers often use RWI insurance as a tool in a bid situation to increase their offer. Buyers can also secure higher coverage limits and longer survival periods with lower collection risk than market terms from a private seller. Sellers can “pre-arrange” a RWI policy offer in advance of seeking buyers, thus giving bidders initial confidence to maximize their bid.
RWI policies have a one-time premium paid at closing equal to approximately 3.5% of the policy limit (e.g. $350,000 premium for $10,000,000 in coverage). A 1% retention deductible is common in RWI policies and the parties often agree to split this amount in a limited indemnity deal.
The chart below compares the closing cash net proceeds available for distribution to a seller with and without a RWI policy.
Transactions with RWI are gaining momentum and are a valuable tool for both buyers and sellers. Buyers and sellers are getting more accustomed to the benefit of removing risk allocations from the negotiation of the transaction’s purchase agreement and shifting post-closing risk to an insurer.
Duffy & Sweeney’s transaction lawyers are experienced in all aspects of securing RWI policies in M&A transactions, including the underwriting and policy procurement process, negotiation with carriers to limit exclusions and utilizing deal negotiations to maximize deal value and protection. Contact Jean Harrington or Mike Sweeney to learn more.