Rep & Warranty Insurance: Product Specifics and How It’s Used Iowa MA_Rep... · 2018-05-29 · Rep & Warranty Insurance: Product Specifics and How It’s Used Prepared in connection

Rep & Warranty Insurance: Product Specifics and How It’s Used

Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 1

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2 0 1 4 M & A C O N F E R E N C E

Rep & Warranty Insurance:Product Specifics and How It’s Used

Ashley Behan, AIGBruce Engler, Faegre Baker DanielsCraig Schioppo, Marsh USA Inc.Moderator: Michael Abbott, Faegre Baker Daniels

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Agenda

► Introductions►General Discussion of Transactional Risk Insurance and Marketplace

► Recent trends and advances

►Reps & Warranties Insurance► Strategic uses► Types of policies► Pricing, deductibles and limits► Underwriting process and timing► Impact on M&A negotiations

►Tax and Contingent Liability Insurance►Claims Experience►Case Studies

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Transactional Insurance Products

►Facilitate mergers, acquisitions, divestitures and other business transactions

► In some cases, remove or reduce escrow or holdback in the transaction

►Provide access to the insurance industry’s capital and allow the transfer of certain transaction-related risks to the insurance markets

►Transactional Insurance Products include:► Representations & Warranties Insurance► Tax Liability Insurance► Contingent Liability Insurance



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Transactional Insurance Market Overview

►Continued Evolution: More innovative insurance solutions than ever

► Insurance market now offers:► Broader coverage and better alignment with underlying agreement

► A more streamlined underwriting process

► Significantly increased limits of liability available

► Material reduction in premium rates and deductible levels: enhanced competition

► Ability to issue policies out of more countries than ever before



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Transactional Insurance Market Overview (cont.)

► Insurance market now offers (continued):► Key drivers of explosive growth

► Greater market awareness and acceptance: lawyers, bankers, end-users

► Competitive deal environment in middle-market M&A► Buyers seek to distinguish bids► Sellers demand limited recourse to enhance returns

► Insurance market evolution► Speed of execution► Sophisticated deal professionals and advisors► Standardization of terms and expectations



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Transactional Insurance Market Overview (cont’d)

►Already an established product in certain markets, has seen significant growth in North America over past 3 years:

Marsh:► 2014: over double the annualized volume from 2013 – 75 deals year to date. $1.5

billion in limits.► 2013 – $1.34 billion in limits / 66 closed transactions► 2012 – $1.43 billion in limits / 51 closed transactions► 2011 – $767 million in limits / 45 closed transactions

AIG:► Over 520 submissions in 2013 (~57% increase over 2012)► Expecting between 800 and 1,000 submissions in 2014 ► Insured 86 deals in 2013 (~56% increase over 2012)► Q1 and Q2 2014: about 78 policies written

►Middle market M&A emphasis and application



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Uses of Transactional Risk Insurance Products

Buyers SellersRisk Management Uses Risk Management Uses

► Increase maximum indemnity / extend survival period for breaches of reps & warranties

► Ease collection concerns

► Provide recourse when no seller indemnity possible (i.e. bankruptcy; ESOPs)

► Manage jurisdictional issues (i.e. cross border deals)

► Reduce contingent liabilities

► Distribute sale proceeds

► Protect passive sellers

Strategic Uses Strategic Uses

► Distinguish bid in auction

► Protect key relationships

► LBO lenders desire backstop on indemnifyfor credit analysis

► Attract best offers by maximizing indemnification

► Include R&W Insurance as the soleremedy in draft agreements in auctions/clean exit

► Maximize net sales proceeds and enhance IRRs



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Types of R&W Insurance Policies

Two Types of Policies:1. Buyer-Side Policy

► Insurance replaces sellers’ potential indemnification liabilities under acquisition agreement► Can enhance indemnification terms set out in acquisition agreement

► Extended survival periods► Increased cap► Materiality scrape

► Covers fraud by the sellers► Limited subrogation rights against seller and management team

2. Seller-Side Policy► Sellers backstop their potential indemnification liabilities agreed to in acquisition

agreement► Mirrors indemnification terms set out in acquisition agreement► Typically excludes fraud by the sellers► Knowledge between sponsors and management sellers can be severed



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R&W Insurance: Key Terms

►Policies are negotiated between insureds and insurer and specifically tailored to fit each unique transaction

► Coverage has become more insured-friendly► Better symmetry with acquisition agreement► Reduction in exclusions► Coverage for pre-closing covenants► Knowledge exclusion advancements► Materiality scrapes

►Premiums► Typically 2% - 4% of limit insured and lower outside of US► Who pays?



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R&W Insurance: Key Terms (cont.)

►Deductibles► Typically 1% - 2% of transaction value (no indemnity deals may be higher)► Buy-side policies often use escrow account as deductible► Seller-side policies use a negotiated amount► Drop downs available and erosion available for loss outside coverage

►Up to $350MM - $400MM of limits available in the global market

►Can be used effectively in transactions from $15MM - $2B+



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Streamlined Underwriting Process

1. Execute NDA2. Provide Submission to Insurer

► Requested information includes draft acquisition agreement, financial information, offering memo

3. Obtain quote within 2 - 4 days► No cost to obtain quote

4. Pay underwriting fee► Underwriting fees range from

$10K - $30K+ (depending on nature/complexity of risk)

5. Underwriting process: 5 - 10 days

► High level review of due diligence process (if buyer-side) or disclosure process (if seller-side)

► Access to legal, financial, tax, other DD reports (if buyer-side)

► Conference call(s) with deal team6. Policy negotiations

► Concurrent with underwriting process

► Work closely with outside counsel



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Impact on M&A Negotiations

►Acquisition agreement contemplating R&W Insurance – draft for it

►Alignment and symmetry between acquisition agreement and policy

► Including advisors, brokers and underwriters early in the process

►Advisors and brokers can help deliver the right terms and package



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Tax Liability Insurance

Insures against the financial consequences of an intended tax treatment being disallowed by the relevant tax authority in situations where:

► there is no clear precedent or guidance;► tax authority approval (e.g. PLR) is not available or cannot be received in the

required time frame;► potential “downside” exposure is significant relative to size of transaction;► financial model for transaction does not allow for “margin for error”.

Common uses:► A tax liability policy is most commonly used in a transaction context and can be written

to:► insure the conclusion of a tax opinion; or► backstop or replace the subject matter of a tax indemnity

► Coverage can be extended to cover “disclosure” risk



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Tax Liability Insurance: Key Terms

►Covered Items► Additional tax► Fines & penalties► Interest► Legal expenses► Gross Up

►Key Coverage Issues► Policy Term – typically up to seven years► Cost – typically, 3% - 9% of policy limit, depending on underwriting analysis► Deductible – varies by deal, but often only applicable to legal expenses► Underwriting – similar to R&W underwriting process; a tax opinion is not required



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Contingent Liability Insurance

►Contingent liability insurance covers “one-off” identified potential exposures that have not yet fully crystallized

►Recent Examples include:► Successor liability► Fraudulent conveyance► Change in law risk► Other legal, legislative or regulatory risks

►Cost, Limits and Deductibles vary based on particular risk



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Claims Experience

► Industry-wide, claims payments have ranged from $500k-$20M► Insurers have dedicated claims professionals and long-established

relationships with premier law firms and experts to offer high quality claims solutions

►Brokers and independent advisors serve as advocates for insureds►Examples of claims:

► Financial Statements: Recently paid approximately $10mm for a financial statements related claim

► Accounts Receivable: Seller-side policy responds to a claim brought by buyer for breach of the financial statements R&Ws in connection with the target’s issuance of over $1mm of gift certificates which had not been recorded in the financial statements

► Patent Infringement: Seller-side policy responds to claim brought by buyer for breach of the IP R&Ws resulting from a third party claim of patent infringement



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Frequently Made Claims

0%

5%

10%

15%

20%

Type of w arranty breach

Financials;AR;Inv. -18% Comp. With Laws/Lit. -17% Tax -14%No. Undisc. Liab. -10% IP -8% Contracts -5%Full Disc. -4% Emp. Ben. -4% Real Prop. -3%Other -16%

Representations relating to financial statements, compliance with laws, taxes and undisclosed liabilities are most frequently alleged to have been breached.



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Timing of Claims

Time Lapse Between Policy Incpetion and Receipt of Notice of Claim

56%24%

20%

0-12 months 12-24 months 24+ months

More than half of all claim notices are received within the first 12 months of the policy’s issuance.



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Case Study: Buyer-Side R&W Insurance – Buyer using insurance to enhance auction bid

►Background► Private equity firm competing in auction with several financial and strategic bidders –

down to final 3► PE firm seeks to distinguish its bid► Seller’s auction draft has no survival of reps

► Issue► Buyer would like to acquire the target but needs post-closing recourse for breach,

including to support lender’s credit assessment of the business for LBO

►Solution► Buyer-side R&W policy► Limit: 10% of purchase price to replicate typical escrow arrangement► Retention: 1.5% of purchase price► Premium: 3.3% of insured amount► Policy in place at signing► PE firm wins auction – Seller maximizes amounts distributable to creditors/investors



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Case Study: Buyer-Side R&W Insurance at Seller’s Insistence in Auction Process

►Background/Issue► PE sponsor/management selling target company equity► PE sponsor seeks to maximize net sales proceeds and limit post-closing

contingent liabilities; PE firm does not want to suffer loss due to any management malfeasance

►Solution► PE sponsor insists on no survival of the reps and encourages bidders to pursue

R&W Insurance; fall back position is to provide recourse against narrow fundamental matters with a modest escrow amount (for policy retention) with the policy sitting above the escrow and sellers responsible for loss for fundamental matters after policy has been exhausted



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Case Study: Facilitating a Deal/Closing a Gap

► Issue► Buyer: private equity firm► Seller: closely-held fund in wind down► Gap: Seller liquidating portfolio at a

marginal gain near end of fund’s term; desire to distribute proceeds to limited partners without escrow or holdback

► Buyer insists on protection for post-closing issues, including breaches of representations, to fulfill fiduciary duties to its investors► Seeks large holdback for 6 years► Concerns about Seller’s

creditworthiness post-closing

►SolutionBuyer-Side R&W insurance with broad coverage for Buyer► Term: 2 year term for general

representations; 6 year term for fundamental representations and tax indemnities

► Coverage: $20,000,000► Retention: $5,000,000 retention with

dropdown to $750,000 6 months after closing; $5,000,000 matches 6 month holdback in deal (10% of deal size)

► Cost: $280,000 premium – paid by Buyer as deal cost



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Case Study: Seller-Side Protection

►Sellers using insurance to limit potential indemnification obligations after closing

►Background► Seller: Several VC Funds and Founders► Buyer: US Publicly-Traded Company ► Target: Technology Start-Up ► Purchase Price: ~$480MM

► Issue► Aggressive strategic acquirer demanding high cap on indemnity, long survival

period for reps (especially IP)► Buyer would not negotiate the reps; very Buyer-friendly reps► VCs wanted to disburse money to their limited partners and not have to worry

about clawing back proceeds



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Case Study: Seller-Side Protection (cont.)

►Solution:► Seller-side R&W policy► Limit: $237MM (50% of purchase price) (6 insurers participated on this program)► Retention: $57MM for the 1st year (~12% of purchase price (this was the amount

placed into escrow by the Sellers)). $28.5MM from 1st year to 18th month anniversary of closing ~6% of PP (part of the escrow was released on 1st anniversary)). $4.75MM for the 2nd anniversary of closing (1% of PP).

► Policy period: 18 months for general reps, 2 years IP, 6 years for fundamental, tax and compliance with laws reps



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Presenters Contact Information

Ashley BehanAIG(212) [email protected]

Bruce EnglerFaegre Baker Daniels+515 447 [email protected]

Craig SchioppoMarsh USA Inc.(212) [email protected]

Michael AbbottFaegre Baker Daniels+515 447 [email protected]

Documents

Rep & Warranty Insurance: Product Specifics and How It’s Used Iowa MA_Rep... · 2018-05-29 · Rep & Warranty Insurance: Product Specifics and How It’s Used Prepared in connection