M&A AND PRIVATE EQUITY BULLETIN 2019 M&A Emerging Trends and Insights: Why Representation & Warranty Insurance is becoming an Integral Part of the Transactions Toolkit for M&A Practitioners

Last Updated: October 1, 2019

M&A Marketplace in 2019 at a Glance

Global merger and acquisition (“M&A”) activity in recent years has witnessed a steady increase in both total deal volume and deal value across all geographical regions. North American, European, and Asian Pacific markets have all experienced notable M&A growth in recent years.[i] The growth in Canada’s M&A market has been particularly robust for Canada in 2019, as its currently on a record-setting pace for total yearly deal volume. The Canadian market this year saw a record high in second quarter M&A activity with 886 announced transactions valued at an aggregate of CA$70.5 billion.[ii] This is on the heels of a very strong Q1 2019, which saw 801 announced transactions valued at an aggregate of CA$74 billion.[iii] Overall, Q2 2019 marks the 6th consecutive quarter where transaction activity has exceeded 800 deals. As is traditionally the case in the Canadian market, mid-market deals (defined as transactions with enterprise values below CA$250 million) have driven the pace in 2019, representing approximately 89% of the total deal activity and 12% of the aggregate value.[iv]

Within the landscape of increased deal volume, however, is a backdrop of increased complexity and uncertainty in the M&A market. At the macro-level, global dealmakers are faced with considerable economic and geopolitical uncertainty. Particularly this year, which has witnessed ongoing trade disputes between the United States and China, the ongoing Brexit negotiations, as well as considerable civil unrest in Hong Kong. At the micro-level, however, surveys of top dealmakers from around the globe indicate that the greatest impediment to completing a deal is the inability to close a negotiated deal quickly.[v] As such, deal uncertainty and execution risk faced by dealmakers becomes a concern worthy of addressing.

Addressing Deal Risk and Top Concerns of Dealmakers

Closing deals takes considerable time and effort by all participants. For many M&A transactions, buyers and sellers undertake extensive due diligence and negotiations prior to entering into the agreement. Among the most time-consuming legal and risk-allocation issues negotiated are the representations and warranties (“R&Ws”)[vi] made by the Seller to the Buyer, whose interests are adverse. Naturally, the Seller wants a clean exit and are interested in limiting: (i) the scope of issues covered by the R&Ws to be made; (ii) the survival period for the R&Ws that are made; and (iii) the amount of any indemnities and monies held back in escrow. On the contrary, the Buyer’s interests are opposite, which is to maximize the scope of the R&Ws made by the Seller, the degree of indemnities provided by the Seller, and the amount of purchase proceeds held in escrow or contingent consideration subject to an earnout. If the Buyer suffers unforeseen post-closing losses resulting from the Seller’s breach of any representation or warranty, the Buyer would then have recourse against the Seller.

This serves to underscore the value of a rapidly emerging trend in Global M&A transactions – the Representation and Warranty Insurance (“R&W insurance”). In North America, the use of R&W insurance in M&A deals has experienced a 40% year-over-year expansion since 2013.[vii] Similar growth patterns for R&W insurance have also been experienced in foreign markets, to the point that distinct regional preferences for risk-allocation and risk-mitigation techniques are noticeable. These subsets include Europe’s penchant for “nil-recourse” transactions and the Asian-Pacific preference of Sellers “stapling” the requirement of R&W insurance programs to bid or offer packages.[viii]  The rise in popularity of R&W insurance cannot be understated as it addresses the concerns and anxieties of dealmakers in an increasingly complex and uncertain economic environment.

In brief, R&W insurance provides increased protection to the Buyer by insuring against the breaches of R&Ws by the Seller which in turn can lead to deals closing faster and improving the efficiency of the M&A marketplace. Therefore, for Buyers and Sellers who are seeking deal certainty and execution expediency in their M&A transaction, R&W insurance may be worthy of consideration.

The Benefits of R&W Insurance

R&W insurance protects parties in an M&A transaction and allow participants to assume and manage risks with which they are comfortable and choose to insure against known or unknown risks in exchange for certainty of loss. The purchase of R&W insurance for a transaction has the benefit of dispensing with potentially contentious issues while also providing numerous additional benefits for both parties. Namely, R&W insurance provides the following benefits to any M&A transaction:

For the Buyer

  • Enhances protection in the event of post-closing damages are suffered, either supplementing or replacing the traditional Seller’s indemnity;
  • Provides coverage for losses in an amount greater than what a Seller may otherwise agree to indemnify;
  • Extends coverage beyond the survival limitations of the R&Ws in the agreement, giving the Buyer a longer time to discover deficiencies and unknown risks;
  • Relieves concerns about collecting from a Seller who may have a poor financial situation;
  • Induces the Seller into making more extensive and more industry-standardized R&Ws which will increase the Buyer’s likelihood of successfully making an insurance claim; and
  • Reduces friction amongst participants during the negotiation process and preserves relationships with Sellers who may continue as employees or consultants to the company.
  • For the Seller
  • Reduces the need and degree of the Seller’s indemnities and escrow holdbacks and, overall, provides the Seller with a cleaner exit with fewer contingent liabilities;
  • Potentially increases the purchase price and reduces the likelihood of the re-negotiation of economic terms during the due diligence phase;
  • Protects minority or passive investors of the Seller who have joint and several liability to indemnify the Buyer and mitigates the impact of issues raised by minority shareholders; and
  • Provides comfort for individual or family run companies who desire cleaner exits.

For Both Buyers and Sellers

  • Expedites the negotiation process and removes significant time-consuming obstacles for closing; and
  • Provides flexibility in coverage options, as many policies can be tailored to a deal’s specific needs.

Usage of R&W Insurance Policies, Premiums and Pricing

Based on a survey done by AIG’s R&W insurance policies, approximately 19.4% of insured transactions wind up having claims submitted.[ix],[x] In North America, approximately 11% of those claims were submitted between 2 to 3 years post-closing. A further 3% of claims are submitted after 3 years.[xi] These insights provide that: from a seller’s perspective, it is not uncommon for breaches of representations and warranties to occur; and, from a buyer’s perspective, it may take several years before such breaches become apparent.

The typical R&W policy covers losses of up to 10% of the transaction purchase price. Insurers will charge a premium for issuing the policy, which is priced in the range of 2% to 4% of the coverage limits. Most providers will also specify a minimum premium payment of around $150,000, as there are significant underwriting costs associated with verifying the transaction due diligence, reviewing the underlying R&Ws of the purchase agreement and pricing the policy appropriately.

The typical policy also includes a deductible (known as a “retention”) which can be anywhere between 1% to 2% of the transaction’s purchase price. Furthermore, the underwriter of any policy may undertake their own due diligence process and review as a pre-condition to insuring the transaction. The costs associated with any due diligence vary depending on their nature and scope and an underwriter’s fee of around $15,000 to $50,000 may be charged.

It should be noted, however, that the figures cited for the typical R&W policy may be subject to rapid change in the coming years. The increased popularity of R&W insurance policies has led to an increase in the competition of underwriters willing to underwrite these policies, which in turn has led to a corresponding decrease in policy premiums. Between 2017 and 2018, the overall cost of obtaining an R&W insurance policy in North America has decreased by 15%.[xii] This is a trend that is expected to continue.[xiii]

Is R&W Insurance Right for You

R&W insurance provides the insured with significant benefits, which explains why they are used as a strategy across M&A broadly. R&W insurance is not necessarily more beneficial for any specific transaction value range. Data from Aon indicates that in 2018, over a third of their R&W policies had limits equal to or less than US$10 million, which suggests strong demand in the mid-market. Ultimately, whether R&W insurance is advisable will depend on the specifics of the transaction and the needs of the parties. To discuss your M&A transaction services needs, whether you are a prospective buyer or seller, please contact Allan Ritchie, Vincent Ho or any member of our M&A and Private Equity group.

[i] Aon, M&A Transaction Solutions: Risk and Review 2019.

[ii] Crosbie & Company, Canadian Mergers & Acquisitions Report for Q2 2019.

[iii] Crosbie & Company, Canadian Mergers & Acquisitions Report for Q1 2019.

[iv] Crosbie & Company, Canadian Mergers & Acquisitions Report for Q1 2019.

[v] Aon, M&A Transaction Solutions: Risk and Review 2019.

[vi] A “Representation” is an assertion that a certain fact is true or accurate as of the date that the representation or statement is made. A “Warranty” is a promise of indemnity if the assertion made is false, and the assertions may be forward-looking. The two are generally used together as “R&W” as the inaccuracy of a representation or the breach of a warranty will give rise to a claim by the party in which the R&W is designed to favour.

[vii] Aon, M&A Transaction Solutions: Risk and Review 2019, “North America”.

[viii] Aon, M&A Transaction Solutions: Risk and Review 2019.

[x] Statistics are from AIG policies only, which totalled over 2,900 deals worth more than $1 trillion in value.

[xi] AIG, Claims Intelligence Series, 2019 Report: Taxing Times for M&A Insurance.

[xii] Aon, M&A Transaction Solutions: Risk and Review 2019, “North America”.

[xiii] The figures cited in the foregoing paragraphs regarding terms of the R&W insurance policies, including premiums and coverage limits, are subject to change and are based on a review of secondary industry sources, such as underwriters and brokers, which may not be an authoritative sample or accurate depiction of the state of the marketplace.