Buyer and seller insurance for mitigating risks in mergers and acquisitions
Published 27 October 2020
The impact of COVID-19 on global economies and Australia has brought a marked reduction in business mergers and acquisitions (M&A), but that isn’t universal, according to a recent study by Deloitte. A survey of leading local dealmakers and 60 corporate heads of M&A identified a number of businesses are poised to take advantage of opportunities for sales, but the need for caution is paramount.
Two thirds of respondents are considering cross-border M&A activity
COVID-19 has dampened confidence, particularly for large deals. However, the outlook for deal volumes remains positive, with the crisis potentially leading to an increase in acquisitions of distressed firms.
Given the uncertain economy it’s more important than ever for buyers to undertake thorough due diligence on their transaction and also ensure they have the right insurance in place to mitigate the increased risks currently being faced.
Similarly when selling your business it is critical for your insurance arrangements to be accurate and complete for buyer’s to assess. In addition, most transactions have embedded warranty and indemnity insurance into the transaction early into the process to facilitate a clean exit for the seller.
Due diligence – have an expert team behind you
Due diligence is an essential activity in transactions. In the M&A process due diligence allows the buyer to confirm relevant information about the seller, such as contracts, finances, and customers. By gathering this information, the buyer is better equipped to make an informed decision and agree to the deal with confidence.
The first step of the process involves gathering a team of legal and financial experts with specialist knowledge in M&A who will be responsible for conducting the due diligence.
The next step in the process involves the relevant advisors requesting documents pertinent to their specialism. While documents required during due diligence can vary depending on the type of business, its size and similar factors, there are several kinds of data commonly requested across the board. These typically include
details of any legal actions against the company.
Antony Butcher, of the Gallagher Mergers & Acquisitions Insurance Services practice in Australia, says, “Transactions may leave the buyer with unforeseen risks post completion. Having Gallagher as an experienced insurance M&A partner can assist in deal facilitation, mitigating risk and enhancing investment return.
“Thorough due diligence is a core part of managing the risks in a transaction. Prospective buyers should take specialist advice on the steps they need to take to ensure they fully understand the business they are buying.
"Insurance due diligence is key to obtaining the right insurance cover for the target company going forward, and understanding the cost of risk, that is: not just the premiums, but the cost of self-insured areas.
Overall, the buyer will need to get a solid understanding of the target company’s financial health, operational assets, legal matters, and strategic position. If any of the information provided poses a problem, the business deal may not occur,” he advises.
Why sellers and buyers should include warranty and indemnity insurance
Regardless of how thorough a due diligence process is, warranty and indemnity (W&I) insurance is an increasingly popular and affordable type of cover that helps protect both buyer and seller when undertaking mergers and acquisition transactions.
When a business is sold a seller is required to give various promises or guarantees (warranties) to the buyer. These are statements of fact about the target business which protect a buyer in two main ways
they help to flush out information which is inconsistent with the warranties that the seller is asked to give
they give the buyer a contractual right to bring a claim against the seller in the event that they suffer losses in circumstances covered by a warranty.
A seller will remain at risk for the duration of the warranty period – which is typically up to two years from the date on which the business is sold for general (non-tax) warranties and up to seven years for tax warranties. A successful warranty claim could result in a seller being obliged to pay back some or all of the sale proceeds.
As Butcher points out, “About 30% of W&I insurance policies placed by Gallagher have been notified against, with the majority of warranty breach related claims made to insurers (instead of seller) related to financial statements as discovered by the buyer 12 to 24 months after a transaction has completed.”
Indemnities can be more significant; they provide the buyer with a refund in the event that losses arise from a pre-identified set of circumstances.
The benefits of W&I insurance to a seller can include
allowing them to use their sale proceeds without the risk that they will later be liable for a warranty claim, enabling a much cleaner exit (can limit seller liability to $1)
enabling institutional investors to immediately distribute sale proceeds to investors
reducing the need for a retention or escrow account (whereby some of the sale price is set aside until the warranty period has expired)
it can enhance the value of the transaction by allowing full warranty provision to be made in circumstances where the sellers would otherwise be unwilling or unable to give warranties.
Equally important are the benefits that W&I insurance can give to a buyer
they may be reluctant to bring a warranty claim against sellers who continue to be employed by the business after completion. A buy-side W&I policy allows claims to be made without damaging the buyer's relationship and potentially losing valuable staff
they are concerned about the sellers' financial strength – claiming under a W&I policy removes the risk that a seller will not be able to pay out should a warranty claim arise
a seller might also be willing to entertain a lower offer if they know that the sale proceeds will be immediately available to them, rather than having the uncertainty of waiting out a warranty period or having money held back in an escrow account
the acquisition is to be debt financed, as negotiations with lenders may be helped by the knowledge that a W&I policy will be taken out
there are also various scenarios in which a W&I policy can be used to reach agreement on a commercial point where negotiations have broken down
they may have no choice if the seller stipulates nil recourse to the sale and purchase agreement.
It is possible for either the buyer or the seller to be insured, but the significant majority of W&I policies are taken out by the buyer. This is because with a seller-side policy the seller is insured, but the buyer will still need to bring a warranty claim against the seller. This negates many of the advantages of a W&I policy, such as preserving the relationship between buyer and seller.
With a buy-side policy the buyer is insured, meaning that they can make a claim against the policy as soon as a breach of warranty occurs. Buy-side policies generally protect the buyer against fraud by the seller, whereas a seller-side policy won’t.
“Warranty and indemnity insurance is increasingly embedded into transactions as a key risk management tool, giving buyers and sellers additional confidence in a transaction,” Antony Butcher says. “Businesses considering a purchase or sale should contact Gallagher who can help advise on the type of cover that should be considered.”
Access the benefit of our mergers and acquisitions expertise in Australia and internationally, as well as a detailed explanation of these market trends, in planning your upcoming deals and transactions.