1. Current development in primary buy-outs
Taking on board private equity (PE) investments for the first time definitely goes along with challenges for the target company and its management. Yet, from an insurer’s point of view, such transactions also involve some special characteristics and risks.
After a brief but severe downturn in Q2 2020 with only 102 completed PE-backed acquisitions in Europe, the PE market picked up speed unabated and has been reaching new heights ever since. In the year between July 2020 and June 2021 there have been 791 buyouts with a cumulative value of EUR 116.6 billion in Europe, which already exceeds the 2019 figures with 716 deals having an aggregate value of EUR 112.4 billion.1
In addition to increased exit activity by PE, also an ele-vated number of so-called primary buy-outs can be ob-served. If a controlling interest in a company is acquired by PE firms for the first time, this is usually accompa-nied by a stronger professionalisation and often also internationalisation of the target in order to provide more value to the company’s shareholders.
Certainly one of the biggest and best-known examples this year is the sale of the previously family-owned Birkenstock company to US-French PE company L Catterton. The German footwear brand was founded nearly 250 years ago and has grown to become one the few iconic brands in the industry. In its press release announcing this deal Birkenstock said that under its new owners it plans to grow in markets such as China and India and will also invest in e-commerce platforms and its direct-to-consumer business.2
2. Risk factors of a primary buy-out
This is a perfect example of how PE investors are looking to identify untapped potential in companies and everage the associated profit. This also shows one of the differences between a primary and a secondary buy-out (secondary buyouts occur when PE firms sell control of a portfolio company to another PE firm). Or to put it another way, in a secondary buyout most of the obvious operational, financial and compliance improvements in the target company should already have been made. And this is precisely where the increased risk profile of primary buy-out for W&I-insurers emerges.
A recently published W&I insurance claims’ study3 shows that a not insignificant number of “high” sever-ity W&I claims ($10m plus) have involved sales by founder shareholders. Some of these have involved suspected fraud by the founder(s). Less robust controls or checks and balances than in institutionally-owned businesses mean that these types of situations can more easily go unnoticed or unchallenged.
2.1. Professionalisation and role of management
The PE’s buy-to-sell approach is typically attributed to a number of factors: high-powered incentives for target management, the use of debt and steering the target company through a transition of rapid performance improvements. In order to realize a short- to medium-term value-creation opportunity, buyers must take outright ownership and control. PE firms are well prepared to turn the target inside out and when no stone is left unturned, the likelihood that potential warranty breaches will be detected increases dramatically.
To improve performance current managers are often given better performance incentives and more auton-omy. Given that management will be most familiar with what is going on within the target, there is a potential risk that a suitably incentivised management will use its detailed knowledge to benefit the new owner and thereby itself. This can lead to an expanded disclosure process that exceeds the one of the purchase agree-ment. Any warranty breaches that would otherwise go unnoticed are thus revealed rather promptly.
This notwithstanding, management continuation is generally a positive aspect in the overall risk assessment of the W&I insurer. Above all, this shows that the inves-tor agrees with the general strategy of the target.
2.2. Structural change
Besides this aspect, the organisational changes can pose a challenge to the insurer. For one, such transactions, in particular compared to secondary buy-outs, often contain carve-out elements (e.g. if certain assets are to remain with the previous owners). Related errors in the transaction documents should not be compensated for under the insurance policy as those are purely transac-tional risks. The insurer will therefore closely monitor how the organisational changes are reflected in the transaction documents.
3. Underwriting approach
The often prevalent focus in the target on the operative business paired with less distinctive compliance struc-tures, a number of issues with primary buy-outs/family businesses are more problematic, and therefore require closer examination:
a) Are the annual accounts audited by the big four?What is the financial reporting structure of the target?
b) What is the tax compliance structure of the target?Is there an internal tax department (how is it struc-tured?) or is it outsourced? Are taxes handled on a centralised basis at the group holding company or is there a decentralised structure?
c) Is a compliance system in place? Are all key issues (anti-bribery and corruption, competition law, trade law, sanctions) adequately addressed?
d) How is the legal department positioned in terms of compliance with law issues? Are there external advisors? Is there a centralised or decentralised approach?
e) Does the target seek external advice on IP/ material contracts? What is the overall contract manage-ment and IP portfolio management like?
f) Does the target have a professional IT infrastructure or is there a significant capex underspend? How carefully are (standard) software licences monitored?
4. Conclusion
This increased risk profile does not make these transactions either uninsurable or unattractive. Experienced W&I underwriters have enough tools at hand to mitigate these imponderables and to assess them accordingly.
Besides good underwriting and a particularly watchful eye for the disclosure process, these tools include higher retentions and/ or de minimis for certain sub-aspects. These processes might not always be as straightforward as usual, but a balanced policy will provide consider-able added value for the buyer, especially in auction processes where such sales often take place.
