Parental Company Guarantees

1. Introduction

The current economic downturn, with insolvencies on the rise, is leading to a growing number of divestments. Sellers are increasingly seeking to streamline their portfolio and convert non-core business (which may be underfunded and undermanaged, or no longer strategically critical) into cash. Studies show that 78% of the companies are planning to divest within the next two years (EY 2020 Global Corporate Divestment Study). In the event of such a divestment however, what happens to the securities given by the sellers for the target subsidiary?

2. Parental Company Guarantees

If the subsidiary company enters into a commercial contract with a third party, that third party may want to ensure the performance of the contract and may look to other companies within the same group to provide a financial or performance guarantee in respect of the subsidiary’s obligations. In such circumstances, parent companies are often requested to provide security in the form of parent company guarantees (“PCG”), to bolster the financial credibility of their subsidiary companies. Under a PCG arrangement, in the event that a subsidiary fails to perform its contractual obligations, its parent company will effectively step in to complete the work and/or cover all losses and expenses which the third party incurs, or will incur, as result of the subsidiary’s breach. PCGs are used in a wide variety of sectors, but are most commonly seen in the infrastructure, engineering and construction industries.

3. Parental Company Guarantees in a Divestment Scenario

In a divestment scenario, a parent company (as seller) will be seeking release from its PCG obligations, and to have such contingent liabilities removed from its balance sheet (i.e. a clean break). Buyers, in particular private equity investors, on the other hand are often neither able nor willing to assume or refinance the seller’s PCG obligations. Many private equity structures will not permit the burden of such operative contingent liabilities, and a private equity investor may also be concerned that such liabilities would impede its exit. For various reasons, the beneficiaries of the PCGs may also potentially not accept a new obligor. If the seller therefore does not proceed with the transaction, the absence of a parental guarantee solution may therefore become a deal breaker.

4. Parental Company Guarantees Insurance

In this scenario PCG insurance may enable the parties to do the deal. In the event that the target fails to fulfil its obligations under the contract with the third party, and that third party demands remedies from the seller under the PCG, the insurer will look to cover any legitimate obligation of the PCG, limited however to monetary compensation. No performance guarantee will be provided by the insurer.

PCG insurance is a unique solution, combining product liability elements and surety elements, but it also has its own particularities. PCG insurance covers the performance default risk, (i.e. that the target will not, or will not properly, fulfil its contractual obligations) provided that the target does not have the financial capacity to fulfil its contractual obligations itself (e.g. due to insolvency). The term of the PCG insurance is generally aligned to the term of the PCG and the underlying contract, respectively.

Based on the available risk-related data (for example loss data, underlying contracts, PCGs, financial data and so on), the insurer will review the technical and credit exposure and perform an actuarial modelling exercise to evaluate the exposure assessment. In order to consider the level and terms of cover it is able to provide, the insurer will take into account the completion phase of each underlying contract (execution phase and warranty phase) in its risk assessment. The insurer will take into consideration a wide range of factors, including the residual contract value, the existence of contractual penalties, the track record of performance issues and warranty claims for each contract and the target in general, ongoing arbitration or court proceedings, the budget planning of the target for each contract, the current financial situation of the target and the business plan of the buyer for the target going forward.

The parameters of the PCG insurance offered by the insurer such as limit and retention, as well as the terms, will reflect the results of the actuarial modelling exercise, in particular the expected loss value derived from the portfolio of underlying risks.

During the underwriting process the insurer and its legal counsel will review all risk-related data in detail, in order to define the insured risk and its trigger events for each and every PCG. The insurer will also review the transaction documents, namely the share or asset purchase agreement, in order to assess the respective rights and obligations of the seller and the buyer in respect of the target after closing. Although the PCG will remain with the seller, the buyer will also have certain obligations to ensure contractual performance of the target. The buyer will have to ensure that existing insurance coverage is maintained after closing, and that the target is adequately capitalised. To the extent certain matters are excluded from cover under the policy, the parties are advised to deal with these issues in the share or asset purchase agreement for appropriate risk-sharing.

5. Parental Company Guarantees and other solutions

The parties may wonder whether other solutions may also be an option.

In the construction business the use of surety bonds/bond guarantees are especially important. A surety bond is a contract between three parties; a financial institution or a dedicated insurance company agrees to pay a stated sum on behalf of the target to the third party, if the target fails to meet the terms of its contract with the third party. These financial securities are a cost-effective form of risk financing. However, the term and capacities of surety bonds are generally limited. The average term of a surety bond is one to three years and, in the event that a bond is used, the guarantor will have a recourse claim against the target, which in turn strains the credit line of the target. Moreover, in carve-out scenarios capital market requirements are very often deemed not entirely matched, thus limiting the access to cost-effective risk financing.

In some transactions the parties may agree to deposit a certain portion of the purchase price into an escrow account, to secure any claims in connection with the PCGs and the underlying contracts, both with respect to the performance, and the financial, default risks. However, from a seller’s perspective, an escrow account is not a favourable solution as it ties up capital that may otherwise be used to boost cash reserves and fortify balance sheets.

6. Summary and Outlook

PCG insurance allows the parties to adequately allocate risk resulting from historic PCG obligations in the situation where the target is divested. With the number of divestments rising, it is expected that PCG insurance solutions will increasingly be demanded in the future.