W&I insurance in M&A transactions – A view from an M&A advisor perspective
W&I insurance solutions have certainly become an established tool in the M&A process toolbox. Thus, when we start designing an M&A process at the out-set of a sell-side mandate, determining the W&I strat-egy is as common as reflecting about something such as which vendor due diligence reports should be pre-pared for the process and the point in time by when the sell-side SPA draft should be made available to potential buyers. In fact, the timing of SPA drafting and W&I preparations are closely linked.
1. Why opt for a W&I insurance solution?
But before diving into the details, I want to shed some light on how prepared sellers are to implement the W&I insurance concept within the sales process, as the readiness to use W&I insurance varies substantial-ly between investor groups. While most private equity funds are familiar with the concept and appreciate the benefits of a W&I insurance, there are still quite a few financial investors who have not yet used this instru-ment in a sell-side process. This is even more the case when it comes to corporate sellers and is topped in cases when private individuals are selling their shares. In these cases, where there is little-to-no detailed understanding of what W&I insurance is and how it works, our advice starts with educating sellers of what the key benefits of W&I insurance are.
First and foremost, there is the “clean exit”, i.e. virtually replacing seller’s liability under the warranties in the SPA, and this is often the most convincing argument for sellers. Issues such as avoiding the need for an escrow procedure and thus allowing for faster access to disposal proceeds (except for earn-out related pur-chase price components) are quickly understood and well appreciated. Less time-consuming negotiations and improved transaction certainty also helps to convince the seller to consider using W&I insurance. Further benefits such as providing transparency regarding coverage and associated costs, enabling an efficient process while controlling the various W&I providers,and a solvent counterpart for the buyer in the case of a claim are of less importance for sellers, but of key importance for us as M&A advisors.
However, especially in primaries, there are usually a lot of prejudices which need to be clarified before pro-ceeding with the design of the W&I process. In many cases, sellers argue that they are not going to assume liability for anything that has not previously been confirmed by the auditor of the target or the incumbent management team, so that effectively any arising claims would have to be settled between buyer, the auditor and/or target management, which sellers assume would be covered by their D&O or professional liability insurance respectively. As a result, they often perceive liability in connection with the disposal of the target as something very distant and highly unlikely to happen. Another reason why sellers are often hesitant to consid-er W&I insurance is that they are wrong in the assump-tion that they have to bear the entire costs of the W&I insurance. In such cases, we typically argue that the costs associated to W&I insurance depend on the chosen approach, such as soft vs. hard-staple, and that in both cases amounts remaining with the seller are relatively low compared to the costs of the overall M&A process.
2. Going down the soft or the hard route?
Therefore, once our client is convinced that implement-ing W&I insurance into the M&A process is beneficial and serves the purpose of running a smooth and effi-cient competitive auction, the next decision to make is whether to opt for a soft- or hard-staple W&I process. This decision is crucial as it has several implications for the entire M&A process and highly depends on the underlying target in terms of business nature and “quality” of the business. As a result, we typically align our initial recommendation with the chosen W&I broker and the law firm advising on the transaction.
In both soft- and hard-staple W&I scenarios, insurance providers only require a draft SPA, the confidential information memorandum, and a valuation range to come-up with non-binding indications of insurance terms. However, for a hard-staple W&I process, W&I insur-ance providers additionally require a full-set of vendor due diligence reports (including financial, tax, legal, commercial, ESG) to successfully complete the sell-side underwriting process. Thus, the decision as to which vendor due diligence reports should be produced must be taken not only with respect to a thorough process preparation and in light of the seller’s budget, but also in relation to the envisaged W&I process. Ultimately, the quality of the W&I process and prepared due dil-igence materials will impact the comfort of W&I in-surance providers for the underlying target, and there-fore influence the pricing of the policy.
By going for a hard-staple W&I process, we also intend to send a certain signalling effect to the investor communi-ty. As hard-stapling means that buyers will be confronted with a pre-negotiated W&I policy which has already undergone a sell-side underwriting process, there is hardly any option to deviate from the prepared W&I solution and related draft SPA if a potential buyer wants to emerge as frontrunner. Thus, by dictating this pretty rigid process design, we are implicitly conveying the message that (i) the underlying target is a high-quality asset, (ii) the disposal process is highly competitive and (iii) once a potential buyer has been awarded a tree at a W&I insurance provider, there is a high likelihood of win-ning the race, since most W&I insurance providers are only able to handle two, and at a maximum three, trees.
Similar to a potential lender education in the M&A process, it is of utmost importance for us to control the entire W&I process, if only to make sure that a preferred potential buyer has access to the best insur-ance terms or solution. Therefore, we usually capture the guidelines for buyers to approach W&I insurance providers in the NDA and then further specify the pro-cedure in process letters. Even in a soft-staple W&I process, in which the entire underwriting process is executed by the buy-side, we closely monitor which potential buyer gets access to which W&I providers in line with the non-binding offers and the related like-lihood of a transaction.
In the recent past, this has quite frequently led to frictions with the more W&I-savvy potential buyers or the law firm acting on their behalf. Here we experi-ence a growing trend towards established relationships between potential buyers/law firms and W&I insurance providers, and the strong wish to collaborate with their preferred W&I partners. The background of this, as we increasingly see it, is that W&I experts at law firms have typically spent quite some time as an underwriter at a W&I insurance provider before re-joining a law firm again and would like to leverage their network. From a deal tactics perspective however, this is not always something we can grant.
3. Getting the timing right
From a timing perspective, we of course monitor all due diligence report providers to ensure that the re-spective reports are not only finalised in time for due diligence but also for the sell-side underwriting pro-cedure too. This is usually a less critical path in the preparation of the W&I process, whereas getting the timing of the draft SPA right is decisive.
A couple of years ago, when W&I insurance was not used very frequently, it was common to provide a draft SPA only towards the middle or even end of the due diligence phase so that the buyer had sufficient time to provide a marked-up SPA as part of the final offer. For drafting the SPA and aligning the final draft between seller, target management, sell-side lawyer and sell-side M&A advisor before it is made available to potential buyers, we usually plan for anything between a couple of days and two to three weeks, depending on the underlying situation. This means that historically the drafting has only commenced around the start of the due diligence phase and legal costs for the seller would only be generated when there is a fairly good view on the success of the transaction.
In today’s process designs, we are initiating this process much earlier for two reasons. First, to be well-prepared for pre-emptive approaches which we increasingly see in today’s very dynamic M&A environment. Second, to be able to provide a draft SPA and an overview of non-binding indications directly at the outset of the due diligence phase in a soft-staple sce-nario and thus to allow the buyer to organise the buy-side W&I process according to the due diligence timetable and deadline for final offers set by us. In a hard-staple scenario, we aim for providing potential buyers with the pre-negotiated policy via the virtual data room around one to two weeks before the fi-nal offer deadline so that the buyer has still sufficient time to finalise the policy with his tree at the W&I broker and W&I insurance provider respectively. Consequently, sellers incur legal costs roughly four to six weeks earlier compared to processes without W&I insurance.
4. Who pays the bill?
To complete the picture around costs related to the W&I process, there are three elements to be considered. First, testing insurance markets for their appetite in the underlying transaction via a W&I insurance broker comes at no cost for the seller. Second, underwriting fees on the sell-side are only incurred in a hard-staple W&I process in the form of legal fees incurred by the W&I insurance provider but charged to the Seller. In a soft-staple process, underwriting fees are either directly borne by the buyer as it is the buyer who is taking out the insurance, or implicitly reflected in the valu-ation. Third, the only kind of cost that could potential-ly arise for the seller is, in the case of a soft-staple W&I, a break fee which is negotiable with the broker and usually a negligible amount compared to other cost items in an M&A process. Advising on the sell-side, we are usually not confronted with discussions around the premium or costs being incurred for W&I insurance needs to be reflected in the purchase price. Advising on the buy-side, however, we are fairly often successful in pushing at least for a 50/50 split in underwriting fees between our buy-side client and the seller.
5. Wrap-up
Ultimately our aim as sell-side advisor is to organise a swift, competitive, and efficient disposal process. While W&I insurance probably had some starting difficulties in its early days, today it accelerates the negotiation phase in most of our transactions, due to underlying representations and warranties catalogues being drafted in a broader and more consensual way from the outset as there will be an insurance covering most of it. However, reality shows that agreeing on a catalogue for representations and warranties can still be tiresome and time consuming, especially when buyers require an extensive prolongation of the sug-gested catalogue, which needs to be closely reviewed by the seller and target management to avoid guar-antees being given into the blue (“Garantie ins Blaue hinein”) and that the seller or target management are potentially acting in wilful misconduct. In addition, a substantial amount of disclosure schedules added to the initial draft SPA can also slow down the process.
For us, W&I insurance will surely continue to be a key M&A process element going forward, as the product is continuously developing itself as the cases and circumstances which can be covered become more manifold (such as in distressed M&A situations), as sellers/buyers increasingly seek solutions to mitigate transaction-related risk, and as appetite for the latter evolves.
