1. Introduction
Carve-out transactions remain very popular in Germany despite their high complexity. Over the last years, their number has increased significantly. One of the main reasons for this increase is the trend towards focusing on the core business that has emerged in recent years, as large listed industrial conglomerates are usually “punished” with a conglomerate discount on their share price. This trend is encouraged by activist investors who buy into listed companies to demand changes to the business model or company structure (often in the form of spin-offs or demergers) to boost the share price. Moreover, despite the economic fallout from the Covid-19 crisis, the war in Ukraine and the current stock market turmoil, valuations remain high, creating a good environment for a proposed sale. In addition, private equity investors are sitting on an all-time high of committed equity (“dry powder”) and have long since shed their reservations about carve-out transactions. A similar development has taken place in the area of W&I insurance, the conclusion of which was the absolute exception in carve-out transactions just a few years ago. This development as well as the special features of W&I insurance in private carve-out transactions will be examined in more detail below from a legal perspective.
2. Carve-out transactions
A “carve-out” is the separation of legally dependent business divisions or parts of a company which are to be continued as an independent entity after completion of the carve-out. As a rule, a carve-out is followed by a capital market transaction (demerger and booking in the securities accounts of the parent company’s shareholders or classic IPO), or the carve-out is combined with a private transaction (sale or contribution into a joint venture) being the norm today. A carve-out transaction should be differentiated from the sale of a business unit that is already operated in separate legal entities within a group with certain centralised overhead functions, the latter also requiring certain disentanglement measures for a successful completion.
Carve-out transactions are usually highly complex processes that can extend over a period of several years, not infrequently between three and five years. Milestones in the process are (i) the implementation decision as starting point, (ii) the development of the target operating model, carve-out plan as well as the draft purchase agreement including the transitional services agreement and other ancillary agreements, (iii) the conclusion of the purchase agreement with the acquirer, which usually marks the beginning of the implementation of the carve-out, and the (simultaneous) conclusion of the W&I Insurance, (iv) the achievement of the closing date under the purchase agreement as the starting point of the standalone operation of the carved-out business, and (v) the achievement of full independence of the business and thus the end of the transitional services provided by the parent. The W&I insurance work stream should be initiated by the seller in parallel with the preparation of the purchase agreement and be flipped over to the bidders as early as possible in the course of the sales process.
3. Preparations on the sell-side
Due to the high complexity, detailed and thorough planning and preparation are required at the operational level, but also from a financial, accounting, tax and legal perspective. This must extend not only to the carve-out but also to the subsequent divestment, which requires a huge effort and good coordination between the various parties involved and the internal experts and external advisors. Without a convincing business model and a detailed carve-out plan, the sale process will be slowed down, which could reduce the interest of potential acquirers and thus minimize the achievable purchase price. Therefore, planning is not only key to a successful implementation of the carve-out, but also to a timely, cost-efficient and smooth completion of the sale process, which helps to avoid or at least minimise the uninsurable risk of business interruptions.
Legal and external lawyers and consultants (with the involvement of a W&I insurance broker) should be involved in the project as early as possible. The first task is usually to analyse the status quo of the target business unit and its interdependencies with the other business units of the group. Once the standalone operating and financial model has been worked out, the tax and legal structuring can be completed. A legal carve-out plan must then be drawn up to govern the various steps required for the operational and legal separation of the target business from the rest of the group. The carve-out plan is closely linked to the purchase agreement, which should provide a detailed legal framework for the implementation of the carve-out. It is also of great importance in the W&I insurance process and should also be coordinated with the insurance broker as early as possible in order to incorporate its experience with carve-out transactions and to anticipate potential pitfalls in the insurance process. The operating model and carve-out plan should also be submitted to the potential insurers so that they understand the scope and implementation of the carve-out and can assess any risks themselves. The various steps overlap to some extent and need to be carried out in parallel with the preparation of and assistance with the due diligence documentation.
4. Use of W&I insurance
The use of W&I insurance has been the absolute market standard in private equity transactions for many years and has now also established itself as market standard in strategic M&A. Even today, strategic M&A transactions in the small and lower mid-cap segment are still sometimes conducted without the conclusion of W&I insurance policies. Particularly in case of the sale of family businesses, the use of an insurance solution is often dispensed with. The main reasons therefore are, among other things, the fact that the business owner is usually active in the management, has a good overview of all aspects of the sold business and thus often qualifies the risk of warranty breaches as manageable.
Until a few years ago, the use of W&I insurance in carve-out transactions was a rare exception. This is in particular due to the greatly increased complexity compared to ordinary transactions as well as the specific risks of carve-out transactions. In addition, the liability regime in the sale and purchase agreement has developed significantly in recent years in favour of the sellers, who – like the W&I insurers –benefit from lower maximum liability limits, leaner warranty catalogues and far-reaching knowledge and materiality qualifiers in the warranty catalogue. Not least as a result of this development, the use of W&I insurance on the buy-side has now also become the market standard in carve-out transactions. In the context of auction processes, this means that bidders are regularly required to complete the underwriting process by the time the final bid is submitted.
The scope of protection in carve-out transactions usually falls somewhat short of the protection in ordinary transactions. In particular, the successful implementation of the carve-out and the independent functioning of the carved-out business after completion are regularly excluded from insurance protection. However, recent developments suggest that insurers have become more willing to insure certain carve-out risks for additional premiums. This trend towards a more carve-out friendly W&I insurance environment is likely to continue, although this will require the detailed conduct of due diligence with particular attention to the specific carve-out risks.
5. Specifics of W&I insurance in carve-out transactions
5.1. Specifics of due diligence
The key areas to be reviewed and documented during the due diligence in a carve-out transaction are the target operating model and carve-out plan, the pro forma consolidated carve-out financial statements, and the assets, contracts and employees that are the subject of the carve-out. While the target operating model and the financial statements are crucial for the valuation of the business to be carved out, the carve-out plan as well as the scope of the assets, contracts and employees to be transferred are essential for the assessment of the stand-alone functionality of the target company after the completion of the carve-out (“sufficiency of assets”). The latter regularly requires the provision of transitional and other services by the former parent company. It should also be noted that jurisdictions, entities or legal areas that have not been reviewed as part of the due diligence are usually excluded from insurance coverage. Therefore, in global transactions, local experts and advisors should be regularly consulted to avoid gaps. The more detailed the due diligence is carried out and documented in the reports, the greater the assurance provided to the insurer, which usually has a positive impact on the scope of insurance cover.
a) Target operating model, carve-out plan and carve-out financial statements
Since the target operating model as such has not yet proven itself on the market, it must be thoroughly examined. It forms the basis for the future cost base and business model of the target company and is thus a decisive factor for future earnings and profit potential. The target operating model established in the preparation phase has a significant impact on the carve-out financial statements. As it is an integrated business unit, separate historical financial data, especially on the cost side, will only be partially available and no financial statements will be available on a standalone basis for the business unit concerned. Therefore, pro forma consolidated financial statements must be prepared that adequately reflect the historical costs of the business unit in question and explain the underlying assumptions and accounting policies. This is where the target operating model comes into play, projecting the conception of the integrated business unit into that of a legally independent entity after the carve-out has been implemented. Ultimately, in order to prepare their business valuation, bidders need (pro forma consolidated) financial statements that provide a true and fair view of the historical situation and performance of the business to be carved out. Insofar as these are not certified by an auditor, the insurance cover is restricted to the effect that the insurance provider does not assume any liability for the presentation of a true and fair view of the assets, liabilities, financial position and profit or loss of the division. Instead, it merely assures that the financial statements do not materially misstate the assets, financial position and results of operations. This standard falls short of the protection afforded by the “true and fair view” standard.
b) Scope of the carve-out
From a legal due diligence perspective, reviewing information about the business unit’s workforce (including employment contracts, compensation structure, benefits provided and retirement plans) and the assets and contracts to be transferred is essential.
Due to their outstanding importance for the business opportunities of the business to be carved out, the employees and the benefits granted to them as well as the underlying individual and collective contracts and regulations within the scope of the warranty catalogue of the purchase agreement are of great importance, which in turn has an impact on the due diligence to be performed. A carve-out generally leads to a transfer of undertaking pursuant to Section 613a German Civil Code (BGB) with the consequence that the employment relationships are transferred by operation of law with all associated rights and obligations, including all rights and claims under collective bargaining agreements, to the acquiring legal entity, unless the affected employees object to the transfer. Since the terms and conditions of employment remain unchanged and cannot be changed without the consent of each individual employee being transferred, a detailed analysis of the remuneration package and the terms and conditions of employment from a legal, financial and operational perspective is essential.
With regard to the assets and contracts to be transferred, the most important task is to ensure the independent functioning of the target business after the completion of the carve-out. Even after completion of the due diligence, a potential acquirer can hardly assess whether all assets required for a seamless continuation of the business after completion will be transferred in the course of the carve-out. Therefore, sufficient protection for the acquirer can only be achieved under the sale and purchase agreement. The seller has a better and more detailed knowledge of the necessary assets, but is often unwilling to accept catch-all clauses for their transfer. So-called “wrong pocket” clauses, which govern the transfer of assets that are inadvertently missing or the retransfer of assets that are inadvertently transferred, are important safeguards for both parties. However, they cannot be covered by W&I insurance. To the extent that the carve-out has not been completed at the time the purchase agreement is signed, which is the usual structuring of carve-out transactions today, there may be gaps in the scope of coverage provided by the W&I insurance. These can often be closed by addenda to the insurance policy if and to the extent that the insurer is notified in writing of the result of the further review and no risks were identified in the process. In carve-out transactions, insurers also regularly require a so-called “bring-down” of the warranties at consummation of the purchase agreement. This obliges the seller to again provide information on the accuracy of the warranties and to disclose any breaches in writing, which are excluded from the insurance cover.
5.2. Carve-out plan and achievement of standalone functioning of the business unit
The completion of the carve-out measures required to achieve the independence of the carved-out business unit is usually a closing condition under the purchase agreement. Since the purchase price in carve-out transactions is usually determined on the basis of interim financial statements as of the closing date, the economic risk of the carved-out business transfers from the seller to the acquirer upon closing. Thus, the acquirer is protected against weak business performance and disruptions during the execution phase of the carve-out until closing, regardless of the W&I insurance and its scope of coverage.
The most critical point in the implementation phase is the closing. At this time, the transfer of the divested business unit to the acquirer takes place and the transitional services agreement is concluded. From this point onwards, the business unit is no longer part of the parent group. This final decisive carve-out step can hardly be simulated or tested and is therefore always associated with uncertainty. Any operational issues and problems that arise after closing must be negotiated and resolved between the seller and the acquirer on the basis of the provisions set out in the purchase agreement and the ancillary agreements and can no longer be resolved internally within the group – as was the case up to the time of closing. In this context, the “sufficiency of assets” warranty and the transitional services agreement are of key importance. While the former is – at least subject to seller’s knowledge – insurable with sufficient due diligence, the scope and performance of the transitional services as well as disputes arising from the underlying contract are not covered by the protection of the W&I insurance.
5.3. Knowledge qualifiers in seller’s warranties
Since German law is very strict with regard to the liability for intent and fraud, which eliminates all limitations of liability in favour of the seller under the purchase agreement, a seller regularly gives only few unqualified warranties. Liability for intent applies when a party makes a warranty without having verified or being able to verify the underlying facts and circumstances and thus makes statements into the blue. By making a warranty subject to the knowledge of the seller (or the natural persons acting on its behalf), this risk can be almost completely eliminated by careful examination of the warranties given. The risk of intentional liability has a particular impact on the “sufficiency of assets” guarantee. In complex carve-out transactions, it cannot regularly be given without knowledge qualification if the seller does not want to expose himself to potentially unlimited liability for intent. The same applies to numerous other guarantees if the business to be carved-out and its legal circumstances are quite complex which is regularly the case.
Under W&I insurance, knowledge qualifications can largely be declared inapplicable in the relationship between the acquirer and the insurer (so-called “knowledge scrape”). However, this requires a robust and comprehensive examination of the facts underlying the warranty in question. Where this is not possible, a “knowledge scrape” cannot be achieved. This is the case, for example, with the “sufficiency of assets” guarantee, so that the risk resulting from the knowledge qualifier must be borne by the acquirer. To the extent an asset belonging to the carved-out business was not transferred, the “wrong pocket” clause applies. However, if an asset necessary for the operation was missing even before the carve-out, the “wrong pocket” clause does not help and the acquirer must acquire or rent/lease the missing asset at its own expense.
6. Recent developments
6.1. Demand for and positive experiences with carve-outs
Unlike a few years ago, carve-out transactions are very popular with private equity investors today. On the one hand, the industry has a record volume of committed equity. On the other hand, the valuations of carve-out target companies are regularly much more attractive than those of secondary or tertiary exits. Moreover, the number of funds evaluating and executing highly complex carve-out acquisitions is still growing. At the same time, nearly all of the most complex carve-outs in recent years have been proven to have been successfully implemented without any major problems having become known in the market. This again increased the attractiveness of carve-out transactions. On the insurer side, the increased demand had a positive effect on appetite and capacity.
6.2. Increasing competitive pressure from additional insurers
Just a few years ago, only the large and established insurers were prepared to insure carve-out transactions. Even then, they employed large teams of experienced underwriters who could execute underwriting of the significantly more complex carve-out transactions in a timely manner and without negatively impacting other transactions. While the number of insurers offering W&I insurance on the German market also increased as the popularity of the product grew, many providers also strengthened their teams by adding underwriters. This increased the number of insurers able to smoothly underwrite complex carve-out transactions. The combination of additional providers and the increasing professionalism of existing market participants led to increasing competition among insurers. This, in turn, had a positive effect on the product of W&I insurance in carve-out transactions in the form of increasing professionalisation. Today, and given the process is properly prepared, underwriting of a carve-out transaction can be completed in a similar timeframe to an ordinary M&A transaction (approximately seven to 14 days). At the same time, sellers and potential acquirers benefit from the increased number of experienced and reliable W&I insurers, especially in auction processes where several bidders need to work in parallel on W&I insurance for the same target.
6.3. Insurers’ increased risk appetite and falling insurance costs
The increased competition among insurers in turn led to an increase in the risk appetite of many insurers. In addition to the established providers, comparatively smaller insurers are now also seeking to insure carve-out transactions with mostly large values. In terms of scope of insurance cover, they are often more flexible and acquirer-friendly than their established competitors. This has also had an impact on insurance premiums, which have been declining for a long time and are still very attractive despite slightly higher costs compared to the pre-Covid times.
7. Current market environment and outlook
With markets having recovered significantly from the Covid-19 shock during 2021 and the German DAX40 index reaching a new all-time high in early 2022, the outlook for 2022 was very promising. There were rumours that some major carve-outs of leading German companies, which had been put on hold during the Covid-19 crisis, would resume and the businesses concerned would come to market during 2022. With the outbreak of the Russian-Ukrainian war and the disruption of global supply chains as a consequence of the strict Covid lockdowns in China, both of which in themselves already entail serious adverse consequences for economies and stock markets, the general uncertainty has returned. It is still not fully foreseeable what impact both events will have on Western economies and stock markets. The German transaction market is currently divided. While the small and mid-cap segment appears to be largely unimpressed, some transactions in the upper large-cap segment have been paused or postponed for the time being. This is mainly due to differing views on valuation and difficulties in concluding large-volume financings, for which uncertainties in the capital markets are not very supportive.
8. Summary
The use of W&I insurance in carve-out transactions is today the market standard. Provided that the specifics of due diligence are taken into account, carve-out transactions can be insured adequately and without major gaps in insurance coverage. However, knowledge qualifications of certain warranties cannot be avoided in some cases due to the complexity of carve-outs, especially in the context of the “sufficiency of assets” warranty. Due to the professionalization of insurers, a policy can also be concluded in a carve-out transaction within a period of approximately seven to 14 days.
