The COVID-19 pandemic has changed trade, commerce, and business in so many ways already… with more changes to come. The world of M&A has reacted as well. But as I noted in my previous piece, No Significant Drop in M&A Activity During This Recession, we won’t see the slowdown happening.
Instead, we’ll see a shift to a Buyer-friendly market. Also, watch for PE firms with plenty of cash to look for opportunities – and bargains… struggling companies they can turnaround.
The pandemic will impact a key part of M&A activity: the due diligence process and the use of Representations and Warranty (R&W) insurance to cover breaches of reps in the Purchase and Sale Agreement.
Just as with any insurance product, COVID-19 must be addressed with R&W policies. And expect pandemic-related questions from Underwriters in the due diligence process.
Not every company, of course, has been affected by COVID-19 in the same way. For example, a software company that already had a largely remote workforce is in much better shape than a retailer forced to close brick-and-mortar locations.
But overall, insurers are closely monitoring the impact of COVID-19 on operations of any acquisition target. This is how I expect it to impact R&W coverage moving forward:
1. Expect all R&W policies to have some form of COVID-19-related exclusions.
As a worldwide pandemic affecting billions, nobody can claim that COVID-19 is an “unknown” prior to a deal being signed. And R&W policies only cover breaches that were unknown, “historical,” or related to issues that were not disclosed by the Seller.
The impact of the virus on the workforce, including layoffs and supply chain disruptions will be the focus on enhanced due diligence in particular, and not considered breaches. Claims related to a drop in revenue are right out the window. These will be excluded, but perhaps covered in another M&A related policy, such as business interruption insurance.
That being said, you can limit exclusions for specific things related to the pandemic, not just anything COVID-19 – that exclusion would be too broad. Despite its seriousness, the pandemic can’t touch every rep. So expect very careful language.
Since R&W policies are largely written for each individual transaction, a broker has the ability to identify the right Underwriters and products and make the exclusionary language in a policy as favorable/narrow as possible for the policyholder.
Take the Fraud Exclusion for example. Fraud is absolutely excluded in virtually every insurance policy because it’s a moral hazard. However, savvy Brokers and Underwriters can create wording in a policy to provide legal defense of a policyholder accused of fraud until the alleged fraudulent behavior is proven. If there is no proof of fraud, the exclusion cannot be triggered, therefore, a policyholder benefits from the protection provided by the policy. Depending on the rep in question and the amount of diligence shown to Underwriters, a Broker can negotiate wording that can lessen the scope of a COVID-19 related exclusion.
2. A close watch on lengthy interim periods.
With some M&A transactions, there can be a long period between signing the Purchase and Sale Agreement and actually closing the deal, especially with large and complex deals. For example, it took months for Amazon’s acquisition of Whole Foods to win regulatory approval and close.
Imagine if a deal like this had been done recently, and COVID-19 swooped in during that interim period. Remember, to be considered a breach, the issue must be unknown and/or result from failure to disclose a harmful issue by the Seller.
But a change in the overall economic environment or the industry such as this pandemic, can’t be considered an “unknown” and therefore would not be covered.
Thankfully, this is not much of an issue with lower middle market companies because interim periods between signing and closing are rare, and if there is an interim, it is likely measured in days, not months.
3. Pricing and retention levels.
One last thing to watch out for. For now, R&W coverage pricing and deductibles haven’t changed. They should be increasing as more claims are coming in in this time of crisis.
The previous trend had been for consistently falling prices and its use in ever-smaller deal sizes – down to $15 million, which was one of the factors in its growing use by middle market companies. It’s something to watch out for.
To discuss the impact of COVID-19 on R&W and other M&A-related insurance, I invite you to contact me, Patrick Stroth, at pstroth@rubiconins.com.