In recent years, as more insurers have entered the Representations and Warranty insurance market (according to a study from Harvard Law School, there are now more than 20 insurance companies writing these policies), there have been more opportunities for ever smaller M&A transactions to secure coverage, with deals as low as $15M deemed eligible.
The insurers that offer these policies understand that given the smaller transaction size, they will be asked to cover most, if not all, of the transaction value (TV) of the deal.
Insurance companies are providing flexibility for Buyers and Sellers by offering policies that provide coverage up to the purchase price, while also insuring the Non-Fundamental reps to a specified Limit – more on this below.
Sellers of small TV targets have less leverage than their counterparts, so having the ability to transfer ALL the indemnity risk can provide a productive tool for both sides.
Naturally, Underwriters in this space require the same levels of Buyer diligence as the larger deals, so eligibility for R&W should be checked before proceeding.
Here’s why this matters: most R&W policies don’t cover the entire cost of the transaction. They only have to provide Limits up to the Indemnity Cap (Cap) as outlined in the Purchase Agreement.
A Seller’s maximum exposure is equal to that Cap and no more. Therefore, there’s no need to provide more protection above that Cap. In many cases, the Cap runs 20% to 30% of the TV.
Typical R&W insurers that cover $100M+ M&A deals are reluctant to insure more than 30% of the TV. So, the maximum an insurer would be willing to cover on that $100M deal is $30M, even though that same insurer has the capacity to provide a $50M or $75M Limit. The reasoning is that Underwriters are not comfortable insuring a majority of the TV.
This position is not the case with deals in the lower middle market (sub-$30M TV space). Unlike the larger deals, it’s easier for Caps to exceed that 30% threshold. Consider a $5M Cap is 33% on a $15M deal. Buyers have significantly more leverage over targets in this sub-$30 TV space, and therefore routinely require higher Caps, particularly with regard to Fundamental reps.
How It Breaks Down
Within the Purchase and Sale Agreement, there are specific categories of reps: Fundamental and Non-Fundamental.
Fundamental reps often include:
- Organization and Standing
- Capital Structure
- Power and Authority
- Title to Securities (stock sale)/Title to Assets (asset sale)
- Taxes
Any rep not identified as Fundamental is considered a Non-Fundamental rep.
Buyers scrutinize the Fundamental reps more closely than any of the other Seller reps, as breaches of Fundamental reps lead to larger, more serious financial damages.
Breaches of Fundamental reps are rare because they have been so closely watched, but according to the recent AIG claims report, they do happen.
R&W insurance is priced based on the amount of Policy Limits provided. Since smaller transactions traditionally don’t need higher Limits, Underwriters haven’t been able to set a price for small deals that justifies the risk.
For that reason, Underwriters developed the approach of offering to insure the entire transaction by covering the Fundamental reps at a maximum Limit, while including coverage for the smaller, Non-Fundamental reps Cap.
The per Limit rate for these purchase price policies is discounted due to the lower risk of the Fundamental reps, while enabling Underwriters to collect sufficient premium to insure the smaller deals.
Take the case of a PE firm seeking to purchase a chain of car washes for $22M.
Within the Agreement, the Buyer seeks a $4.4M (20%) Cap on Non-Fundamental reps, but no Cap on Fundamental reps.
Prior to the entry of the new R&W policies, the maximum limit of coverage for Fundamental and Non-Fundamental reps would be $6M to $7M and the parties would have to bear any risk above that Limit.
Today, policies are readily available to offer a package that provides $22M in Limits for Fundamental reps, with a Sub-Limit of $5M for Non-Fundamental reps.
Consider the pricing benefit as well.
A $22M Limit R&W policy runs $400K to $600K. However, a policy with a $22M Limit on Fundamentals and a $5M Sub-Limit for Non-Fundamentals can be as low as $220K.
It’s clear that the use of R&W insurance will continue to grow as more Buyers and Sellers come to understand its benefits and insurers are willing to cover a wider range M&A deals.
If you are considering a M&A deal on the small side but didn’t realize you could secure R&W insurance to protect yourself, let’s talk about this recent trend of insurers covering full transaction value.
You can reach me, Patrick Stroth, at pstroth@rubiconins.com or 415-806-2356.