Case Study: A PE Acquisition and Add-On Gone Wrong

News came across the wire recently about a major lawsuit targeting a well-known Private Equity firm due to a post-closing dispute in a substantial M&A deal.

If the judge rules against them (a decision is expected very soon), they could stand to lose $275 million. In any case, this not the type of PR any PE firm… or anybody in M&A would want.

Why is this significant? If there was a Representations and Warranty insurance policy covering the transaction, this whole situation could have been avoided. The insurer would have paid the perceived damages, insulating the Seller and making the Buyer happy, too.

And this situation makes a great case for why an R&W insurance policy should be used in every merger and acquisition, due to the protections it provides.

Let’s dig in to this case more in-depth.

When M&A Goes Bad

The Players:

HGGC (HGGC) – Palo Alto based PE Firm

Citadel Plastics Holdings (CP) – Portfolio Company owned by HGGC

Lucent Polymers (LP) – Specialty polymer plastics company acquired by Citadel in 2013

A Schulman, Inc. (AS)– Leading international supplier of high-performance plastics compounds

Our story begins in 2013, when Citadel Plastics Holdings, a portfolio company of PE firm, HGGC (formerly known as Huntsman Gay Capital Partners), acquired a polymer plastics company called Lucent Polymers.

Fast forward to March 2015, when A Schulman, Inc., supplier of high-performance plastics compounds, purchased Citadel Plastics from Palo Alto-based HGGC for $800 million. This is known as an add-on and doubled A Schulman’s size and made them more competitive on the global market. (Funnily enough, A Schulman had previously competed with Citadel to buy Lucent.)

This is where things get ugly.

Alleged Fraud and a Lawsuit

In January 2016, A Schulman alleged that a Lucent Polymers plant in Evansville, Indiana had falsified test results to make it seem like its products were Underwriters Laboratory certified. They also said that this had an impact on their bottom-line.

According to an article in Crain’s Cleveland Business from April 7, 2016: “As much as $20 million to $25 million of Lucent’s $71 million in annual sales could be lost as a result of the alleged false results, [company] officials said.”

As a result, they sought to keep $31 million in escrow from HGGC, plus another $7 million. It’s a tough spot for HGGC. They’re technically managing this company, but it’s just one in their portfolio. They can’t know everything, especially with a subsidiary. It would have been very hard for them to identify this falsification, if it indeed happened. They’re essentially a victim here, too.

The lawsuit continued, with the case going to trial in April 2018. Now the Buyer, A Schulman, is seeking $275 million in damages. And the FBI is investigating the allegedly falsified test results. The judge’s decision is expected soon.

HGGC has a high-profile board, including Hall of Fame quarterback Steve Young. Even if the HGGC board had no knowledge of this issue they’re still roped into the litigation. As they contend, they invested in Citadel, they advised them, but they didn’t actively manage them. Yet, the PE firm can still be held liable.

The Silicon Valley Business Journal reported that “HGGC said in court papers that their involvement at Citadel was financial and denied knowledge of the alleged fraud.”

R&W Insurance to the Rescue

After reviewing this case, I contended that R&W insurance would have covered this situation and paid the damages on behalf of HGGC if the judge rules against them. I reached out to underwriters I work with to get confirmation.

What I heard back was in line with my theory. As one of them told me, R&W insurance “responds even in ugly, messy circumstances.”

A.J. Kritzman, Underwriter with Tokio Marine HCC put it this way:

“If (1) A. Schulman Inc. purchased RWI to insure HGGC’s reps and warranties, (2) the issue with the failure of Citadel’s products to meet Underwriters Laboratories specifications was unknown during due diligence, and (3) there was an applicable rep in the Citadel PSA, than a claim for breach of that particular rep could be made. PEFs should insist on RWI when selling a portfolio company.”

Based on the reported $800M purchase price for Citadel, an R&W policy to cover this deal would have involved an $80M Limit R&W policy (10% of transaction value) costing $2.4 to $3 million premium, with an $8 million deductible (1% of transaction value). This would provide more than enough funds to cover A Schulman’s initial demand of $38M.

PE firms are the biggest buyers for R&W out there. Even so, all too often they don’t use R&W, viewing it as an unnecessary expense. But as you can see from this example, such a policy can save a lot of heartache for a small investment in insurance coverage.

As AJ put it: PE firms should insist on R&W insurance when selling a portfolio company. I couldn’t agree more.

One of the most common objections I hear from PE firms and other potential beneficiaries of R&W insurance is the cost. The truth is you can’t put a price on the peace of mind and hassle-free negotiation you’ll experience when you transfer risk to an insurance company.

But in dollars and cents, this specialized type of insurance has never been more affordable. Be sure to download my free Representations and Warranty Insurance Cost Calculator to see how this coverage might fit into your next M&A deal.


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