Regarding the way the M&A transactions are conducted recently, we notice that the representations and warranties insurance policy for breaches of representations and warranties by the seller in the M&A (the “Warranty Insurance Policies” or the “RWI”) transactions are used more frequently.
A brief overview of the mergers and acquisitions market in Croatia
Against expectations and despite the global Coronavirus pandemic, in the last year, the M&A activity in Croatia was on the year 2019 level, with a total of over 40 transactions concluded. Several significant transactions marked the year, such as Nanobit, Infobip, Sunce Group and others.
We have also noticed that the Covid-19 more resilient industries, such as IT, gaming, healthcare and pharmaceutical sector, retail, e-commerce, and food sector, still show a impressive M&A activity and spark investors' interest worldwide. Additionally, private equity investors are still very active, particularly the specialized tech funds. Another trend we have noticed, is that a growing number of companies in the region, such as the Polish Allegro, see their future in in the listings and IPOs on the European and global stock markets, and are currently preparing intensely for this step forward.
As a background information, RWI for corporate transactions has existed for approximately two decades in the UK and the US, but has only recently become practice in the Croatian and regional deals. R&W insurance, as the name suggests, provides coverage for breaches of representations and warranties regarding the business acquired that were not known to the buyer at the time of the purchase. While RWI was viewed historically as a product of limited application in Croatia and the region, we have seen in recent years a significant expansion of the use and importance of these policies. Today, RWI in the region is generally viewed as an attractive product when deployed in the right circumstances, often providing for a longer period of coverage and higher limits than would be available in a customary seller indemnification arrangement.
What are the warranty insurance policies?
RWI is typically procured by the buyer, with the buyer being the insured party under the policy. In its basic form, RWI covers breaches by the seller or target of their respective representations and warranties in the acquisition agreement up to a policy limit. Policies largely incorporate the indemnification terms of the acquisition agreement (including the underlying representations and warranties).
Under the RWI, the buyer in an M&A transaction recovers directly from an insurer for losses arising from certain breaches of the seller’s representations and warranties in the share purchase agreement. By transferring the risk of such losses from the seller to the insurer, the buyer and the seller can limit or eliminate the seller’s liability for certain breaches of the representations and warranties, all without materially reducing the buyer’s coverage or the amount of the compensation itself.
The goal of the buyer and the seller in every M&A transaction is to come out satisfied, but also unconcerned with potential representations and warranties they have given or that have been given to them. Precisely this type of insurance policy helps cover a large portion of the risk, which is an integral part of every M&A transaction.
The seller wants the freedom of manipulating the purchase price and does not want a part of that amount to be locked until the expiration of the period in which the buyer may claim damages from representations and warranties breaches, which period often tends to last several years. On the contrary, the buyer wants to be sure that there will be a source of money from which he will recover for potential claims for breaches of the seller's representations and warranties.
In most cases, we see that the policyholder of such an insurance policy is the buyer in an M&A transaction, but sometimes the policyholder is also the seller, who aims to protect himself from potential unintentional breaches of his representations and warranties and claims arising from such breaches. It is often a matter of negotiations between the contracting parties, regardless of who the policyholder is, who will bear the costs of this insurance policy.
Advantages and disadvantages of RWI policies
The main advantages of the RWI for a buyer:
- The primary benefit of an R&W policy is to distinguish a bid (or, often, keep pace with other bids) in an auction or other competitive process. We have experienced this trend set by the seller to be the driving force of the RWI in recent transactions;
- It allows the buyer to obtain post-closing recourse from a third party (as opposed to the former stakeholders of the target—some of whom may be key employees of the buyer after closing);
- The buyer is certain that he will be able to recover for potential damages arising from the seller’s representations and warranties breaches in the full amount, since the liability has been shifted to the insurance company. The buyer should also feel more secure because the management board of the company is, together with the buyer, focused on the future development of business without the fear of the “ghosts from the past” popping out.
Advantages of the RWI for a seller:
- R&W significantly lowers the amount of money the seller must place in escrow to cover its post-closing indemnification obligations (approximately 0.5% to 1% of the purchase price as compared to a 10% escrow);
- In the seller’s friendly M&A environment, frequently we are seeing “no seller indemnity deals”, where the seller is not required to place any funds in escrow;
- It may prolong the validity period of the representations and warranties compared to the standard periods in the SPAs;
- Particularly advantageous for private equity sellers looking to close end-of-life funds and distribute the proceeds from the sale to their investors as quickly as possible.
The RIW Pitfalls
Despite the advantages, RWI is not the cure for everything. As the name suggests, RWI covers only the breaches of representations and warranties, and not the breaches of the conditions precedent, indemnification liability, changes in the purchase price, or other pecuniary obligations that might arise from the share purchase agreement. Also, it is possible that the RWI coverage is set in a percentage of the value of the transaction, which leaves the buyer exposed to the extraordinary losses due to breaches of representations and warranties that surpass the coverage limit. However, in a transaction with the seller's indemnity, the seller may agree to indemnify the buyer for losses arising from breaches of representations and warranties that surpass the coverage limit.
As mentioned previously, one should bear in mind that it is generally not possible to cover all risks that result from the breaches of seller's representations and warranties and that most of insurance policies will include several coverage exclusions or limitations. For example, the representations and warranties regarding certain criminal and bribery liability, tax issues, environmental issues, disallowed payments in the Locked Box mechanism of the closing of the transaction, obligations relating to the compliance with certain aspects of labor laws, personal data protection or all those facts that were expressly presented to the other party in the process of due diligence, often cannot be included in this insurance policy. Consequently, the buyer's due diligence will potentially be a double-edge sword, since the buyer will want to conduct a comprehensive due diligence to be entirely aware of all risks of the company he is buying, but that will potentially cost him the coverage under the policy for all obligations he uncovers. To mitigate this, the insurers are becoming more willing to offer excess coverage for some or all of the obligations mentioned above, in which case the mentioned policy is positioned above the primary policy.
There is no question that the advantages of such insurance policies are clear for both parties. Not only will the transaction be concluded much faster in the first step, since the time negotiating the seller's representations and warranties will be shortened, but the sellers will after Closing end up with funds which they will be free to use without retaining a certain amount on the escrow account, either with the notary public or the bank. Also, using the insurance policy to limit the seller's liability may make the seller more willing to expand the substantive coverage of his representations and to reduce the use of knowledge qualifiers, thus improving the buyer's basis for recovery under the RWI policy.
Our latest practical experience with the RWI
One example where we noticed the advantage of this insurance policy in transactions, is in competitive processes where several potential buyers compete for a single target company. Namely, the RWI will enable better structuring of the transaction and higher cash payment for the sellers, which may ultimately be crucial for selecting the final buyer.
Another example are situations when a Private Equity Fund, as the seller, disposes of its portfolio companies. The RWI policy enables the fund not to have a portion of their funds trapped in an escrow account until the representations and warranties expire, but to be able to freely dispose of its means and continue with its investment strategy once the transaction is closed. However, a case which we most often notice in transactions in the region, is that, when there are several shareholders who are simultaneously members of the management board in targets being sold, those shareholders seek new partners to further develop their companies. Private Equity Funds often appear as those partners/buyers. Additionally, because a common condition for the transaction closing is the continuation of engagement of the company's management board after the acquisition of the company by the Private Equity Fund, it is important to avoid situations where claims for damages from breaches of the seller's representations and warranties would be potentially directly claimed from the same persons. Therefore, the RWI policy helps to separate the ownership function from the management function of the seller and enables simpler communication in the further development of the company, to existing shareholders as well as to new investors.
Why the trend is ascending?
A number of aspects of this growing R&W insurance marketplace are notable and contributed to the increased expansion of this product:
- While R&W insurance was previously used almost exclusively in transactions with private equity sellers, the R&W insurance market has evolved. Outside of Croatia & the region, public companies selling divisions or subsidiaries are sometimes expecting buyers to seek protection through R&W insurance; public companies wishing to limit exposure with respect to private acquisitions are sometimes purchasing R&W insurance; and R&W insurance has even been purchased in public company transactions, although exceptionally.
- Insurers have traditionally been hesitant to cover a transaction in which there was no seller indemnity. Rather, they expected the seller to have the “skin in the game” and that R&W insurance should respond to a claim only in excess of a seller indemnity. More recently, however, insurers have been more receptive to writing R&W insurance in transactions without a seller indemnity. However, it is important to emphasize that the lack of a seller indemnity might discreetly increase policy pricing and result in enhanced insurer due diligence.
Where and how to shop the RWI?
As the RWI policies are more and more becoming the M&A standard recently, a significant number of new insurers have entered the RWI market. With such increased competition, the insurers offer better terms and are willing to consider covering more non-standard risks, such as tax and data privacy. With respect to Croatia & the region, this type of insurance is offered only by foreign insurance companies. Potential purchasers should be aware of the importance of using experienced and sophisticated brokers when purchasing R&W insurance.
By Tarja Krehic, Managing Partner, and Matea Gospic Plazina, Partner, Krehic & Partners in cooperation with Deloitte Legal