Five years ago, when a private equity firm sold a business the buyer would require the seller to establish a funded escrow account (5-10% of the purchase price) with an independent bank as a convenient source of indemnification for representations and warranties. Until recently, in the lower middle market, it was highly unusual for a third-party insurer to underwrite and insure that indemnification obligation. In a recent survey by GF Data (September 2018) the prevalence of representation and warranty insurance is notable:
“Use of an insurance product continued to rise, from 43 percent of all deals in 2017 to 47.3% in the first half of 2018. At $50-250 million TEV, the jump was from 66.7% to 69.7%.”
” Valuations remained at historically elevated levels on deals utilizing insurance – maintaining an average mark of 7.7x. The average multiple fell, however, on deals completed without insurance – from 7.1x to 6.4x. Average indemnification caps rose slightly across the board in the first six months of this year.”
Data Rooms Become The Underwriters’ File
We utilized our first indemnification insurance product in a sale in December 2013. At that time the number of insurers who were willing to underwrite a smaller transaction was limited. Today there is competitive interest from many insurers in transaction sizes $20 million and larger. It shows the maturation of the private equity industry and the comfort underwriters have for PE due diligence. Partly this is attributable to data rooms where 100% of the due diligence information for a transaction is posted to a data repository that, in essence, then becomes the insurance company’s underwriting file. Sellers and buyers often split the costs of this insurance policy and the retention, which works like a deductible on your homeowner’s policy, is usually also split. In the competitive M&A markets right now, it is also becoming more common for the policy to be structured so there is zero recourse against the seller in competitive auctions.
In addition to underwriting the data room file, the insurer looks at the reputation of the parties to the transaction, the quality of their advisors and the independence of the various “experts” who report on quality of earnings, environmental matters, human resources, health and safety and wage and benefits. Because the insurer is stepping into the shoes of the seller for any major indemnification claims, there are often specific matters where there is known risk that are excluded from the policy. That might mean that a known environmental cleanup responsibility remains 100% with the seller or responsibility for existing litigation is not insured.
Third Party Insurance Fits The PE Model
The nature of private equity with finite fund lives and relatively short investment periods lends itself to a third-party stepping in. There was always a great temptation for a disappointed buyer to invent a series of claims against the indemnity escrow after the closing simply to reduce the purchase price. Now the insurer bears a large portion of that post closing responsibility and has both the time and infrastructure to dispute buyer claims. A private equity firm was more likely to compromise a bogus claim because of time, legal costs and fund life considerations.
According to Jeff Phillips, Vice President and Practice Leader of Transactional Risk for Oswald Companies who were early advocates of “reps and warranty insurance” for the lower middle market, the claims administration process has also been professional and reliable:
“Twenty percent of Reps and Warranties polices are going on claim with issues arising most frequently from Financial, Tax, Compliance with Laws and Material Contracts. Generally, our clients have been pleased with the claims administration process and the insurers understand that for this product to be viewed as an attractive alternative to traditional seller indemnification, valid documented claims must be paid promptly.”
These Policies Are Affordable
The other surprise about this insurance product is affordability. The typical premium for $5.0 million of coverage in a clean $50 million transaction with a deductible of 1% of the purchase price might only be $150,000-175,000 depending on the industry. This suits a private equity firm that can then operate with certainty about its ongoing contingent liabilities for portfolio companies that have been sold. This usually means quicker distributions to fund investors and general partners.
The ultimate test of this product will come when there is the next recession. Highly indebted companies with shrinking cash flows and earnings may look to insurers for help through indemnification claims. It will be interesting to see how well the insurance industry has really underwritten its risks. My prediction is this product will do better than the underwriters expect largely because the reps and warranties made by sellers get diluted by the auction environment in which each buyer has to operate today.
In any event, the next time a politician tries to convince you that private equity is bad for business just recall all the companion industries are thriving due to its model. The latest winner may be the insurers who are underwriting a majority of these deals.