The W&I tool in M&A
Neil Brown and Joy Tickler highlight the increasing use of W&I insurance by M&A negotiators.
The use of warranty and indemnity (W&I) insurance has rapidly increased over the past few years, becoming a strategic tool in the toolbox of any M&A negotiator. We set out here the reasons behind this ever-increasing trend, together with some of our observations on how W&I has been effectively deployed.
What is W&I?
W&I insurance covers financial liability for a seller’s breach of warranty and/or tax covenant under a sale and purchase agreement (SPA).
It covers the unknown risks on a transaction, with actual knowledge of the buyer and the seller being specifically excluded, including (for the avoidance of any doubt given the name of this type of policy!) indemnities given by the seller in the SPA.
It is, however, also possible to obtain insurance to cover specific known risks, including tax risks, although these tend to take longer to place and are generally more costly.
Costs of W&I
One reason for the increased use of W&I insurance is that the W&I market has become more accessible financially.
Whereas premiums for W&I insurance used to be somewhere in the region of 2-3 percent of the limit of insurance sought (known as the “rate on line”), premiums can now be obtained in the region of as low as 1 percent, depending on the insurers’ appetite for the industry in which the target company operates.
So what are the costs? Each insurer will have a minimum premium that it needs to achieve on a transaction. As the premium is calculated based on the rate on line, this can mean that you ultimately get more limit for your money. There are also a number of underwriters established in the last couple of years that focus purely on mid-market M&A transactions, and therefore offer premiums within a very competitive price range.
In addition to the cost of the premium, once the underwriting stage has begun, there is usually an underwriting fee, in the region of £15,000, to cover the underwriter’s costs. However, this is often waived by the insurer if the policy is ultimately taken out, and is therefore, in effect, a break fee in the event the policy is dropped from the transaction.
What to use it for
The motivations behind the use of W&I insurance have also diversified in recent years. We set out a few of these below, from both a buyer’s perspective and a seller’s perspective.
Seller’s perspective
- Seller clean exit: as the cost of W&I premiums have gone down, sellers on transactions are using W&I insurance as a means of ensuring that their liability is limited (if not extinguished) post-completion.
- Escrow account: as security for warranty claims, sellers are often required to place a certain percentage of the sale proceeds into a third-party escrow account. Depending on the amount of the excess under the policy (see below), this requirement may be removed altogether.
- Differentiate an auction bid: W&I insurance can be deployed very effectively on auction sales by bidders seeking to differentiate their bid.
- Private equity: the motivation here is clear – it can be very difficult to sue your own management team for breach of warranty.
- Insufficient seller liability cap: where the seller is in a particularly strong bargaining position, there may be a low seller liability cap in the SPA, so a buyer may seek W&I insurance to sit as an extra layer of cover on top of this.
- Concerns over long-term security of the seller: a buyer may want to obtain W&I insurance as a “sleep easy”, just in case the seller has solvency issues in the future.
The skin in the game
The amount of the excess under the policy – the “skin in the game” – usually matches the basket in the SPA (and can either be fixed or tipping), and is calculated based on the enterprise value of the target company (i.e. including the amount required to repay any debt). It is, however, not impossible, depending on the industry, to obtain a W&I policy with a nil excess.
An important point to note is that W&I insurance does not operate as a substitution for a negotiated transaction.
To avoid holes in coverage, the underwriter will want to see that the tyres on each warranty have been kicked, and that the sellers have made the effort to limit their liability by going through a thorough disclosure process.
The W&I timeline
Generally, from the moment a broker is engaged on a transaction, to when the deal completes, it takes around two to three weeks to place W&I insurance. However, the W&I process can be expedited to around two weeks, which is where your broker’s understanding of the market’s appetite and particular underwriter’s ability to meet the transaction timeframe becomes particularly invaluable (see more on this below).
It is, of course, wise to assess whether W&I insurance is an option on a transaction as early as possible, most suitably in conjunction with the negotiation of the liability piece.
The placing of W&I process is broadly split into two stages.
Stage one: this involves an introductory call with the broker where the broker will ask about the background details to the transaction (including whether a buy-side or sell-side policy is sought – the former being more common), the enterprise value of the target, limit of insurance sought and structure of the transaction.
Following that, the broker will go out to the market to request nonbinding indications from insurers, to including pricing and initial coverage comments. To do this, the broker will need the latest SPA (preferably the buyer’s mark-up of the seller’s draft, as this will show the worst possible warranty position), accounts for the target and the information memorandum or sales brochure.
From the non-binding indications received, the broker will prepare a report setting out the key details of the non-binding indications received, together with their recommendation.
Stage two: once an insurer has been selected, underwriting will start and the underwriter will require access to the data room, copies of the latest drafts of the transaction documents and the final due diligence reports.
From this, the underwriter will produce a set of questions ahead of an underwriting call with the deal team.
A draft policy will then be circulated, which the broker will negotiate on the proposed insured’s behalf. The policy will incept on completion of the transaction.
The key factors that can have a significant impact on the timeframe of placing W&I are as follows:
- the domicile of the insured;
- the governing law and jurisdiction of the SPA; and
- the scope of the due diligence undertaken.
Benefit of the broker
When seeking to obtain quotes for W&I insurance, we would always recommend going via a broker, who are able to provide the following additional value:
- experience of the “ultimate sweet spot” and appetite of each of the underwriters;
- history of negotiating dozens of policies with underwriters, and will know if an underwriter has taken an unreasonable stance on policy coverage;
- awareness of the capability of an underwriter to underwrite a risk where the insured is incorporated in a jurisdiction overseas; and
- crucially, which underwriters can meet the timeframe of a deal.