Take cover

Rather than using W&I insurance merely to minimize post-closure transactional risk, increasingly private equity investors are applying it as a risk management tool to gain a strategic advantage in M&A negotiations. By Judy Kuan

Traditionally used to protect vendors of businesses from post-transaction contingencies, warranty and indemnity (W&I) insurance has undergone a significant evolution since its arrival in the London insurance markets in the 1970s. The product is now emerging as a means of generating a competitive advantage for users in the private equity universe. Private equity investors are turning to W&I insurance as another way of carving out an angle over rival bidders in M&A negotiations – withoutcompromising the valuations of the assets being acquired.

Among private equity firms, greater awareness of and a more positive attitude toward W&I insurance is a noticeable and recent development. According to Andrew Hunt, who leads insurance broker Marsh's European practice for transactional risk in private equity and M&A insurance, there has been a 100 percent increase in buyouts using W&I insurance put through by Marsh for its clients in 2005 versus 2004.

Progress is also noted by Alistair Lester, cohead of the global M&A group at Londonheadquartered insurance broker Willis.?There has been a big step forward in private equity investors' attitude toward W&I insurance compared with four to five years ago,?Lester says. ?People were very sceptical then, and while many are still relatively sceptical, they are coming to understand how these products can be used in a strategic way.?

In its early days, W&I insurance was packaged as what insurance brokers, M&A advisors, dealmakers and corporate users viewed as an off-the-shelf product that offered little flexibility to policyholders. Historically, W&I contracts have typically been used as a ?sleep easy?provision by vendors wishing to reduce the likelihood and quantity of posttransaction claims made by the buyer of an asset, says Willis M&A project director Deborah McBrearty. ?[W&I insurance] quickly became a bespoke product, but until recently, with the increased sophistication of the underwriter teams, one of the barriers to using this type of product was seen as the time and process involved.?

Sellers often faced the decision of either compromising on the front end of a transaction by marking down the sale price of an asset in exchange for limited recourse (or ?reps and warranties?) granted to the buyer, or jeopardizing returns by providing and then being held liable for breach of more extensive guaranties on the asset after the deal has closed. W&I insurance allowed sellers of assets to shift a portion of the risk burden to the insurance markets at a cost. However, due to its one-size-fits-all structure, W&I insurance in its initial years of existence was used infrequently.

In Europe, a new application for W&I insurance developed in the mid-1990s, when US-based companies began engaging in transatlantic acquisitions of European assets.?In the US, there is often an expectation to get reps and warranties up to the full value of the deal. In continental Europe and the UK, this tends to be a smaller proportion of the transaction value, say 10 to 50 percent,? says Hunt at Marsh.?The insurance marketevolved so that only a portion of the coverage came from the seller of the asset, and the rest could be topped up by an insurance policy held by the purchaser. This is where the buy side W&I policy started to emerge.?

As insurers began to offer a wider array of options in response to what they saw as an untapped market, private equity investors also became savvier on the workings of W&I instruments. Whereas in the past legal advisors would often seek coverage options on behalf of their private equity clients, today the investing principals of general partner groups are doing the exploratory work into insurance options themselves, observes Hunt.?There is no doubt that there are a number of private equity firms who actually have as partof their investment committee checklist, ?Should we think about using insurance??? says Hunt. ?I think we will see increasing familiarity among investors going forward.?

US private equity groups are moving in the same direction, insurance professionals say. ?Based on our experience at Aon, in the US these products are used in a very small percentage of deals overall, but of the W&I policies structured in 2005, I would say 50 to 60 percent were done on behalf of private equity investors,? says Mary Duffy, the Philadelphia-based managing director of Aon's private equity and transaction solutions group.

Most if not all private equity firms familiar with W&I insurance are turning to the insurance market as part of a proactive strategy rather than a reactive strategy, as is illustrated by the experience of UK-headquartered mid-market buyout specialist Barclays Private Equity.

Even in continental Europe, where awareness and use of W&I insurance has lagged behind that of the UK and US, private equity investors have begun to use the product strategically in their M&A negotiations. For instance, Frankfurt-based private equity firm Deutsche Beteiligungs AG (DBAG) has used W&I insurance in two instances, first in 2003 to acquire the subsidiary of an insolvent parent company – which could offer very limited guaranties – and again in 2005 to buy Clyde Bergemann Group, a power supply systems manufacturer, from US private equity firm Saw Mill Capital.

In the latter transaction, Saw Mill Capital made it clear from the beginning of the negotiation process that it wanted a clean break from its portfolio company and would sell Clyde Bergemann with only ?extremely limited guarantees?attached, says Roland Egerer, a senior vice president atDBAG. In other words, an insurance wrap arranged by Marsh was essential if a deal on terms acceptable to DBAG was to go ahead at all.

Egerer says that his firm is likely to go down similar routes where necessary in future deals as well: ?We will try to obtain appropriate guarantees from the seller, but where that is not possible, we would consider using W&I insurance.?

are bidding for assets, there are competitive situations in which the vendor may be willing to provide warranty cover, however, we can potentially differentiate the terms of our offer by using a [W&I] policy strategically,?says Myers atBarclaysPrivate Equity.

In some cases – and again in auctions especially – insurance may not merely give a party a competitive edge over competitors, but it can also impact the actual economics of the transaction by influencing valuations.

An example – although in this case involving a tax policy rather than a W&I policy – was a Willis-advised transaction in 2004 where a client decided to sell an asset through a managed process. The client received three offers: one from a trade buyer offering a good price but demanding significant recourse on warranties; another from a private equity-backed buyer who offered a lower price in exchange for less recourse;and a third from another private equity-backed buyer who was attracted to the project but had issues with a possible post-sale tax liability.

?The kick in the tail was that this third offer was €10 million higher than the other bids,? says Willis' McBrearty. ?We suggested our client provide a buy-side tax policy. The costof the policy was €€1 million, so our client netted €9 million in additional value through using the insurance policy.?

While W&I and tax insurance can be used either by the seller or purchaser of a business, private equity firms looking to buy new assets are more likely to take out a policy than firms acting as sellers.?Itbecame more obvious that a way of releasing funds for sellers coming out of an investment was to have buyers be the holders of the insurance policy,? says McBrearty.?I would say that 75 percent of the policies thatWillis has placed would be a buy side solution.?

?W&I insurance does not replace the need for normal professional processes in a deal,? says Willis' Lester. ?It is important to keep in mind that this is not a product designed to make a bad deal happen or to replace disclosure or professional due diligence in a wellmanaged professional transaction.?

Best practices for W&I insurance
?Get people involved in the process early on and be clear aboutwhat you want to achieve, so it can be established whether aims are achievable.?? Anka Taylor, director, Aon

?Ensure that the broker has a well-developed relationship with a group of specialist potential underwriters. It will be key that the underwriters are satisfied with the scope and extentof all due diligence carried out:the ultimate pricing of the policy will inevitably be a function of the underwriters' level of comfort with the nature and profile of the risks involved with the asset.?? Rob Myers, director, Barclays Private Equity

?Even if you don't actually purchase a policy on every deal, make sure to at least consider it on every deal because your competitors are likely to be doing so.? ? Mary Duffy, managing director, Aon

?Don't allow the insurance companies to manage the process. Otherwise, the process will have a slightly different dynamic than if you and your insurance advisor control it. Insurance companies are looking to maximize the premium and minimize the risk.?? Alistair Lester, co-head of global M&A, Willis

?Fully understand and consider the specific risk exclusions applicable to any given policy.? ? Rob Myers, director, Barclays Private Equity

?If you compromise the due diligence process, then you compromise your ability to use insurance effectively: you can't replace a prudent, well-negotiated deal.?

? Andrew Hunt, Mars

?Have good management:One of the hindering aspects of W&I insurance is that it does add extra workload to making a private equity transaction. Therefore, the more sophisticated the advisor, the better.?

? Roland Egerer, senior vice president, Deutsche Beteiligungs AG

The complete version of this article is available in the November issue of Private Equity International, a sister publication to Private Equity Manager.