August 27, 2020 by Ben Nelson, CFC Underwriting
Transaction liability insurance is a valuable tool for helping buyers and sellers facilitate mergers and acquisitions — and presents a significant opportunity for brokers to add value to their client offering and drive revenue growth.
From humble beginnings more than 15 years ago, the success of the representations and warranties (R&W) insurance has become widespread, with one recent report indicating double-digit growth in the number of M&A deals with insurance in 2019 over 2018.
North America was the fastest-growing M&A insurance market in 2019 with deal values climbing to US$1.71 trillion and the region accounting for more than half of total global M&A value.
The outbreak of COVID-19 has clearly had a significant impact resulting in a decrease in M&A activity in the first half of 2020. As Canada comes out of the initial shock of the pandemic, buyers are expected to take advantage of opportunities, particularly in the lower middle-market space. As businesses assess “the new normal” and as confidence slowly returns, deal volume is expected to increase. More than half (55%) of Canadian executives expect their involvement in deal completions to increase over the next 12 months.
This anticipated recovery combined with the long-term trend of growth in North American M&A activity means there are more and more opportunities for insurance brokers — however, it can appear a little daunting on the surface, particularly if there’s a completely new line of business to explore.
Before recommending R&W insurance — as with any product — it is important to understand the purpose of the product and the protection provided in order to determine whether it is an appropriate solution for your client’s needs.
Under the terms of a typical M&A contract, sellers carry the risk of any liabilities which occurred while they owned the company. A seller will represent and warrant, hence the name of the product, certain facts about the company they are selling. If issues are discovered after the transaction and these representations and warranties are found not to be true, and the buyer of the company suffers a financial loss as a result, the seller is financially responsible. Some of the more common representation breaches include financial statements, compliance with laws, tax liabilities and material contracts.
This risk can be reduced by taking out an R&W insurance policy.
Available to both buyers and sellers, R&W insurance is designed to reimburse the buyer for any financial loss suffered because of inaccuracies in the statements made around the condition of the company. For the seller, it’s attractive as it frees up sale proceeds that would otherwise need to be set aside to meet the potential post-sale liabilities that are now covered by insurance.
By transferring this risk to the insurer R&W insurance can be used to:
Let’s take a look at an example of R&W insurance in action. Let’s say a private equity fund acquired a group of over 200 fast food restaurants. After closing, they discovered that the seller had innocently failed to disclose a number of property issues at certain restaurants which required significant capital to remediate.
Additionally, a local municipality initiated an investigation into alleged violations of maximum working hours at certain restaurants while it was under the seller’s ownership. The investigation resulted in fines and penalties payable by the seller.
The buyer brought both claims under their R&W insurance policy and the buyer was indemnified as a result.
R&W insurance should always be considered when your client is looking to buy or sell a business and the earlier you can get involved the better. While Canadian uptake has typically lagged the US, this is changing with significant runway ahead in Canada. There are now markets for historically underserved areas such as Quebec, while the tech boom in Vancouver is also driving increased activity.
The value offered by R&W insurance should not be ignored and with North American private equity funds continuing to propagate the use of the product both as buyers and sellers, those that don’t use the product put themselves at a significant disadvantage when looking to close a deal as efficiently as possible.
There is a real opportunity for Canadian brokers to deliver a real value-added service to their clients involved in M&A deals – don’t let them miss out!
Ben Nelson is the transaction liability team leader at CFC Underwriting
Feature image by iStock.com/natasaadzic