Insurance removes need to hold portion of deal amount in escrow to cover errors, misrepresentations
Insurance for merger and acquisition activity has been around for more than two decades, but its use has taken off in the last four or five years, says Jason Stone, who heads the North America private equity and mergers & acquisitions practice for BMS Group.
Those involved in M&A deals have come to realize the advantages of insurance for any possible misrepresentations, errors, or omissions in a deal, Stone says. Traditionally, a portion of the deal’s value is put into escrow, held back until the buyer is satisfied that all is correct and that there have been no misrepresentations.
However, Stone says that private equity increasingly likes the concept of M&A insurance, where the total value can be distributed on closing. In North America, a BMS report on 2020 activity says that four out of five transactions involving PE used M&A insurance.
Another trend is the increasing average limit being purchased on M&A insurance in all parts of the world – from 19 per cent of enterprise value in North America to 27 per cent of enterprise value in Europe.
Historically, in North America, the representation and warranties product used to minimize or replace escrows had a limit representing 10 to 15 per cent of enterprise value. But the BMS report says clients are viewing the product “not just as a deal facilitation tool but as a risk transfer solution, especially in a climate where valuation multiples across sectors continue to grow.”
Private equity tends to acquire companies with a specific investment time frame in mind before selling. “So, when they sell a company, they’d prefer to have the full proceeds come when the deal closes, rather than keeping a portion in escrow,” Stone says. “One way to do that is to take out M&A insurance, which can cover any areas of concern.”
Typically, a seller represents and warrants that all material contracts are correct, that the financial statements are in order, with tax returns filed in the appropriate jurisdictions. These policies can also specify exclusions that would not be covered.
“The whole idea of this type of insurance is to say we’ve looked at all the material, both the buyer and seller, and we’ve come to the conclusion that what the seller is telling us is true and correct,” Stone says. If financial statements are found to have errors after the deal closes, the insurance would kick in.
While M&A insurance is currently more popular in the United States than in Canada, Stone says the market is catching up quickly. “We think about 60 per cent of all U.S.-based deals have M&A insurance, Stone says. “In Canada, it’s more like 35 to 40 per cent, but the uptake is getting stronger.”
In 2019, the British Columbia Investment Management Corp. and a private equity firm based in London, Preservation Capital, acquired BMS. Since then, the broker has been on a growth campaign.
Stone says a potential buyer is also interested in M&A insurance, as it could make its offer look more attractive to the seller. “Think of it this way — you’re putting yourself up for sale, and you think you’re worth $100 million. Two potential buyers come, one offering $90 million and $10 million held back for 12 to 24 months, the other saying I’ll give you $99.5 million, and you don’t have to worry about anything being held back because there is M&A insurance. For many the second offer looks more attractive.”
Adds Stone: “The cost of capital for that $10 million held back is worth a heck of a lot more than the $500,000 that they’d pay for getting insurance. The money not held back can be put to work and give you a far better return. So, it makes sense to obtain M&A insurance.”
The BMS report says the M&A insurance market saw 2020 as an unusual year, with much deal activity put on hold for Q1 and Q2 but roaring back in the latter half of the year. Growth in the North American M&A insurance market carried over into 2021 due to increased geopolitical certainty and should carry on for the balance of this year. “Many PE and similar funds have built up dry power reserves during the pandemic and are ready to make deals.”
The report says that M&A insurers have also curtailed pandemic-related exclusions introduced at the start of the pandemic. Now, insurers are simply seeking information regarding the effects of the pandemic on the target business, for example, inventory or supply chain disruption.
Prices for M&A insurance have increased proportionately to the claims insurers are paying. According to the BMS report, “to date, we have seen multiple nine figure pay-outs which included multiplied damages. As M&A insurance carriers continue to respond to valid claims, the market for M&A insurance in North America will continue to grow.”
Stone says lawyers who work on M&A transactions have come to know the potential advantages of M&A insurance. “They probably represent more than 90 per cent of our clients,” he says. “They’ll call up and say, we have this deal on the go, we want to make sure the buyer is protected from any risk, can we get quotes on insurance for this.”
He adds that having M&A insurance can help speed up negotiations about “whether there should be an escrow for this or an indemnity for that — it just makes things easier.”