Managing and Mitigating Risk in Mergers and Acquisitions

LAGOS, Nigeria, Capital Markets in Africa: A fragile global economy, coupled with local market uncertainty, and concerns over the recovery of equity markets followed by a business environment that places increasing pressures on profitability has significantly increased the complexity of deal making today. Corporate governance issues are paramount and regulatory and compliance issues demand that greater caution be exercised in ensuring that proper due diligence is conducted in assessing transactions and their associated risks. Notwithstanding all these “good” commercial considerations and the degree of reasonable care that a buyer may exercise in conducting a proper and thorough due diligence process it is impossible to uncover all potential and unknown risks that may exist.

It is for this very reason that buyers will typically demand that sellers provide them with a comprehensive set of warranties that underpin a transaction so as to ensure to the extent possible that the buyer ostensible gets what it is paying for and is not left “high and dry” with limited recourse options available to it. In the event that there were no warranties, the buyer would need to prove that there was a misrepresentation by the seller party. The legal ramifications of proving a misrepresentation are both costly and onerous in that one has to establish that the misrepresentation was untrue, was material and induced the contract.

Warranty and Indemnity (“W &I”) Insurance is increasingly being considered and used as a means of protecting against breaches of the representations and warranties provisions contained in mergers and acquisitions sale agreements. This insurance which had its origins back in the mid 1990’s has over time developed into a sophisticated and invaluable tool to mitigate risk and help facilitate deal closure. Most policies today are purchased by buyers.

The insurance can significantly assist contracting parties from the perspective of reducing both the seller and buyers risk in doing a transaction and additionally minimizing the time needed to reach an agreement and close the deal. Negotiating the warranties often comprises the most contentious and time consuming part of any M & A transaction and utilizing the insurance can significantly assist parties to reach consensus sooner as the insurance is used as the primary recourse tool following a breach of the warranties.

During share sales it is common for the seller to provide warranties to the buyer on a broad range of matters about the target such as title to shares, property, employment, tax, intellectual property, and other commercial matters. The insurance provides protection to either the seller or the buyer (depending on who the insured party is) against breaches of the warranties and indemnities being given by the seller in the sale and purchase agreement (SPA). The insurance provides cover for unknown and unforeseen breaches of the warranty provisions and for defense costs. Policies are bespoke and will be negotiated on a case by case basis.

From a policy structure perspective, there are two types of policy, namely a buyer-side and seller -side policy. A seller-side policy is designed to protect the party that gives the warranties and typically in this situation a seller would “off load” a portion of its warranty cap liability to an insurer. Conversely under a buyer-side policy, the buyer is protected from financial loss that may arise as a result of a breach of warranty where either the buyer is unable to or chooses not to claim under the SPA. Typically, this can be as a result of the warranty cap being too low or simply that they do not wish to pursue a claim against the seller.

There are a number of key reasons why this form of insurance has grown in popularity. From a buyer perspective it provides the buyer with direct recourse against an “A” rated insurer without the need to seek recourse against the seller , buyers can also top up the level of recourse available to them in addition to that which is provided by the seller. Importantly it is possible to not only top up the limits but also extend the warranty time periods under the SPA. The policy could as such have an extended time period in excess of the periods provided in the SPA. Typical policy periods are 2 years for operational warranties, 5 years for title and capacity warranties and up to 7 years for tax.

From a sellers perspective the insurance is appealing because it limits their post-closing liability to the buyer and gives a clean exit, mitigates against claw back of cash raised by sale proceeds (no escrow provisions) where funds could be tied up for a period of 7 years for tax liabilities.

The Insurance can also serve as a strategic tool for bidders engaged in a competitive bid process where the insurance is stapled on to a bid process thus making their bid more appealing versus other bid parties. Typically in this situation a buyer would advise the seller that it is not seeking a high seller warranty cap, but is happy to procure W & I insurance, where the insurance would provide the required relief in the event of a breach typically in excess of a retention or attachment point of 1% of the transaction value.

The insurance can also assist where buyers may be loath to institute proceedings against a seller in situations where there is roll over management and the buyer wishes to retain the goodwill of the seller in respect of post-completion trading relationships, jurisdictional issues may mitigate against litigation being considered as a viable option because buyer and seller may be domiciled in different territories. Finally the policy can also provide parallel cover to a buyer where it has secured comprehensive warranties from the seller subject to a suitable warranty cap, however the buyer retains residual concerns over the seller’s ability to meet a warranty claim some period of time after the deal closes.

From a Global perspective demand for W & I insurance continued to increase during 2015 across all regions as investors looked to reduce deal risk. The Asia-Pacific region particularly accounted for the largest year on year increase. Globally Marsh’s merger and acquisition (M & A) professionals placed 450 W & I policies during the year, a 32% increase from 2014. Limits placed increased year on year by 45% to US$11.2 billion driven principally by larger deal sizes as well as more insurance limit being purchased per transaction.

Originally used almost exclusively by private equity firms we have seen an uplift of corporate buyers using W & I insurance to better compete for assets, especially in auction situations. The split between private equity and corporate buyers continues to even out, moving from 61%/39% in 2014 to 56%/44% in 2015. Regardless of this trend we still see Private Equity exists as being the dominant driver.

Typical pricing on a South African transaction is between 1.5% and 2.5% of the limit purchased, retention levels or policy attachment points are typically set at around 1% of the Transaction Value (“TV”). Pricing will vary based on a variety of factors.

Insurers will often have minimum premium levels so for some smaller limits of insurance the price may be higher than the indicated range of 1.5 to 2.5%. Conversely, if large limits of insurance are required, often a programme of insurance is built using capacity of various insurers which may mean the overall premium rate is lower than the indicated rate on line. Note the pricing does not include insurance premium tax/VAT or other applicable regulatory taxes.

There is growing appetite from insurers for emerging markets, including South African risks and the use of transactional risk insurance continues to broaden in terms of jurisdictions. During 2015 Marsh placed policies for deals in 23 different countries with respect to the target company’s HQ domicile.

Claims statistics reveal that if difficulties are going to arise pursuant to a deal, they tend to do so fairly quickly. Specifically, more than half of all global claims reviewed were reported within the first year after a deal closed and 74% were filed within the first 18 months. On a global basis the most common forms of breach were in the areas of financial statements, tax and contracts while in Europe, the Middle East and Africa (EMEA) and Asia Pacific, there were significantly more accounts related breaches and alleged breaches of contracts being the dominant areas where losses arose.

Recent claims statistics reported by AIG (a leading Global Market insurer) show that about one in every 7 policies issued globally reported a claim. The frequency of claims varies by region, with transactions in Asia Pacific having the highest claims frequency and EMEA the lowest [18% vs 11.4%]. Interestingly the majority of the largest losses came from EMEA. The statistics also revealed that where deal values were greater than US$1 billion the claim percentage was highest at one in 5 policies reporting a claim.

Marsh is the only firm with dedicated transactional risk resources based in South Africa leveraging the expertise of our global insurance market placement hubs in London, Hong Kong, Sydney and New York.

Contributor’s Profile
Kevin Paarman is based in Johannesburg South Africa and is part of Marsh Africa’s Private Equity & M&A Services Practice. His primary responsibilities are to provide transactional risk solutions to our corporate and private equity clients. Kevin has in excess of 20 years short term insurance experience. Most of this experience was gained in his capacity as Head of Legal for Alexander Forbes Risk Services (Pty) Ltd prior to the merger of the Alexander Forbes and Marsh businesses in January 2012 and in a similar capacity with Marsh post the merger. As a corporate lawyer of many years standing his in depth knowledge of company law coupled with general legal and insurance expertise paved the basis for his transition across to the Private Equity and M & A Practice Division with effect from 2015. Kevin spent some months in London working with the Marsh UK Transactional Risks Team and works closely with these colleagues on all the South African Transactional Risks deals.

This article was featured in the INTO AFRICA July edition, with focuses on Private Equity in Africa and is titled Private Equity: Africa’s Trump Card.