How Representations & Warranties insurance can make a difference to M&A's

With experience analysing, advising on and underwriting mergers, acquisitions and other corporate transactions, Michael McGowan has seen up close how deals can drive value for a variety of stakeholders.

He has also observed risks that can derail deals and erode value. In this Let’s Talk Q&A, he discusses how Representations & Warranties insurance can make a difference in the M&A space and help bridge gaps between deal parties.

What are the key areas to consider in the due diligence process for a merger, acquisition or other transaction?

McGowan: On every transaction, it is important that proper diligence is performed on business or operational risks, legal and regulatory issues, and financial and tax items. A thorough assessment should include a review of multiple factors. For example, is the target compliant with relevant laws and regulations key to their business? Who are the target’s major customers and how do the terms of their contracts read? Does the target have any issues relating to financial and accounting data or with their internal controls?

Detailed analyses of the target’s domestic and foreign tax exposure as well as its financial statements are also important. These give a buyer, and ultimately an insurer, insight into the quality of the target’s earnings, revenue recognition policies and its asset and liability makeup. Depending on the nature of the target company’s operations, additional diligence may also be critical. For example, certain transactions may require environmental diligence at a target’s material manufacturing or distribution sites, while other companies with increased exposure for data breaches may require fulsome cyber security diligence. Cyber security in particular has become a hot-button issue recently, and some insurers may require underlying cyber insurance to effectively cover this exposure if the risks appear too great. This also holds true for underlying environmental insurance for companies with a history of environmental non-compliance or that have underground storage tanks on company-owned real estate.

What challenges do acquirers face in identifying and assessing risks during the transaction process?

While it tends to differ from deal-to-deal and buyer-to-buyer, generally most acquirers in this market perform robust due diligence in the material areas where risk can arise. Most acquirers hire third-party advisors and/or have dedicated internal deal teams that perform diligence in key areas. Private equity firms are especially keen at assessing the risks to future business profitability and growth, while strategic buyers may place greater emphasis on future integration risks, obtaining business synergies and shared services.

Certain challenges can arise when dealing with a target that has substantial international operations or when a deal is a carve-out involving multiple subsidiaries or assets. For example, it is important for buyers in a more complex international transaction to employ the same degree of materiality in their diligence process into a target’s overseas operations as they do to their domestic operations. For target companies with material operations in foreign countries where geopolitical or other circumstances create increased risk, it may be important to outsource diligence to local advisors on the ground. This provides a deeper review into the unique regulatory, labour and tax regimes and cultural issues of each jurisdiction.

In your experience, what are the most common post-acquisition issues after closing?

While it is always difficult to fully assess issues that can arise during the integration of a target’s operations into the buyer’s business — especially for strategic buyers or platform acquisitions — some of the most common problems involve contract disputes with customers or suppliers, key employee or management retention issues, IT integration, and post-closing tax treatment. For carve-out transactions, there is also increased risk that shared services between the buyer and seller parties will be insufficient or that additional incremental costs could result from unforeseen infrastructure upgrades or key new employee hires.

Those additional costs can surprise buyers when a target represents that the assets being purchased are sufficient for the business to perform in the ordinary course. Effective planning for integration well in advance of the closing and performing adequate due diligence into these key operational areas can help mitigate the risk that a deal is non-accretive or unsuccessfully integrated. As insurers, we always gain additional comfort that post-closing integration issues will not result in a claim when it is apparent that a buyer has thought through these issues in advance.

How can Representations & Warranties insurance and Contingent Tax insurance policies facilitate transactions and manage risks?

Both Reps & Warranties insurance and tax liability insurance can help a buyer manage the risks associated with an acquisition. Many times, these policies coexist, providing extensive coverage that can apply to issues both pre and post-acquisition. For instance, a Reps & Warranties policy typically covers unknown tax liabilities that existed at the signing of the transaction or during a pre-closing tax period. On the other hand, a tax liability policy may be purchased to provide protection after a transaction to the extent a buyer requires coverage for specified, identified tax risks that could result from the IRS (or other tax authority) taking a detrimental tax position.

R&W insurance can facilitate a transaction and smooth out negotiations as well as either reduce the escrow or provide a clean exit for a seller in transactions where there is no recourse against a seller indemnity. R&W coverage also reduces potential friction with newly acquired management teams by shifting the risk of a seller’s breach of a representation to the insurer.

On the other hand, tax liability insurance is designed to address specified known issues that can arise in a deal and protects a buyer from loss that could result from the IRS or any other applicable tax authority deeming the buyer to have a greater tax liability than otherwise believed. It can also be utilized to cover specific issues such as renewable energy tax credit investments, the tax treatment of a spinoff or divestiture, or other financial considerations, such as the usability of net operating losses in a deal.

How do you see transactional insurance and risk management developing in the years ahead?

While the M&A insurance industry is substantially more mature than it was a few years ago, we expect there will continue to be growth in both the percentage of transactions that utilize the product as well as the amount of capacity available. Market capacity is now able to offer more than $1.2 billion in limits, making R&W insurance a viable solution on nearly any transaction size. While private equity buyers are already well-versed in the coverage, there is a lot of runway for growth with strategic/corporate acquirers as more and more risk managers and internal deal teams gain comfort with the coverage.

As competition increases and more specialized talent from law firms, banks and various industries move into M&A insurance, we can expect that coverage will also continue to broaden as underwriters finely tune their approach to tackling various issues. As insureds and their legal advisors continue to purchase more coverage and become more comfortable with the product, increased claims frequency is also likely. Because of these factors, it is very important for individuals in the space to ensure consistency in their underwriting appetite and approach to dealing with particular risk areas and hire the right talent to fully underwrite the risks of each deal.

Michael McGowan joined AXA XL in 2016 after serving as an executive in the transactional risk practice of another global insurer, where he led the underwriting and structuring of transaction-based products. He previously was an M&A and private equity attorney.