Designed to introduce a third-party insurance company as the ultimate bearer of risk, representations and warranties insurance protects buyers in the event a seller misrepresents their assets’ value.
The notion of insuring an M&A transaction has its origin in real estate, where companies shield themselves from unexpected costs or misstated valuations when acquiring properties. But buying and selling an operating company is more complex. A typical M&A transaction may involve 30 or more representations and warranties, which are intended to inform a buyer on the company it intends to acquire. Due to this complexity, the R&W insurance market has struggled to gain a footing.
Additionally, R&W policies require a high level of customization, which can make it difficult for insurance companies to underwrite. At the beginning of my career in the 1990s, insurance companies only offered a standardized policy covering the most basic parts of a transaction. The rest would fall back to the buyer and seller to hash out protections on their own.
I remember trying to use this type of policy as a young associate. I painstakingly compared the representations in the basic policy to those in the draft purchase agreement we had been negotiating for months. The goal was to use the R&W insurance policy to bridge the gap in the negotiations between buyer and sellers. Unfortunately, the gaps between the representations in the policy and those in our purchase agreement proved to be too great and we were left with the same inability to allocate on risk for post-closing liabilities.
Trivest Partners was one of the first private equity firms to use R&W in a private equity transaction. Our first case was in 2010 with Ellery Homestyles, a company that provides branded and private label home-fashion products to major retailers. In that transaction, the founder of the company wished to receive 100 percent of the sales proceeds by year-end without escrow or holdback provisions that are common to private equity deals. Usually, investors ask to put a portion of the purchase price in an escrow account to cover the costs of any claims that might arise after the deal has closed.
When we made the decision to invest in Ellery, we offered an R&W policy as a shared cost between Trivest and Ellery’s founder in lieu of an escrow account in our letter of intent. This was the first time a private equity firm offered these terms in a letter of intent. The one-time policy cost only a small fraction of the purchase price of Ellery Homestyles.
Most insurers now start with a basic framework of what will go into an R&W policy and build in customization from there.
For Ellery, the benefits were clear. Claims would be handled through the insurance company and the founder could realize nearly 100 percent of the proceeds at closing. As buyers, we didn’t give away our mechanism for redress if something came to light after the deal—we were just able to handle it in a new way.
Mary Duffy, head of the Global Mergers & Acquisitions Group at AIG, who worked with me on our first policy, calls this the “magic” of R&W insurance. The policy helps both sides agree to terms without sacrificing protections.
This September, Trivest sold Ellery Homestyles to a corporate strategic acquirer that also used an R&W policy to protect itself. It was great to see this transaction and the use of R&W insurance come full circle.
A Growing Industry
Trivest’s journey with R&W insurance mirrors the industry. In 2010, ours was among a handful of policies AIG sold worldwide that year. Over the last eight years, Trivest regularly used R&W insurance as both a purchaser and a seller. Meanwhile, AIG sold close to 1,000 policies in 2017.
Since our first transaction, Duffy, who has worked as both an insurance broker and an underwriter, says she’s seen a significant uptick in the use of reps and warranties insurance over the years. “AIG brought in several people with M&A backgrounds to work on these policies because we recognized that it’s absolutely critical that you understand what’s being discussed and that you can stay in the mix throughout the life of a deal. Without that you risk incomplete coverage,” she says.
In order to make the most of R&W insurance, it’s important to have a robust and open diligence process.
Other insurers have followed suit. As a result, getting this type of coverage is becoming streamlined. Most insurers now start with a basic framework of what will go into an R&W policy and build in customization from there.
In order to make the most of R&W insurance, it’s important to have a robust and open diligence process. This is especially true on environmental, labor and employment representations, which can include many potential liabilities. If information is not communicated clearly throughout the due diligence process, insurers are more likely to exclude certain coverage, even if it’s been part of past policies. As with investors, insurers need to have a complete picture of what is happening at a company before they back a deal.
While R&W insurance is becoming more common for private equity transactions, it’s still a growing area of coverage.
Duffy adds that insurers are understanding the value of R&W insurance in a variety of business transactions and she is working with policyholders to craft policies that meet the diverse needs of the middle market. In the future, that may mean pairing R&W insurance with other types of coverage or self-insurance to take more of the risk out of transactions.
“We see reps and warranties coverage as part of a growing risk management toolkit,” Duffy says. “Ultimately it’s a collaborative process, so we are speaking to firms or individuals that have had policies with us before and engaging on what might be relevant for the future. Firms like Trivest that are proactive about identifying potential coverage areas are leading the way.”
David Gershman is a partner, general counsel and member of the six-person investment committee at Trivest Partners. Founded in 1981, Coral Gables-based Trivest is the oldest private equity firm in the southeastern U.S. and invests exclusively in founder- and family-owned companies in the lower middle market.