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Thorts - W&I Insurance in the New Dynamic
Thorts - W&I Insurance in the New Dynamic
Published Date: 2020-07-27 | Source: DealMakers | Author: Samantha Hogben
An increasingly common feature of the global mergers and acquisitions markets has been the use of warranty and indemnity insurance (W&I Insurance), also referred to as reps and warranties insurance. The use of W&I Insurance has been one of the more significant developments in M&A transactions in recent years. Although used on some South African transactions, W&I Insurance is not as commonly used as it is in the European and North American markets. Emerging out of the COVID-19 pandemic, we anticipate growth in M&A activity to be partly driven by funds activity and distressed deals. In this New Dynamic, the use of W&I Insurance in South Africa should increase.
What is it?
W&I Insurance is an insurance product specifically designed to cover the financial loss that may arise in the event of a breach of a warranty or indemnity under a sale of shares or sale of business agreement. Originally intended to provide sellers with peace of mind once they exited a business, W&I Insurance has evolved to include buy side as well as the original sell side policies, with buy side policies now constituting the largest portion of the W&I Insurance market. Under a sell side policy, a seller would be able to claim from the insurer for its own innocent misrepresentations in the event a buyer successfully claims against that seller. Under a buy side policy, the buyer would be able to claim from the insurer for the seller's misrepresentations without having to seek recourse directly against the seller.
Why use it?
Primarily, W&I Insurance works to close the gap between the comfort a buyer needs and the comfort a seller is prepared to give on a sale transaction through warranties, representations and indemnities. Where that divide cannot be bridged through a negotiated solution, W&I Insurance can provide a deadlock breaking mechanism to avoid a failed deal. There any number of advantages to both sellers and buyers:
Key advantages for sellers:
- Achieves a clean exit for the seller. This is often of importance to private equity and family / individual sellers.
- Avoids the need for complex and expensive escrow arrangements around warranty recourse.
- Enables immediate utilization of sale proceeds and faster distribution of those sale proceeds to seller shareholders / investors.
- Can be essential to facilitate nil-recourse deals.
Key advantages for buyers:
- Alleviates buyer concerns about the ongoing credit worthiness of a seller and the seller's ability to pay out on a warranty claim.
- By avoiding direct claims between the seller / other warranty providers and the buyer, a buy side policy preserves the working relationship between the seller and a buyer. Preserving such relationship will be most important where the individual seller or senior management who provided warranties remain in management positions post the sale.
- A buy side policy may protect the buyer from seller fraud.
- Where the inherent risks of a deal are not familiar to a buyer (for example, because they are entering into a new sector or unfamiliar territory), W&I Insurance can provide a large measure of comfort and risk mitigation.
- A buyer will often find it easier to pursue claims directly against an insurer, who may be located in the same jurisdiction as the buyer, as opposed to a seller, who may be located in another jurisdiction. This avoids the expense, time and complexity associated with pursuing and enforcing cross border claims.
How W&I Insurance should shape a deal right from the start
Insurers will interrogate any due diligence undertaken as part of the underwriting process. Particularly, insurers and their counsel will want to understand scope and gaps in that due diligence. By ensuring early on that the due diligence scope aligns specifically to the underlying target business, is not generic in nature and that the warranties and indemnities align with the due diligence findings, better coverage from the ultimate W&I Insurance policy is a more likely outcome. Failing to correctly scope the due diligence and the warranties and indemnities can have a direct impact on the coverage offered under the policy. Choices to exclude certain areas from the due diligence will have consequences further down the line and counsel for the buyer or seller may find themselves somewhat nonplussed to be questioned on the due diligence they have undertaken and the gaps that have now been identified by counsel for the insurer. Conducting the due diligence in a manner that includes consideration of eventual W&I Insurance and drafting the warranties accordingly should ultimately lead to better coverage and better outcomes for clients.
The direct impact of COVID-19 on W&I Insurance
Early on in the pandemic, in light of there being little visibility on even the short-term impacts of the pandemic and government responses to it, blanket COVID-19 exclusions on W&I Insurance policies were seen in the market. As the pandemic has progressed, we expect general exclusions to be pulled back to more specific exclusions focusing on identified areas of concern. Dependent upon the underlying business, these may include warranties and indemnities around supply chain disruptions, impact on commercial agreements, impact on lease arrangements, cyber risks, COVID-19 disputes and litigation, impact on existing funding or funding accessed specifically as a result of the pandemic and the like. Similarly, the pandemic is also likely to leave a permanent mark on due diligence and warranties and indemnities in M&A deals. Just as buyers are going to focus on areas that COVID-19 has revealed to be high risk, so too will insurers.
M&A activity coming out of the pandemic and the role of W&I Insurance
Growth in M&A activity in 2020 has been forestalled by COVID-19, but, once economies start to reopen, and in the absence of systemic underlying problems in the economy, M&A growth should start to take shape again. The COVID-19 pandemic and associated government imposed lockdowns have created an environment where this growth is likely to be driven by private equity funds and distressed M&A deals.
Private equity funds, currently sitting on an estimated US$2.6 trillion in funds1, are one of the biggest users of W&I Insurance globally. M&A activity in South Africa off the back of investment by global private equity firms should lead to an increased demand for the use of W&I Insurance. In a distressed sale scenario there are two key factors at play that will likely drive growth in the use of W&I Insurance: sellers want clean exits and buyers may doubt counter party credit risk in the event they need to claim for breach of warranty. We therefore anticipate that the trend in South Africa towards greater use of W&I Insurance will continue and likely increase as a result of the type of M&A growth expected in the New Dynamic.1SS&C Intralinks Deal Flow Predictor Q3 2020
Samantha Hogben is a Partner, Dentons Johannesburg.
DealMakers is SA's M&A publication.
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