Unlocking deals and creating liquidity

As we move from lockdown to reopening, COVID-19’s initial wave has left a volatile M&A market in its wake. Macro-economic uncertainty, questions around valuation and difficulties in conducting diligence are just some of the challenges facing dealmakers.

The continuing evolution of W&I and other transactions-focused insurances in recent years offers dealmakers a toolkit to help solve these challenges. Together with Tom Saunders of Aon’s M&A and Transaction Solutions team, our Dublin and London M&A teams explore four ways in which dealmakers can use transaction insurance to help unlock opportunities in a volatile M&A environment.

1. Creating seller liquidity: cash-release insurance

One aspect of the general post COVID-19 transition to a buyer’s market is an increase in the use of escrows on M&A deals, in part driven by buyer concerns about sellers’ liquidity to meet future warranty claims. At a time where “cash is king”, sellers may wish to extract cash from escrow sooner than envisaged and cash release insurance provides them with a means to achieve this, creating additional liquidity on deals that would otherwise have been tied up for a long period of time.

Whilst cash release insurance has typically been used to cover actual or potential litigation, tax and environmental liabilities, underwriters are now adopting a more expansive view and offering it as a tool to replace cash that would otherwise be held in escrow. Moreover, it can also be used for existing escrow arrangements, for both individual assets or on a portfolio basis to provide coverage for a number of historic transactions.

Cash release insurance, therefore, helps create liquidity for investors who want access to cash, to de-risk their balance sheets and to accelerate returns to their stakeholders. Equally, introducing the possible use of a cash release insurance policy can also assist buyers in successfully overcoming sellers’ traditional reluctance to the inclusion of an escrow mechanism. The buyer is therefore satisfied that they have an adequate avenue of recourse for any claims arising after the sale has closed. This then affords the seller the scope to negotiate down the amount of funds required to be held in escrow.

2. Tilting the balance: sell-side policies

Up until recently, a seller-friendly market resulted in the majority of W&I policies being initiated by buyers. In the current climate, it is expected that there will be an increase in the number of sell-side policies (ie policies initiated, packaged together and paid for by a seller). Sellers may (temporarily) no longer enjoy a superior negotiating position to clean exits with limited outstanding liability.

With a sell-side policy, the seller retains meaningful liability for breach of warranties given to the buyer under the transaction documents, and then seeks coverage under a W&I insurance policy to insure itself in the event of loss suffered from a subsequent claim made by the buyer for breach of warranty. This alignment between insurer and the insured (the seller) provides for a favourable level of skin in the game by the seller, which is attractive for buyers.

In part, this tilting of the balance may be driven by informed and institutional sellers seeking to present a well-structured and attractive package of protection to a buyer to try and avoid negotiation around escrows and to enable them to swiftly distribute sale proceeds.

3. Bridging the gap: distressed deal policies

It is widely anticipated that the post COVID-19 M&A landscape will see a significant increase in distressed deals. Traditionally, underwriters have had a limited appetite for providing insurance on distressed deals, primarily due to the low-levels of due diligence that a prospective buyer can undertake and the fact that the parties negotiate very limited, if any, warranties for them to insure.

Times have changed, and many underwriters are now prepared to offer policies in the distressed arena, which enable a larger pool of potential buyers to explore distressed deals. The availability of such policies also incentivises management engagement, which ought to generate an accompanying enhancement of buyer protections. The growing use of “synthetic warranties” (provided by the insurer under the W&I policy rather than by the seller under the sale agreement) can also be used to bridge gaps in the levels of protection which a buyer is able to obtain from sellers and management teams in distressed scenarios.

Insurance can also be used to mitigate known risks and release funds when dealing with an insolvency process, such as release cash held as a hedge against tax risks prior to a liquidation. Insurance also allows an administrator/examiner to release indemnities given to receivers to arbitrage the cost, and increased risk, of a longer administration or examinership against the cost of contingent risk insurance.

4. W&I 4 P2P

The impact of COVID-19 on listed companies’ share prices and the widening of institutional investors’ crosshairs, is expected to generate an increase in public to private (P2P) deals. While W&I insurance has historically focused almost exclusively on private company M&A, insurance providers have been increasingly willing to underwrite policies for P2P deals.

Whilst much will hinge on the relevant takeover rules and market practice around giving warranties, in a significant number of P2P deals, at least some of the warranties can be synthetic (provided by the insurer under the W&I policy rather than by management). At the same time, where management do provide warranties, this is typically done via a warranty deed or similar, subject to regulatory requirements and market practice.

Premiums for public to private deals are likely to be higher than for private M&A with premiums in the 1.5% – 3.5% range, correlating to the level of management involvement/assumption of risk and due diligence. Therefore, coverage given on a fully synthetic basis (where warranties are negotiated between the insurer and the insured with no involvement from management and then given by the insurer) will be at the higher end of the premium range.

Dealmakers will also need to be alive to the confidentiality and regulatory challenges inherent in any P2P deal, which will necessitate careful choreography and consideration around the point in time at which insurers can be involved in the process, as well as what non-public information can be shared.