The mergers and acquisitions (M&A) market is facing a series of consecutive challenges. Whilst trying to recover slowly from a worldwide pandemic, Russia's invasion of Ukraine and the associated political instability has led to an inevitable acceleration of an economic crisis driven by spiralling energy costs. Warranty and indemnity insurance (W&I insurance), which has in recent years become a widely used risk allocation solution in M&A transactions, has not been spared by the impact of that economic turmoil.
W&I insurance is an insurance product designed to cover financial risk connected to a potential breach of warranty or tax covenant. W&I policies may be taken out by sellers or, more typically, buyers. Whichever type of policy is taken on a particular deal, the future policy holder will engage a broker to find the best suited policy terms available in the underwriting market. The broker will be the main point of contact with the underwriters during the W&I process and as such, has the best seat to witness and analyse the W&I underwriters' behaviour and developing market trends. Particular areas of focus tend to come to the fore for underwriters in times of economic uncertainty. We outline below some of the trends brokers have been highlighting to us recently.
There are various ways of valuing a target entity, including, for example, using financial indicators such as the EBITDA (earnings before interest, tax, depreciation and amortisation) to which a multiple will be applied, or looking at the company’s net assets. Whichever method a party wishes to use, W&I insurers are scrutinising the valuation model more than ever before. Indeed, the economic uncertainty makes the company's financial performance very difficult to predict. , The increase in conservative company valuations warrants a separate in-depth discussion, but suffice it to say that policy holders should be aware of the need to have a robust valuation model which can withstand thorough scrutiny by W&I insurers.
What flows from the above observation is that when buyers notify a claim under the W&I insurance policy, it is more likely to be connected to the financial statements or other financial information provided by the sellers than anything else. If the buyer considers that it has applied the wrong EBITDA multiple as a result of the information provided by a seller, it will be more likely to pursue a claim for breach of the finance warranties as it will feel that it has overpaid for the target. It is therefore understandable that W&I insurers have the same concern, especially in uncertain times.
Intrinsically linked to the above, another focus of W&I insurers is the profitability of the target entity. Again, whilst investors have little appetite for breach of warranty litigation, in the current fragile market, investors are more prone to claim under W&I policies where the target has failed to deliver the anticipated financial returns post completion. How does this concern transpire in insurers' behaviour? W&I policy providers may be reluctant to award cover where the target is not performing well at the outset of the transaction (i.e. is loss making), unless there is a compelling reason to think that the company will become profitable post completion. Whether there is a compelling reason will be highly dependent on the sector in which the target operates and its age. For example, start-ups/companies in the technology sector experienced a very fruitful time during the COVID-19 pandemic. Tech valuations reached lofty heights, but in recent months have experienced a sharp correction led by the US public markets.
Two risk preventive methods to avoid the unwanted outcomes of a failed investment may be highlighted: strong due diligence and involvement of key actors in the disclosure exercise.
Financial due diligence
It is key in any transaction, whether supported by W&I or not, that the buyer must undertake its own financial due diligence before acquiring (or even valuing) a company. One of the key drivers of this financial due diligence will be the target's statutory financial statements. For various reasons, including for example increased conditionality around regulatory approvals and notifications required under the National Security and Investment Act, transactions are taking longer to complete. As such, it may be that the date of a target's latest accounts (which is the base of the accounts warranties in the transaction document) is "stale" by the time the parties are ready to sign. As we have observed in the recent years, a few months may drastically change the economic climate which would in turn affect the performance of a company. A buyer cannot rely on outdated accounts and it must make sure that it is provided with trading performance updates (whereas in the form of management accounts or else). From a W&I insurer perspective, as we set out at the start of this article, W&I claim notifications are mostly based on the target's failed financials and so the buyer will seek to pursue claims for breach of the financial statement warranties. It is therefore important that W&I insurers have access to recent target financials to assess the target's risk profile. Due diligence is a continuous exercise and it is important to renew it in areas such as this where deals are dragging.
Meaningful disclosure and transparency
The fact that a deal is (or may be) insured does not mean that the warrantors are relieved of their disclosure duties. W&I insurers will (rightfully) expect the disclosure exercise to be conducted seriously and to the standards set in the transaction document. Disclosure cannot be meaningful if it is conducted with individuals who are not close to the running of the day-to-day business of the target. It is fundamental for insurers (and the buyer) that the warrantors are either confident that they know enough to make a disclosure where appropriate or if this is not the case, that they have enquired from the relevant people in the business. A thorough, detailed disclosure letter that captures the knowledge of the relevant business personnel will provide comfort to both sides of the transaction and most importantly the W&I insurer. Indeed, if the W&I insurer refuses to insure the deal on the basis of lack of information, the seller's scope of liability will increase. Fair disclosure goes in tandem with due diligence. The seller needs to be amenable to share enough information with a buyer so as to enable it to make an informed decision in its valuation and acquisition of the target. Poor disclosure and engagement from the sell-side in the due diligence process may result in W&I insurance not being available.
W&I insurance continues its growth in the UK private market and the amount of W&I insurance claims is on the rise, with the top three sources of claims being (1) financial statements, (2) tax, and (3) compliance with laws. With no signs of the current economic challenges abating, those seeking to take out W&I insurance can expect the increased scrutiny by W&I underwriters of the areas highlighted above to continue for the foreseeable future.