However as the economy restarts experts predict** M&A activity will bounce back with deals that would have happened earlier in the year back on the table, new transactions driven by distressed sales due to the tough economic times or businesses selling off non-core assets to raise capital.
Given the uncertain economy it’s more important than ever for buyers to undertake thorough due diligence on their transaction and also ensure they have the right insurance in place to mitigate the increased risks currently being faced.
Due diligence
Due diligence is an essential activity in transactions. In the M&A process, due diligence allows the buyer to confirm relevant information about the seller, such as contracts, finances, and customers. By gathering this information, the buyer is better equipped to make an informed decision and agree the deal with confidence.
The first step of the process involves gathering a team who will be responsible for conducting the due diligence. To ensure that the process is executed properly, the buyer will need a team of legal and financial experts with specialist knowledge in M&A. The next step in the process involves the relevant advisors requesting documents pertinent to their specialism.
While the exact documents required during due diligence can range depending on the type of business, size of the business, and similar factors, there are several kinds of data that are commonly requested across the board. These typically include financial records, contracts, business commitments, insurance information and details of any legal actions against the company.
George Minoprio, Executive Director of Gallagher’s Mergers & Acquisitions Practice, advised: “Overall, the buyer will need to get a solid understanding of the target company’s financial health, operational assets, legal matters, and strategic position. If any of the information provided poses a problem, the business deal may not occur. Thorough due diligence is a core part of managing the risks in a transaction and businesses should take specialist advice on the steps they need to take to ensure they fully understand the business they are buying. Insurance due diligence is key to obtaining the right insurance cover for the target going forward, and understanding the cost of risk i.e. not just the premiums, but the cost of self-insured areas.”
Warranty and Indemnity (W&I) insurance
Regardless of how thorough a due diligence process followed, Warranty and Indemnity insurance is an increasingly popular and affordable type of cover that helps protect both buyer and seller when undertaking a transaction.
When a business is sold a seller is required to give various guarantees (warranties) to the buyer. These are statements of fact about the target business which protect a buyer in two main ways; they help to flush out information which is inconsistent with the warranties that the seller is asked to give, and they give the buyer a contractual right to bring a claim against the seller in the event that they suffer losses in circumstances covered by a warranty.
A seller will remain at risk for the duration of the warranty period – which is typically up to two years from the date on which the business is sold for non-tax warranties, and up to seven years for tax warranties.
A successful warranty claim could result in a seller being obliged to pay back some or all of the sale proceeds. Indemnities can be more significant; they provide the buyer with a refund in the event that losses arise from a pre-identified set of circumstances.
The benefits of W&I insurance to a seller include:
- It allows them to use their sale proceeds without the risk that they will later become liable for a warranty claim i.e a much cleaner exit.
- It enables institutional investors to immediately distribute sale proceeds to investors.
- It reduces the need for a retention or escrow account (whereby some of the sale price is set aside until the warranty period has expired).
- It can enhance the value of the transaction by allowing full warranty provision to be made in circumstances where the sellers would otherwise be unwilling or unable to give warranties.
Equally important, however, are the benefits that W&I insurance can give to a buyer:
- They may be reluctant to bring a warranty claim against sellers who continue to be employed by the business after completion - a buy-side W&I policy allows claims to be made without damaging the buyer's relationship and potentially losing valuable staff.
- They are concerned about the sellers' financial strength – claiming under a W&I policy removes the risk that a seller will not be able to pay out should a warranty claim arise.
- A seller might also be willing to entertain a lower offer if they know that the sale proceeds will be immediately available to them, rather than having the uncertainty of waiting out a warranty period or having money held back in an escrow account.
- The acquisition is to be debt-financed, as negotiations with lenders may be helped by the knowledge that a W&I policy will be taken out.
- There are also various scenarios in which a W&I policy can be used to reach agreement on a commercial point where negotiations have broken down.
- They may have no choice if the seller stipulates nil recourse to the sale and purchase agreement in the knowledge that W&I is now widely used.
It is possible for either the buyer or the seller to be insured, but the significant majority of W&I policies are taken out by the buyer. This is because with a seller-side policy the seller is insured, but the buyer will still need to bring a warranty claim against the seller. This negates many of the advantages of a W&I policy such as preserving the relationship between buyer and seller. With a buy-side policy the buyer is insured, meaning that it can make a claim against the policy as soon as a breach of warranty occurs. Buy-side policies generally protect the buyer against the fraud of the seller, whereas a seller-side policy will not.
George, added: “W&I insurance is a cornerstone risk management tool giving buyers and sellers additional confidence in a transaction. Businesses considering a purchase or sale should contact Gallagher who can help advise on the type of cover that should be considered.”
These are brief product descriptions only. Please refer to the policy documentation paying particular attention to the terms and conditions, exclusions, warranties, subjectivities, excesses and any endorsements. FinProms reference FP1271-2020
