The Value of Reps & Warranties Coverage for Strategic Buyers

North America Mergers & Acquisitions (M&A) activity in 2017 posted an impressive $1.8 trillion in deal value involving 10,465 deals, according to Pitchbook.¹ Of this amount, approximately $1.3 trillion was represented by strategic buyers in 7,200 deals. Indeed, according to a March 23, 2018 article in the Wall Street Journal², ‘corporate acquisition activity has been robust, crowding out buyout firms.’ As strategic buyers complete integration of recent acquisitions into their operations, it can be expected that they will continue to be active contributors to North America M&A activity.

Against this backdrop, strategic buyers seeking middle market acquisitions are encountering the same unique financial exposures in their deal making activity as do private equity firms. One such exposure, the risk of loss to the buyer as a result of unknown breaches of a seller’s representations and warranties, has historically been addressed through a seller indemnity (often including an escrow) in an acquisition or merger agreement that provides buyers with recourse against sellers after a deal closes. Through purchase of a representations and warranties insurance policy, however, a strategic buyer can limit or completely replace the seller’s indemnity for representations made in the agreement by shifting exposure for loss to an insurer.

The beginnings of representations and warranties policies date back more than twenty years, but the process of obtaining a policy then was relatively time consuming and laborious. Today, a representations and warranties policy can be quickly procured and deals can often be underwritten by a carrier’s transactional risk department in as little as less than a week. The purchase of representations and warranties policies can be a more economical alternative to traditional seller indemnities and escrow.

Benefits of Reps & Warranties Coverage

It is not hard to understand why representations and warranties coverage has now gained in popularity among strategic buyers. The value proposition for corporate acquirers is the same as it is for private equity firms:

• Longer Survival Period – the amount of time that a buyer may seek recourse for breaches of a seller’s representations and warranties is three to six years, as opposed to the typical twelve to eighteen month duration of an escrow account.
• Avoid Party Acrimony Post-Close – key relationships are maintained, enabling the buyer to avoid having to claw back funds from an escrow, which can create an uncomfortable relationship with management.
• Investment Grade Counterparty – it relieves the buyer of the credit risk of a seller, providing recourse via a representations and warranties policy issued by a creditworthy insurance company.
• Clarity – it removes many of the arguments over the size of the indemnity or escrow, thresholds, baskets and survival period, and may result in equal or better coverage.
• Clean Exit – the seller is afforded a fast exit from the transaction, with a larger amount of the proceeds from the sale in hand.

These points are meaningful to either strategic or financial sponsor-backed buyers. For example, in a scenario where two bidders – whether strategic or private equity – are each offering $200 million to acquire a target, the first bidder may ask the seller to keep $20 million in escrow to back its indemnity obligations, whereas the second bidder, who has secured a representations and warranties policy, may ask the seller to retain only $2 million in escrow. Of course, all else being equal, the seller would likely opt for the bid with the lower escrow requirement, as it reduces its cost of capital for amounts placed in escrow to cover possible breaches of its representations and warranties. The buyer’s purchase of a representations and warranties policy makes the second bidder’s offer more appealing to the seller.

The benefits to a strategic buyer to procure a representations and warranties policy are readily apparent and, accordingly, strategic acquirers should consider this coverage for their acquisitions, particularly as transaction activity is expected to remain vibrant.

¹Pitchbook (2018). 2017 Annual M&A Report. Retrieved from https://pitchbook.com/news/reports/2017-annual-ma-report.

² Miriam Gottfried, “Toys ‘R’ Us, iHeartMedia Haunt Buyout Firms Sitting on Trillion-Dollar Cash Pile,” Wall Street Journal, March 22, 2018, https://www.wsj.com/articles/toys-r-us-iheartmedia-haunt-buyout-firms-sitting-on-trillion-dollar-cash-pile-1521720000.