Torys’ guide to private equity in 2015: The changing face of deal terms

Last month, Torys LLP released its annual Private Equity in Focus, which focuses on the environment for deal making in 2015.

In an exclusive to peHUB Canada, Torys is sharing report findings with readers in three installments. In the first and second installments, we talked about recent shifts in Canadian market dynamics and the broadening scope of private equity investment.

In this third installment, Stefan Stauder, Laurie Duke and I discuss the changing face of deal terms.

In our view, current M&A deal terms show the continuing influence of a seller’s market in Canada. We feel that changes in indemnity terms and the growing use of representations and warranties insurance (R&W insurance) are just two important examples of this trend.

In the terms

Torys analyzes deal terms in private M&A transactions that we advise on to monitor changes in market practices over time. Our latest analysis of terms, including those that apply directly to PE transactions, illustrates a number of noteworthy developments, including the continuing influence of sellers on deal terms.

Caps, deductibles and survival periods

Our first observation is that the average indemnity cap for non-fundamental representations and warranties increased to nearly 45 percent of deal value in 2014, up from less than 40 percent in 2013. This may partly be a function of our sample, which included a relatively large number of transactions in the mid-market range (higher caps being more frequent in deals of a smaller value).

As was the case in 2013, sellers continue to be successful in negotiating for the use of true deductibles (where the buyer bears the amount of losses up to the deductible) rather than thresholds/tipping baskets (where the buyer can claim the total loss once the threshold is exceeded).  Deductibles were agreed to on 53 percent of our canvassed deals and thresholds/tipping baskets appeared in 40 percent of the sample deals.

The average deductible/threshold amount in our sample was 0.9 percent of deal value. A slight increase in the average from 2013 may be explained by the emerging use of “materiality scrapes,” which, in our experience, sellers will sometimes accept in exchange for a somewhat higher deductible.

Although survival periods varied from deal to deal, the period for non-fundamental representations and warranties most often seen in our 2014 sample was 18 months.

Materiality scrapes

Our sample shows that materiality scrapes (that is, provisions that read out materiality or “material adverse effect” qualifiers in the representations and warranties for the purposes of indemnity) were used more often in 2014 than in prior years. This trend mirrors a corresponding U.S. trend, where materiality scrapes are also gaining ground.

While materiality scrapes are still less prevalent in Canada than in the United States, we see a continuing convergence in market practices.


One result of the highly competitive deal environment of 2014 was that more buyers agreed to forgo post-closing escrows to backstop potential post-closing claims. This is indicative of a wider trend to execute private M&A transactions in a “public-company style,” particularly in the context of hot auctions. We also believe that the rising popularity of R&W insurance as an alternative to seller escrows contributed to this trend.

Where deals included escrows, the amount of the holdback, as a percentage of deal value, commonly fell in the range of 5 percent to 10 percent, though in some instances exceeded 15 percent of value.

Reverse break fees

Several of the PE deals in our sample included so-called reverse break fees payable to the seller if a buyer failed to pay the purchase price, despite all closing conditions having been satisfied or waived. The fee amounts were generally below 5 percent of the value and the reverse break fee mechanic was coupled, in most instances, with the right of seller to cause the buyer to close the transaction so long as debt financing was available.

This model follows a common approach used on U.S. PE deals, although reverse break fees paid on these transactions sometimes exceeded 6 percent of value.

R&W insurance

Our data shows a veritable explosion in the use of R&W insurance, although product use was more frequent on U.S. deals than Canadian ones.

Our data points line up with what other market players have observed: One global insurance broker reports that insurance limits placed and associated deals closed in North America essentially doubled in 2014 from 2013, and since 2011, have increased by more than 300 percent.

What makes R&W insurance so attractive?

Consider a traditional mid-market PE deal valued at $100 million. The recourse package for the deal might include an indemnity for breaches of non-fundamental representations with a cap in the range mentioned above and a seller escrow (accruing nominal interest) in which 5 percent to 10 percent of proceeds are held back for at least one audit cycle. The former puts at risk a sizeable portion of sellers’ return; the latter is a meaningful drag on the sellers’ returns. An R&W insurance policy, by contrast, permits an almost entirely “clean exit” from the sellers’ perspective for a moderate premium.

Pricing for policies varies, but as of late has trended within a band of 3 percent to 4 percent of the insurance limit for a “middle-of-the-road” set of representations and warranties, meaning that a $10 million policy can be purchased for about $300,000-$400,000, plus a small underwriting fee in the range of $30,000. The costs can be allocated among the seller and buyer.

Most of the insurers have groups of former M&A attorneys who assist with putting a policy in place. That greatly facilitates the resolution of issues and the process, which typically consumes two to three weeks from start to finish.

Does R&W insurance pay, if indemnity claims are asserted?

While the product has not been around long enough to definitively answer this question, insurers have tended to honour claims swiftly. The conventional wisdom is that it may well be easier to collect from an insurer trying to establish a reputation in this increasingly popular and competitive insurance niche than from a seller, who almost always has an incentive to fight tooth and nail in connection with a rep and warranty claim.

Concluding thoughts

The rising popularity of R&W insurance and changes in indemnity terms are reflective of the recent sellers’ market that we expect to continue in 2015. We at Torys believe it will be interesting to see how deals terms evolve as Canada’s highly adaptive PE market hits its stride in the months ahead.

The entire Torys’ report and related statistical charts can be viewed here.

Sophia Tolias is an associate at Torys LLP, focused on M&A and private equity transactions. Stefan Stauder is a Torys’ partner with a broad transactional practice emphasizing M&A and private equity. Laurie Duke is a partner at Torys with a corporate law practice that includes a focus on private equity and M&A. 

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