As representation and warranty insurance (R&W) remains white-hot in the U.S. M&A mid-market, a number of additional underwriters have entered an increasingly competitive space. That, in turn, has spurred interesting developments in deal terms in both the United States and Canada in the past year.
Here are some key trends from the last twelve months that are worth keeping an eye on in 2018:
(1) Better pricing
In just the last twelve months, premiums on the heart-of-the-market policies, those underwriting deals with $100 million to $500 million enterprise value, have dropped to 3.0 percent to 3.4 percent of EV. This represents a meaningful price cut from the previous 3.25 percent to 3.75 percent range.
Even better pricing is available where the underwriting market views the deal as a good risk. In those cases, premiums can be as low as 2.5 percent of EV.
Not surprisingly, increased competition by new market entrants in the United States and Canada is the key driver for the drop in pricing, as newcomers like Blue Chip, XL Catlin and Euclid challenge the established underwriters like AIG and Ambridge.
(1) Special considerations in Québec
Despite the overall theme of expansion and growth in the United States and Canada, this past year did mark a reduction in underwriter interest in “QC based deals,” i.e., those governed by Québec law or involving a named insured located in Québec.
Under Québec law, insurers may be on the hook for defense costs, regardless of the limits of liability of the policy. Some insurers (AIG, for instance) attempt to mitigate this exposure in a side letter or waiver, but the risk remains too great for most.
(3) Cyber security comes into focus
While competition may put pressure on insurers to slim down their standard exclusions from coverage, one area where underwriters appear less willing to take on risk is cyber security.
Increasingly carriers are flagging cyber security as an area of heightened underwriting, and in certain cases insurers insist on an outright exclusion for cyber security matters. Buyers, especially buyers of targets dealing with personally identifying information, should be prepared to demonstrate that the target has adequate cyber liability coverage and a clean history when it comes to data breaches and hacking.
(4) As retentions are dropping, “public company-style” is en vogue
Where a year ago, a buyer could routinely expect to accept a self-insured retention (i.e., the deductible under R&W insurance) of 1.25 percent to 1.5 percent of EV, a 1 percent retention has become standard.
And where once underwriters expected to see seller ‘skin in the game’ as a matter of course, typically by splitting the retention evenly between a seller-funded escrow and buyer-funded deductible, brokers are now seeing 20 percent to 25 percent of their deals being underwritten with no seller indemnity.
Those no-seller indemnity deals will generally still attract higher policy premiums in the range of an extra 25 basis points. But a retention of 1 percent looks similar to what a buyer deductible might have looked like a few years ago in a competitive conventional private M&A deal.
This, in turn, has motivated some buyers to agree to do private M&A deals “public company-style”, that is, letting a seller off the hook with respect to any indemnity recourse.
While endorsing the “public company style” paradigm may allow a buyer to distinguish itself (for example in a hot auction), the competitive edge comes with costs beyond the extra 25 basis points in insurance premium.
For example, a buyer should consider what else it is giving up, beyond recourse to seller for breach of reps, when agreeing to a no-seller indemnity deal.
The reason for this is that “public company-style” is a binary proposition and agreeing to this construct also cuts off buyer’s recourse for breach of covenants, company debt and transaction costs not picked up in the purchase price adjustment, and exposures in excess of the R&W insurance policy limit. Notably, not all of these risks can be mitigated through buying more R&W insurance coverage.
Also of note, if the transaction is “public company-style,” underwriters will not always underwrite coverage for pre-closing taxes.
(5) Hybrid coverage may provide the right protection at the right price
While the public company-style recourse package can be an attractive bargaining chip, for some buyers it may prove conceptually difficult to let a seller off the hook entirely, particularly on the fundamental reps.
As a solution, buyers may wish to consider tiered coverage, for example to get a typical 5 percent or 10 percent coverage policy on the general reps, but to layer on an additional tier of coverage for just fundamental rep breach. This fundamentals-only tier can be purchased at a lower premium than the general reps, reportedly under 2 percent, given the low frequency of fundamental rep breaches and given that these reps are relatively easy to diligence.
Stefan Stauder is a partner at Torys LLP with a broad transactional practice that includes M&A and private equity. He wrote this article in collaboration with Meghan McKeever, a senior associate with a practice that includes corporate transactions, including M&A, and debt finance.
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