Cash is king, and it can be rather hard to come by under current market conditions. As corporates and private equity portfolio companies set up their cash war rooms and seek to identify cash levers1, attention is turning towards the insurance market to see how it can help. This article summarises the suite of M&A insurance products that can help release cash reserves and provides real-life case studies where specific insurance products were utilised.
Within the field of M&A insurance, the most commonly known product is the Warranty and Indemnity Insurance (the “W&I Insurance”), where the risk of a breach of warranty or a claim under the tax indemnity, given by the seller to the buyer under an asset / share purchase agreement (SPA) and/or Notary Deed (in the French market), is transferred from the seller to an insurance company in real estate or operational transactions.
While W&I Insurance covers only unknown risks, specific risk insurances (the “Specific Risk Insurance”) were developed to supplement W&I Insurance by providing wider cover and to mitigate a broader array of risks arising in the context of a transaction. Specific Risk Insurance can also assist in covering risks that insolvency practitioners or other risk-averse parties (such as security trustees) are unwilling to assume. These risks can be transferred to the insurance market via a corresponding insurance policy. Without an insurance solution, cash will be required to be held in escrow, at fund level or on the target’s balance sheet. Moreover, international investors not familiar with the local risks are often requested by their boards and their risk committees to secure all / most of the identified risks.
Common underlying issues which can typically be covered by Specific Risk Insurance are
(i) ongoing or potential litigation;
(ii) potential tax liabilities; and
(iii) potential environmental remediation liabilities.
Specific Risk Insurance is usually put in place either at signing or at closing of the relevant transaction. However, Specific Risk Insurance can also be placed outside of the context of a transaction, i.e. Specific Risk Insurance is also a viable post transaction solution to release cash.
2. Cash is king
Amidst the uncertain and potentially volatile economic environment caused by COVID-19, concerns have arisen about private equity portfolio companies across industries facing sharply declining revenues and short-term cash crunch2. Capital injections, debt buy-backs, reset covenants, waiver or deferment of payments are the traditionally suggested solutions to financing concerns at portfolio company level.
Another tool can now be added to this list: the cash release insurance (the “Cash Release Insurance”). Post transaction, Cash Release Insurance sees an insurance policy replace “trapped” cash (i.e. as mentioned above, cash held in escrow, at fund level or on the target’s balance sheet). Whilst the suite of products that facilitate cash release has been around for some time, the current severe demand for cash at short notice has adjusted the cost/benefit equation. In simple terms, the value of the liquidity created by these products is often materially higher than the cost of the premium.
The most common uses are:
(i) replacing potential or existing escrows held by escrow agents or notaries which have been put in place during a previous transaction, which potentially could have been covered by a Specific Risk Insurance;
(ii) facilitating transactions or restructurings by transferring known risks to the insurance market;
(iii) releasing cash held at fund or portfolio/corporate level trapped due to identified risks after M&A transactions; and
(iv) enabling the release of cash held against potential liabilities (e.g. litigation) in a fund wind-up or insolvency event.
Some insurers are also willing to, in effect, co-invest with acquirers of litigation portfolios by providing insurance for downside risk in the event that recoveries are lower than the amount paid for the portfolio.
3. Case Studies
3.1 Litigation – facilitating distributions
- The target company was faced with litigation in which claimants requested (a) EUR 40m damages and (b) unwinding of various corporate transactions, which would have led to a massive value reduction of the target company.
- The seller offered an indemnity in respect of the EUR 40m damages claim but no further protection for the buyer. The sale of the target company was subject to a competitive process and buyer was not in a position to negotiate additional protection from seller.
- • An insurance policy covered the risk of the corporate transactions being unwound, providing protection for the buyer against the remote risk of a catastrophic value reduction of the target company.
- • The policy also covered 50% of the EUR 40m damages exposure, releasing EUR 20m from seller’s proposed indemnity and materially improving the position of the buyer in the sale process.
3.2 Tax – releasing cash collateral
- A European fund held EUR 20m at fund level instead of distributing the amount to their limited partners , in order to protect against potential tax liabilities including: (i) potential claims for withholding tax against historic distributions; and (ii) an indemnity given to a buyer of a portfolio company against the risk of contractors being reclassified as employees.
- A tax insurance policy was put in place which covered the tax liability and any penalty interest accruing. The policy enabled the general partner of the fund to release the trapped cash (minus the premium) and wind up the fund structure, making further savings on administrative costs.
3.3 Environmental – escrow replacement
- A European corporate sold off a Spanish manufacturing asset, with the SPA including an EUR 8m indemnity to cover remediation costs for site contamination.
- The buyer required EUR 8m to be held in escrow for 2 to 3 years but the seller sought to avoid this by arranging an environmental policy.
- The environmental policy was structured in such a manner that it exactly reflected the indemnity language which freed up the EUR 8m for the seller.
The above are examples of what has been achieved using Cash Release Insurance, but a far broader array of issues can be solved. Investors, sellers and buyers should be encouraged to discuss any live deal situations, which pose a cash (release)-related challenge with their M&A insurance broker of choice to potentially find insurance solutions. Because at the end of the day – cash is king!
- www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/privateequity-and-the-new-reality-of-coronavirus ↩
- https://www.dlapiper.com/fr/france/insights/publications/2020/04/covid-19s-impact-on-portfolio-company-financing/ ↩