Despite economies around the world receiving unprecedented governmental support, the financial repercussions of the pandemic are affecting many businesses, forcing some to restructure or suspend their activities and others to close their operations permanently. Whilst it is difficult to forecast the long-term effects of the current circumstances on the M&A world, opportunities to invest in distressed businesses will become likely. In fact, recent developments show that this trend has already started. Once governmental suspensions or easings of filing requirements for insolvencies laps, this trend will likely accelerate. HWF conducted a detailed exercise interviewing seventeen insurers in the market to provide first-hand insights and reliable guidance on how warranty and indemnity (W&I) insurance and contingent risk insurance policies can be used in distressed transactions.
2. What types of insurance cover are available for distressed transactions?
For distressed transactions, three insurance options can be offered: (i) traditional W&I cover, (ii) synthetic W&I cover, and (iii) contingent risk cover.
- Traditional W&I cover can be used where the process mirrors the process in a non-distressed deal, i.e. a full suite of warranties is given by the seller under the SPA or by management in a management warranty deed; adequate disclosure is provided in a data room reflecting the contents of the warranty catalogue; and the buyer has conducted market-standard due diligence covering the scope of the warranties. Where possible, this is the recommended option mainly because insurers get comfort when someone with knowledge of the business carries out a robust and fulsome disclosure exercise and stands behind the warranties (even if capped). This often results in broader coverage and in order to achieve this in distressed scenarios, the parties might want to consider incentivising management to give warranties and conduct a full disclosure process by offering them some benefits (e.g. sweet equity).
- In a synthetic W&I policy, a set of warranties is offered solely under the policy as if they had been given in the transaction documents. It can be used where neither seller, management, nor an administrator in case of an insolvency proceeding are willing to give any or only limited warranties. Insurers then substitute the recourse which is not available under the transaction documents. Synthetic cover is more expensive and more limited in scope than traditional cover due to obvious reasons such as limited disclosure available, different risk profile where the sellers have no skin in the game and the resulting higher risk of moral hazard.
- Contingent cover can be utilized when a specific risk (e.g. tax, environmental, litigation, contractual, etc.) has been identified and the risk assessment is backed by advisor opinions quantifying the risk and the probability of loss. Contingent policies offer a substantial benefit to the process as they can be used to resolve the high quantum, low risk items that often prove to be roadblocks in the parties’ negotiations.
3. Main factors affecting an insurer’s decision to offer insurance coverage for distressed transactions
In our survey we have asked insurers to highlight the main factors which will affect the decision to offer cover for a distressed deal.
- Insurers want to understand what the cause for the distress is and if the target was viable before the outbreak of Covid-19. In this regard, seeing the target’s financials pre-crisis will be of utmost importance for insurers. If, for example, the target’s distress originates from liquidity issues, external debt or a specific, one-off event but the underlying fundamentals remain positive, the transaction is likely insurable. Conversely, if the distress is deeply rooted in the overall performance of the business and has been apparent pre-Covid, insurers will be reluctant to provide cover due to the increased risk of moral hazard. In addition, certain deal dynamics will be scrutinized in distressed scenarios:(i) type, sector, and experience of the buyer, (ii) motivation for the acquisition, (iii) turnaround plans, and (iv) deal structure (shares/assets sale) (Fig. 1).
- Insurers place great importance on having (i) a clear understanding of who has most visibility on and knowledge of the business and (ii) access to those individuals. In a distressed transaction this might be the management team or the insolvency practitioner.
- Geography limits some insurers’ appetites. With respect to distressed transactions, some have adopted a more conservative approach for countries that have been impacted more significantly by the financial repercussions of the pandemic. However, several insurers indicate that they would have a broad geographic appetite.
- Other factors that influence insurers’ appetite for a specific distressed transaction are the scale of the business as well as the industry in which the target operates. Insurers are less likely to offer cover for large distressed deals (particularly if synthetic cover is sought) as these are often more complex and multi-jurisdictional. Similarly, the sector heavily influences insurers’ appetites. Transactions in travel and leisure, aviation, retail, and food and drink sectors as well as acquisitions of highly regulated targets will be scrutinised in detail and certain insurers are unable to offer (synthetic) cover for these. Further, the type of cover sought (traditional W&I or synthetic) will exclude certain insurers who are unable to offer synthetic warranty packages. Lastly, the opening of formal insolvency proceedings or a going concern nature of the business will be looked at differently by different insurers. Where insolvency proceedings have commenced in practice sellers rarely stand behind the warranties and provide disclosure. This will affect breadth of cover available.
- Regardless of the foregoing, insurers currently (and for the foreseeable future) expect that the impact of Covid-19 on the target and its operations will be adequately considered by the parties and mitigation measures presented to them.
4. Broad synthetic W&I insurance cover: the importance of disclosure
Where traditional W&I cover cannot be used due to a lack of warrantors, disclosure, visibility of the business, or a combination thereof, and synthetic cover must be put it place, the challenge lies in negotiating a warranty pack that meets the buyer’s requirements and addresses the major risk areas. Breadth of cover under a synthetic W&I policy is dictated solely by the quality and scope of the information provided by the sellers (assuming at least a non-reliance population of a virtual data room and participation in a Q&A process) and diligence performed by the buyer corresponding to the warranties provided in the policy, which all insurers require to overcome the lack of involvement of and/or no recourse to the sellers/management.
- Insurers expect the seller-side to collate as much information as possible in an orderly manner in a VDR. In practice, this is often achieved by providing incentives to a party with knowledge of the business (e.g. asset managers, management, etc.). The quality of the information provided and its significance for the warranty suite have a direct impact on the scope of the synthetic cover offered.
- If insurers are offered an opportunity to engage with the sell-side through the Q&A process, broader final cover is likely. The Q&A remains the only option for quasi-disclosure against the warranties. Additionally, where insurers are not conducting their own due diligence, they will require close interaction with the buyer and their advisors.
- Buyer’s diligence is an obvious source of comfort for insurers. Customary reviews across legal, financial, and tax should be conducted and should correspond to the synthetic warranty package. Financial diligence with a view on the valuation of the target is crucial to demonstrate the cause of distress and the underlying positive prognosis. Some insurers may mandate a specific scope of work. A limited number of insurers indicated to be able to carry out their own due diligence. From a buyer’s perspective this leaves little room for discussions about the offered cover position. In all cases, the warranties, scope of cover, and pricing will be dictated by this workstream.
5. Scope of synthetic coverage
As the purchase agreement in these instances does not contain any warranties or remedies, typically insurers provide their own set of warranties (which can be negotiated) in the policy. Others require the buyer to provide a set that is then negotiated with the insurer as the diligence process unfolds. The former gives more certainty both as to cover and speed of delivery at the outset, whereas the latter may give more flexibility if time permits and information flow is favourable. In each case, where the diligence is not carried out by the insurer, the insurer will seek to influence the diligence by providing due diligence request lists to ensure that the review matches the scope of the warranty suite. Further, the policy will contain a standard set of limitations to claims such as matters included in the accounts, buyer voluntary acts, change in law, etc. Lastly, the policy will contain disclosure provisions similar to those in a market standard purchase agreement, i.e. general disclosure of the data room, matters discoverable from public registers, corporate searches etc.
It must be noted that not all warranties are capable of synthetic cover. If the requirements illustrated under 3. above are met, the major risk areas of a target are generally insurable. However, certain types of warranties that are commonly used to ringfence operational risks of the target business, would not be coverable as there is no relevant seller knowledge and/or disclosure against them. This applies to (i) knowledge qualified warranties, (ii) warranties about actions of third parties, (iii) statements of opinion, or (iv) circumstantial/subjective language. On the other hand, warranties speaking to circumstances that can be factually ascertained based on information provided in a data room should be insurable synthetically. For example, with respect to material contracts/permits/licenses/litigation, a warranty that speaks to their validity can only cover those that are disclosed. We have asked insurers to categorise warranties that are normally included in auction draft SPAs into three groups (Fig. 2).
6. Contingent risk policies: how can they contribute to the successful completion of distressed transactions?
These policies are often used strategically to overcome barriers to deal completions posed by the existence of specific known exposures such as tax, environmental, litigation, employment, regulatory and contractual risks. In addition, with many companies struggling for cash, contingent insurance policies can be used outside of the M&A context. If a business has large contingent assets or liabilities on its balance sheet, insurance can be used to release those provisions and free up cash. The kinds of risks insured vary considerably from tax to IP, environmental to litigation, clearances and regulatory permissions related risks and so on. In particular specific tax insurance can serve as a valuable and highly flexible tool to de-risk historical, transaction-related or ongoing operational tax issues It covers any tax, interest and penalties arising in the event of a successful challenge by a tax authority, together with any costs incurred in defending the challenge and any gross-up risk.
In a distressed context, there are several heightened areas of tax risk, for example:
- release of debt/debt for equity swaps: often distressed assets have undergone a restructuring of their financing involving a waiver or forgiveness. Whilst most countries have debt forgiveness rules that can treat such restructurings as non-taxable, there is often uncertainty around the application of these rules which potentially creates risk for a buyer;
- management equity refresher: in a distressed scenario, the value break often occurs in the debt layers and, therefore, the shares held by the management team can be effectively worthless. Therefore, it is relatively common for the management equity plan to be refreshed to provide some value to the management team. Depending on how it is structured, the refresh can create tax issues (e.g. robustness of valuation) that a buyer may struggle to get comfortable with; and
- historical re-organisations: for more complex target groups, a pre-sale re-organisation may have occurred e.g. for the purposes of separating profitable from distressed operations, transferring certain assets into a newco for sale etc. Such re-organisations can be complex from a tax perspective and can create a risk that capital gains taxes, transfer taxes and/or corporate income taxes could arise.
To provide market participants with reliable guidance in relation to the general insurability of distressed deals we asked insurers to indicate (i) the sectors which they assume will produce the most distressed transactions over the coming months as a result of Covid-19 and we surveyed in comparison (ii) which targets generally fall outside of insurers’ underwriting appetite for distressed deals. The results show that insurers expectations at an early stage of national and global lockdowns have largely materialized. They also show that insurers are generally sector-agnostic in distressed transactions. However, there will be limits to insurability, in particular because of a target’s geography. Overall, the market seems equipped to address specific questions arising in the context of distressed M&A and to provide creative and innovative solutions to facilitate deal-making in uncertain times (Fig. 3).