The global Covid-19 pandemic has led to a significant decrease in overall economic activity across the globe and consequently also a sharp decrease in M&A activity – for the first half of 2020, different sources estimate a reduction of about 50% in year-on-year global M&A volumes. Around the globe, companies have refocused on bolstering their financial capacity, ensuring sufficient liquidity cushions and sharpening their operational profile. With severe recession concerns looming on the horizon, strategic reviews and corporate restructurings represent a commonly deployed tool in order to improve financial metrics and demonstrate a coherent corporate strategy by divesting non-core business units. Combined with a high level of “dry powder” in the private equity industry, an increase in carve-out transactions across various industries is widely expected in the post-Covid-19 era. This assumption is also backed by recently announced carve-out transactions as well as ongoing discussions around the M&A pipeline.
There are several ways M&A insurance can effectively mitigate a variety of risks regularly occurring on carve-out transactions, yet a number of important steps and requirements need to be considered early on in the process to implement an appropriate solution for both sellers and buyers.
This article summarises some of the key aspects to be considered from a W&I insurance perspective to make a carve-out transaction a success.
2. Due Diligence Requirements
As discussed in various other articles of this M&A Review edition, a comprehensive due diligence is of utmost importance to a smooth W&I insurance process. W&I insurers typically only cover risks that have been subject to adequate due diligence. This principle particularly applies to carve-out transactions.
Securing fulsome cover on carve-out transactions is much more straightforward if the carve-out has largely taken place prior to signing – this typically allows for a more detailed review with respect to the relevant assets, the implementation of various legal and tax related carve-out steps.
If, however, the carve-out is set to take place between signing and closing – as is regularly the case – buyers should expect gaps in insurance cover around the transfer of certain assets including intellectual property rights at signing, with those gaps being removed or substantially narrowed down at closing subject to a review of the carve-out implementation including asset transfers. Risks speaking to the implementation of the carve-out will only be coverable subject to the insurer’s review of the relevant due diligence report. For a comprehensive cover position of operational warranties per closing, an adequate bring-down mechanism is also likely to be requested by insurers in the SPA.
In addition, the geographical footprint of the carved-out entity should be carefully considered when mapping out the sell- and/or buy-side due diligence scope. In case of various activities across different jurisdictions with revenue generating units and employees on the ground, insurers would require at least a reasonable sample of the most important entities and risks to be included in the due diligence scope. Such scope should be matched with the warranty catalogue (e.g. for which entities, jurisdictions and/or risks the warranties are given). For certain risks and jurisdictions, insurers might require the involvement of local counsels or tax experts.
3. Coverage for Financial Statements
In case the target has historically not prepared stand-alone financial statements, in the course of the carve-out so called pro forma carve-out financials are typically being drawn up. A high degree of transparency around the underlying assumptions and accounting rules applicable will support a robust financial due diligence by the buy-side and consequently, a higher degree of comfort on the insurers’ end.
In case the pro forma accounts are subject to customary audit / review procedures, the degree of insurers comfort will be further increased. Nevertheless, unaudited accounts are typically well insurable provided that the wording of the relevant warranty reflects the underlying work around the accounts preparation as well (i.e. a “true and fair view” standard is only insurable for audited accounts – for unaudited accounts, insurers will consider covering a “do not materially misstate” standard subject to their review of the financial due diligence). Further, a mechanism providing for a subsequent “upgrade” of the cover once the envisaged audit procedure has been completed can also be included in the policy.
4. Tax Implications of the Carve-Out
Insurers will expect a so called “step plan” to be prepared, the relevant tax risks to be reviewed and a confirmation that the steps have been (or will be) implemented in accordance with the “step plan” ahead of providing cover for the underlying tax risks.
As a starting position, insurers will not cover identified tax risks. However, with the tax appetite of insurers growing, numerous identified tax issues can potentially qualify for an explicit cover confirmation or a separate contingent tax risk policy – depending on the risk profile and exposure.
Cover can be secured for these tax risks ahead of the restructuring actually taking place, so long as the process follows the steps detailed in the steps plan.
5. Parent Company Guarantees
When under the ownership of the parent company, the target company may benefit from a diverse set of so called parent company guarantees (PCGs), either required by governmental bodies or third party customers. Sellers typically wish to cancel such PCGs at closing, which can result in the buyer having to secure an alternative source of such guarantees which regularly poses a challenge implying additional funding requirements particularly for financial sponsors.
So-called “surety bonds” can provide an elegant solution to the PCG issue, with an insurer providing the requisite guarantee, but the implementation of such a solution requires engagement by the buyer and seller with a surety broker well in advance of when the bond is required.
Other solutions to the PCG problem are increasingly offered in the insurance market. Some insurers will consider covering legitimate calls of the PCG subject to a breach of contract being documented and the target being unable to pay (default risk). A detailed understanding of the PCGs in place including expiry dates and currently outstanding amounts is key to obtain a good understanding on the potential “insurability” of these elements.
6. Specific Exclusions to be expected in Carve-Out Deals
(i) Secondary liabilities
Secondary liabilities, in particular arising from tax and environmental matters, are of heightened concern to insurers in carve-out scenarios. While most insurers include a secondary tax liabilities exclusion in their policies, it is crucial that tax contributions made by the target to the primary tax payer of the group are not considered secondary tax liabilities.
It is recommended that the due diligence discusses in detail the risk of liabilities of the parent transferring to the target post closing.
It may also be possible to secure cover for secondary tax liabilities subject to the relative complexity of the seller group and appropriate due diligence having been conducted on the seller group’s tax affairs – again, this should be discussed at the outset of the W&I process on carve-out transactions.
(ii) Excluded assets
Buyers should seek to ensure that the W&I policy does not exclude losses arising from assets / liabilities that are retained by the Seller. The position of insurers varies on this point, so it should be discussed ahead of insurer selection.
Further, to maximize the recovery available under the W&I policy, buyers should consider including specific language in the SPA. As there may be a breach of warranty or a claim under the tax indemnity which also gives rise to a claim against the seller for loss arising out of assets / liabilities retained by the seller, it should be clarified in the policy that the duty to mitigate damages does not imply an obligation to pursue potential claims against the seller.
Insurers will typically expect the buyer’s diligence to review any material exposure to losses arising from the retained assets / liabilities flowing into the target group.
(iii) “Wrong pockets” clause
A “wrong pockets” clause is a post-closing undertaking of the seller in the SPA to transfer any assets to the target that should have, but have in fact not been, transferred to the target.
The inclusion of a sensibly drafted “wrong pockets” clause is a helpful addition to provide the insurer with comfort around warranties surrounding ownership / sufficiency of assets.
(iv) Transitional Service Agreements (TSAs)
Some insurers will exclude losses arising from disputes surrounding TSAs. The implications of this exclusion and whether or not the buyer can accept it should be discussed ahead of insurer selection.
7. Case Study – carve-out of a German subsidiary with an international set-up
- A large international chemicals and gas company was selling a subsidiary active globally in industrial services to a private equity fund.
- Transaction structured as a carve-out with a combination of share and asset deals. Core part of the carve-out implemented between signing and closing.
- Process: W&I work stream initiated by the sellside in the interest of process efficiency. Final policy to be taken out by the acquirer.
W&I considerations (Sell-side):
- The target is active with numerous revenue generating entities across the globe. Therefore, it was key to advise on a reasonable sell-side due diligence scope (esp. legal, tax and financial) and align on buy-side top-up due diligence requirements to ensure a wide cover position under the W&I policy.
- The specifics and envisaged carve-out steps were outlined in detail by the sell-side and discussed early on with potential insurers.
- Potential cover positions and exclusions were made available to both the sell- and the buy-side which eased the SPA discussions around non-insurable matters as well as potential risks which could be incorporated into the W&I policy.
- Audited financial statements were prepared for the carved-out subsidiary.
- Disclosure requirements as of Closing (after the carve-out) for the sell-side were discussed to ensure a smooth closing procedure and corresponding cover of certain carve-out matters.
W&I consideration (Buy-side):
- Based on the above, it was possible to advise the buy-side on the required due diligence scopes and key topics to be covered in connection with the requested warranty cover.
- Tailored and detailed overview of cover positions (geographic and topic-wise) were agreed with insurers upfront subject to a corresponding buy-side due diligence supported by a reasonable sell-side disclosure process.
- The considerations described above resulted in a smooth underwriting process with a wide and adequate cover position for the buyer under the W&I policy.
- Due to the competitive tension among insurers, a broad cover position incl. blind spot cover (i.e. cover of risk areas without a detailed due diligence) for operational, fundamental and also tax risks was achieved.
Provided that a customary buy-side due diligence is undertaken and the implementation of the carve-out is adequately reviewed, W&I policies can provide comprehensive cover on carve-out transactions. It is crucial, however, that experienced M&A advisors / W&I insurance brokers are involved from the outset to ensure that the process and the transaction documents are tailored to some specific requirements of W&I insurers.