Private equity acquisition activity in the United States has rebounded nicely from the lows of 2009. The number of transactions and capital invested from 2009 to 2011 has increased 25 percent and 137 percent, respectively—1,393 to 1,738 transactions and $62 billion to $147 billion of capital invested.
Contributing factors include:
1. Improving economic conditions.
2. Cooperative debt markets.
3. An estimated $425 billion in capital ready to be invested.
4. 4,200 companies held by private equity investors longer than three years- many are ready to exit private equity portfolios.
All of the above, combined with strategic acquirers looking for attractive acquisitions to enhance their growth, are fueling an increase in purchase price multiples. Even though multiples differ broadly across company sizes and industries, they have climbed back to near the all-time highs set in 2007.
In an increasingly competitive deal environment, many purchasers look to differentiate their bids. A healthy purchase price is certainly one way to get attention, but there are other strategies that can be equally effective. For example: replacing the risk allocation mechanisms (indemnification and survival period) in a purchase agreement with insurance capital, i.e., a buy-side representations and warranties insurance (R&W) policy.
In most private company transactions, the seller will provide an indemnification for breaches of representations and warranties outlined in the purchase agreement for a specified period of time – the survival period. Representations and warranties are statements of fact made by the seller regarding the business being sold, e.g., the company’s financial statements are in conformance with GAAP, the seller has the authority to sell the business, the seller has title to the assets, all taxes have been filed and paid in a timely manner, etc. If the purchaser suffers a financial loss because a representation turns out to be untrue, the seller has a contractual obligation to indemnify the purchaser, typically excess of a deductible and subject to a monetary cap.
Negotiating limits on indemnification caps and survival periods can create considerable tension in a transaction. Ideally, the seller wants none of the representations and warranties to survive the transaction and thus no indemnification obligation, whereas the purchaser wants the representations and warranties to survive forever and an indemnification cap equal to the purchase price.
By structuring a representations and warranties policy into a bid, a buyer can propose reduced seller indemnification limits and reduced survival periods, enabling the seller to exit the deal with the majority of its sale proceeds locked in. Insurers will not write a policy with no deductible, so a small escrow or holdback equal to the R&W policy deductible (ranging from 1 to 3 percent of deal value) will be required.
The R&W policy provides value to both parties in a transaction. The seller not only locks in the proceeds from the transaction, they also don’t have to deal with claim negotiations—the purchaser goes directly to the insurer with his claim. The policy provides the following value to the purchaser:
- Assurance that the value of the acquired business will not be reduced by unexpected liabilities.
- Protection against fraud—The policy does not exclude seller fraud.
- Reduced counterparty risk—The seller’s credit risk is being replaced by a highly rated insurer.
- Supplementary due diligence—The insurer’s underwriting process provides an additional level of due diligence by experienced professionals.
R&W policies are very flexible contracts. They can be written from either the buy or sell side of a transaction, policy terms can extend to six years, and they can be looked to act as either primary or excess protection.