The growing opportunity for M&A insurance brokers
Many executives are unfamiliar with this safety net for both buyers and sellers.
Mergers and acquisitions (M&A) hit record numbers in 2021. Economies rebounding from the economic impact of COVID-19 proved to be the perfect launchpad for a slew of deals with momentum set to continue in the North American market through 2022.
Research from PitchBook Data found that North American M&A activity accounted for 18,539 deals, with an aggregate value of $2.8 trillion. This buoyant market presents an attractive opportunity for insurance brokers providing specialist M&A insurance.
Parties on both sides tend to want a swift and certain resolution to a transaction so they can both move forward unhindered by the risk of future liabilities and clawbacks. M&A insurance creates this safety net for both the buyer and the seller, although it is an option with which many executives at small and medium enterprises are not familiar.
There is growing opportunity for brokers to recommend M&A insurance as an alternative to sellers having to provide an escrow to buyers.
What you should know
M&A insurance indemnifies the seller for any loss payable to a buyer arising from a breach of representation and allows the seller to avoid having to tie up a portion of the sale proceeds for up to two years, which is expensive both in fees and opportunity cost. Similar to an escrow, the buyer still has comfort that there is security standing behind the risk of a breach of representations.
Buyers will often advocate for the seller to take out the insurance as a way to differentiate their investment. This is especially important in an increasingly competitive market. And since the insurance indemnifies the seller, the seller will still give representations to the buyer.
For small and midsize enterprise (SME) deals, this is an attractive dynamic due to the limited diligence common for SME acquisitions. Comfort can be taken from the fact the seller is giving representations (even if being backstopped by insurance) due to the fact the seller is best placed to undertake a thorough disclosure process. After all, the seller should know the business better than anyone.
Consider this…
As awareness and understanding of M&A insurance grows, the market looks set to build on the accelerated growth it has enjoyed in recent years. The example detailed below explains how the protection provided by an escrow agreement might compare to M&A insurance in relation to a specific deal.
In this instance, the deal concerns a manufacturing business that’s being sold to a cash buyer for $5 million. The purchase and sale agreement requires the seller to indemnify the buyer for representations and warranties up to the full value of the business.
To meet the conditions of the agreement, 10% of the purchase price is placed in escrow for a period of two years. The seller also agrees to indemnify the buyer up to 100% of the purchase price in regard to losses arising from breached representations and warranties.
What does this mean in practice?
In the event that the buyer asserts a breach of a representation within the applicable period of the escrow, the seller will incur costs to defend or settle the claim, which could exceed the amount held in escrow; in this case, up to the $5 million indemnity limit.
In the event there are no alleged breaches, the $500,000 escrow is released after two years. The money held in escrow cannot be used by the seller for any other purposes, so the seller suffers an opportunity cost for having their sale proceeds tied up and at risk for claim. Assuming a 5% return over two years, the seller suffers an opportunity cost of $50,000 over the period.
Consider, then, how M&A insurance would operate as an alternative to the escrow.
If the seller was to take out a policy with a $5 million liability limit, premium would be around $75,000, covering the seller for contractual liabilities and any defense costs incurred in connection with a claim brought by the buyer for loss arising from a breach of the representations.
While there would be a premium to pay, this could be offset by returns made from the $500,000 that would otherwise have been held in escrow. Assuming the same 5% return over two years — or $50,000 — this would bring the net cost of the M&A insurance down to $25,000. When you take into account the administrative costs to establish and manage an escrow, the net cost of insurance is reduced further, to around $20,000.
If there were a buyer’s claim for a breach of representation, the insurance would pay, leaving the seller with a far cleaner exit than what would have been the case through an escrow and without impairing the terms of the transaction (including the purchase price) since the buyer still has a similar level of protection via insurance.
Each transaction is unique
The buyer and seller in any deal will have different needs and priorities. Some will value certainty around their potential liabilities once a sale has completed. It may be that sellers have ready-made plans for investment and so want to access sale proceeds immediately. In other circumstances, key personnel including the previous owner, may continue to work for the business following its sale. In such a scenario, without insurance, a claim by the buyer for a breach of representation to be indemnified and paid for by the seller (now working for the buyer in the acquired business) would be detrimental to their ongoing commercial relationship and that of the business.
M&A insurance provides an effective solution for these scenarios, and brokers can help their clients by making them aware of its benefits. This way, client can choose the most appropriate solution rather than simply defaulting to an escrow as the perceived usual approach.
Joe Perrett (jperrett@cfcunderwriting.com) is Transaction Liability Private Enterprise Product Manager at CFC Underwriting.
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