Safeguarding the M&A market

Safeguarding the M&A market | Insurance Business America

Safeguarding the M&A market

As the global economy starts to recover from the crises triggered by the COVID-19 pandemic, merger and acquisition (M&A) deals appear to be on the upswing at the onset of 2021. These transactions carry a certain amount of risk, which businesses can protect against with insurance.

According to Dean Andrews (pictured), head of tax liability insurance at BMS, there are two sophisticated insurance solutions commonly used to protect businesses engaging in M&A activity. These are warranties and indemnities (W&I) insurance and tax liability insurance (TLI).

“W&I policies are used as a strategic risk transfer tool to give protection to either the buyer or seller of a business against financial losses suffered as a result of an unexpected breach of warranty or claim under a tax indemnity in a share purchase agreement (SPA),” Andrews said. “Bespoke protection is provided by the insurance market to the insured for unknown issues such as financial statement errors or undisclosed regulatory matters.”

Meanwhile, TLI was created over 20 years ago in London, UK, to meet increasing market demand for an effective transfer of tax risk. This risk may arise from a successful challenge by a tax authority to the expected tax treatment of a current, proposed or historic fact pattern, Andrews said. By transferring the risk to an insurer, the corporate taxpayer can remove the potential financial exposure from its balance sheet.

Andrews explained that an SPA usually provides a comprehensive list of facts (also known as warranties) from the seller regarding the target business. If, after the purchase has been completed, the buyer discovers that a warranty is not true, the buyer can make a claim from its W&I policy for the financial loss, rather than from the seller. However, in some cases, a claim can be brought against both.

“The use of W&I insurance dramatically increased after the last financial crisis in 2011/12,” Andrews said. “In some cases, buyers considered that financially distressed sellers lacked sufficient covenant strength to stand behind the warranties for the full seven years that some of them are given. By taking out a W&I policy, in the event of a breach of warranty, the buyer could rely on the insurance policy and in turn the balance sheet of the relevant insurance institution and / or Lloyd’s capacity.”

But there has been a shift in the motivation for taking out W&I insurance on a transaction over the past 10 years, according to Andrews.

“The strength of the bull run across the global M&A market over the last decade has fundamentally altered the allocation of risk upon the sale of a business,” he said. “Sellers use buy-side W&I to transfer risk to buyers by reducing their financial limitation in the SPA (commonly as low as £1/US$1.37). This means that buyers typically only have recourse against a W&I policy for any losses above the excess, and no cover where the issue is excluded by the policy. This approach is now so entrenched in the M&A process that, in most competitive auctions, bidders have to utilize W&I if they are going to remain competitive.”

On the other hand, TLI has a much broader application, extending even beyond the M&A market.

“Although the majority of TLI policies placed are used to ring-fence tax risks uncovered during an acquirer’s diligence process when buying a business, they are being used more and more frequently by business to internally manage tax risks,” Andrews said. “Such tax risks can arise from a wide range of scenarios such as; refinancing, reorganization, value chain transformation, group simplification, on-shoring IP as well as on-going transfer pricing and substance risks.”

Without W&I insurance, Andrews said that a bidder will have to internally “hedge” the risk of an issue in a business that comes up after they’ve acquired it in order to remain competitive.

“Alternatively, where a buyer makes a direct approach to buy a business, they are more likely to rely on the traditional protection dynamics,” he said. “Being the seller provides more substantial financial cover in the SPA (i.e. 20% of the enterprise value) and the buyer then brings a claim against the seller in the event of a breach, hoping the seller still exists and is in a financial position to pay out.”