Transactional risks - Solutions: Coming of age

The effect of the credit crunch on merger and acquisition activity across the global economy has been well reported, with both deal frequency and size falling significantly. But 2010 appears to have been a turning point as companies with reinvigorated balance sheets look to diversify and make acquisitions.

The picture is not uniform but, according to Merger Market data, global M&A activity totalled $881bn (£565bn) in the first half of the year — up 7.8% from the same period in 2009. European M&A in the second quarter of the year was up 53.8% by value, with UK deals accounting for a significant percentage of that. And private company deals — those that most frequently employ M&A insurance — have increased substantially in 2010 versus 2009, in Europe, Asia and North America.

There is, however, something of a sea change in the way that buyers and sellers are looking to manage the risks involved in these transactions. In part, this is driven by increased risk aversion following the downturn — for example, buyers often seek more protection on M&A transactions than is being provided by the sellers, perhaps due to concerns about the strength of a seller's financial covenants. Equally, banks providing acquisition financing may be concerned about managing their exposure.

Other reasons include private equity sellers looking to secure a clean exit from a deal — private equity deals are up 40% on the same period last year — or management sellers that are giving warranties but looking to protect against a potential liability arising out of an unforeseen breach. Whatever the reasons, buyers and sellers are increasingly turning to the insurance markets for solutions to these issues.

The result is that the M&A insurance underwriters are not only seeing more enquiries, particularly for warranty & indemnity insurance, but a greater number of enquiries are converting to policies issued. There is a real sense of this market having come of age; a market no longer restricted to the specialist brokers but an area about which any broker advising clients on their overall risk management programme should be aware.

Heightened sophistication
The market has grown in both sophistication and responsiveness in the last few years so that the products — and the processes involved — now more closely match the needs of the buyers and sellers. Over the past five years, very positive steps have been taken to develop and improve (from the insureds' perspective) policy wordings, so that terms and conditions are clearer and easier to understand.

There are also generally fewer standard exclusions — the common ones being forward-looking warranties; warranty breaches known at inception; fines and penalties; and fraud or fraudulent misrepresentation by the insured (although seller's fraud may be covered on a buyer's insurance policy). It is also possible to negotiate exclusions and conditions to ensure they match the underlying indemnification structure and contents of warranties in the sale and purchase agreement. Insurers are now much more commercial in their outlook and are looking to deliver a real solution, with the breadth of coverage and flexibility required in the deal environment.

Effort has also been invested to ensure the due diligence required to write the insurance policy can be accommodated within the timeframe of the overall M&A negotiations. In the past, response times were not sufficiently swift and, as a result, deals could be delayed. There is also increased underwriting appetite for a wider range of risks, with a much greater deal variety being presented including distressed sales and secondary private equity sales where there is limited recourse against the sellers.

A wider range of industry sectors are also being underwritten; more heavily regulated industries such as financial services and pharmaceuticals are showing more interest, as are mid-sized technology and media businesses plus firms within the energy sector. And the geographic base is expanding. Previously the product was well-established in the US, UK and Europe, as well as countries such as Australia and New Zealand. But now, in Greater China, Asia more broadly, and Eastern Europe, both demand and supply for transactional risk insurance solutions have increased — where once they were almost unknown.

Educating the client
Despite these market developments, many deals still close without any form of insurance advice — let alone a policy. This means buyers and sellers are leaving themselves open to risk or, at the very least, not looking at all the tools available to them. Some deals are planned but many others are more opportunistic, so it is important for brokers and risk mangers to understand how the product works before they need it.

Once a deal is on the cards, there is a greater need than ever to research, identify and assess the risk itself, as well as consider the financial strength of the counter-party from whom you might be seeking redress, or where there is an option to transfer significant portions of contingent liability on a transaction.

Typical coverages in transactional risk insurance
Warranty & indemnity (also known as representations & warranties) insurance. Financial losses that buyers might incur from inaccuracies in the representation or warranties made in the sale and purchase agreement or other deal documentation.

Tax insurance. Protection against adverse interpretation of specific tax issues. For example, if a deal is done based on the expectation that capital gains tax will be treated one way — but the tax authorities subsequently decide they are interpreting legislation or rules in another — then there may be an unexpected tax bill for either buyer or seller.

Contingent liability coverage. Issues that are known about and might frustrate the completion (or valuation) of the deal — for example, missing share certificates, product liability problems or employment claims.

John McNally and Tim Allen are transaction liability underwriters at Beazley