Private equity is all about cash in and cash out – the sooner monies drawn down from limited partners can be returned to them with the contracted hurdle, the sooner the fund gets into carry and the general partner starts to reap the rewards of making profitable investments.
It follows that anything that delays or reduces cash flows to limited partners is to be avoided if at all possible. This is particularly the case with respect to exit proceeds. In an ideal private equity world, portfolio companies would be sold voetstoots, with the possible exception of warranties of title. It is, after all, difficult to resist warranting that you actually own what you are purporting to sell…
Sadly, the ideal private equity world is not to be found in South Africa, or indeed in our experience in Africa more broadly. Irritatingly, purchasers will insist on obtaining a formal set of warranties that relate not only to title, but to the essence of the business they are buying. Warranties exist for two reasons – the first is to flush disclosure, helping buyers understand the business they are buying and the risks that it faces. The second reason is obviously to afford buyers a right of recourse if what they think they are buying turns out not to be the case. A wise old lawyer once said that if you buy a cake, the warranties are there to ensure you get the full cake, without a missing piece.
However, warranties are pointless if the cash that backed them had been distributed to the seller (or its limited partners). So, it became common practice for warranties to be backed by escrow, where a portion of the price would be held back to ensure it was available to meet warranty claims. Cash held back is cash that cannot be distributed to limited partners and which cannot turn off the hurdle. Bother, as Pooh Bear might have said.
Then into this realm of imperfection rode the white knight of warranty and indemnity insurance. All of a sudden, it was possible for a seller to provide warranties but pass the buck of paying out claims to an insurer, all for payment of a reasonable premium. The warranty cover was fairly generous, the underwriting process not overly onerous and the time periods covered by the policy longer than that often negotiated by a miserly seller. The private equity industry has embraced the concept enthusiastically – one scarcely sees an auction these days where the seller has not tested the insurance market and received indicative terms from an insurer, subject to underwriting.
But recently, things seem to have changed. It’s not exactly that there is trouble in paradise, but our recent experience is certainly indicative of a hardening market. Insurers world-wide are spoilt for choice, given the global M&A boom in 2021. Some have exhausted their capacity, whilst others are cherry-picking the best deals which most properly fit their risk profile. In this market, the appetite to insure African risk seems to have diminished, and premiums have risen.
A consequence is that in a number of the deals we are seeing, only one insurer is showing appetite to underwrite the risk. This means that the insurer is in a position to adopt a ‘take it or leave it approach’, which is sub-optimal for the buyer and the seller.
The underwriting process also seems tougher than it was. There is laser focus on the quality and extent of due diligence undertaken by the buyer (and by the seller in the case of a vendor due diligence). If a risk has not been investigated, it will not be covered. In an environment where deals are taking longer to consummate, there is also pressure to keep updating due diligence to ensure that it does not go stale.
So, does this mean that W&I insurance is no longer attractive? We don’t believe so, but contracting parties need to be aware of a couple of important consequences of a hardening market.
The first is that if you want cover, you may have to conduct much more extensive due diligence than in the past, to facilitate underwriting. There is clearly a cost of doing so, which needs to be borne in mind when looking at the increased premiums that are being demanded.
The second is that there is likely, in many deals, to be a bigger gap between what the policy covers and the warranties that the purchaser requires. Many purchasers will require their seller to fill that gap, and that may bring escrow discussions back into play.
So, in conclusion, the warranty discussion is likely to become much more difficult, and warranty arrangements much more complex as a result.
Bellew is Head of Private Equity at Bowmans.