DealMakers - Q1 2022 (released May 2022)
W&I insurance – A key consideration for M&A transactions (Part 1)
by Andrew Giliam and Anita Moolman
In recent years, warranty and indemnity (W&I) insurance has become an increasingly familiar product in the South African M&A market. There are a number of reasons for this. Not only have transacting parties gained a better understanding and appreciation of the process and benefits of an insured deal, but W&I insurance policies have themselves evolved to meet the needs of parties in the context of their transactions.
At its heart, W&I insurance exists to support a clean exit for a seller and to ease a buyer's concern that a seller may not be able to make good on a warranty or indemnity claim once a transaction has closed. M&A activity is expected to increase in the short- to medium-term as the market reacts to the effects of the COVID-19 pandemic. This is largely as a result of distressed disposals and private equity fund activity. In this context, W&I insurance could be a useful tool for transacting parties to mitigate certain risks identified in relation to a transactional process, or to offer particular benefits that may be advantageous to parties in a given transaction.
As a product, W&I insurance is constantly evolving. As such, while we have observed certain trends in the W&I insurance market as it has grown in popularity and prominence, we expect that insurers are likely to become more flexible in their approach to coverage in order to provide competitive products. Nevertheless, there are a number of considerations that transacting parties should bear in mind when obtaining W&I insurance in the present market, both in terms of the cover that can be obtained from an insurer, and in relation to the process of concluding a policy and how it dovetails with the negotiation of the sale agreement.
This article, which will be published in three parts, provides a basic high level background to W&I insurance and highlights some key considerations that, in our experience, parties should bear in mind when it comes to negotiating and concluding insured deals. There are a number of subjects around W&I insurance that warrant their own in-depth discussion and analysis that are not the focus of this article. Of course, as W&I insurance products develop, and the market progresses and becomes more competitive, there may be new trends that emerge that will need to be considered by transacting parties when considering whether to take out insurance. It is always advisable for parties to discuss the potential of procuring W&I insurance with their advisors as early on in the life of a deal as possible, to understand the market position at the time and what can (or cannot) be covered by insurance.
Benefits of W&I insurance
Warranties and indemnities are often one of the areas of divergence between parties to a sale agreement and, more often than not, require extensive negotiation. W&I insurance can be a key tool in reducing the execution risk of a transaction, as it provides comfort to the parties, after having negotiated the warranties and indemnities, that warranty or indemnity claims are to be brought against a third party insurer, rather than against the parties themselves.
W&I insurance is not intended to replace the negotiation of a sale agreement. On the contrary, an insurer needs to be satisfied that warranties and indemnities have been negotiated by the parties, tested for accuracy and are relevant to the underlying target. However, transactions covered by W&I insurance generally benefit both parties by reducing the amount of time that is spent negotiating warranties which, in turn, frees up the time of management and/or the principals involved on the seller's side to continue to manage the target's business without being consumed entirely with the sale process.
Either the buyer or the seller can take out W&I insurance, resulting in either a buy-side policy or a sell-side policy, respectively. Under a buy-side policy, the buyer is the insured party and can claim from the insurer for a valid warranty or indemnity claim under the sale agreement without having to first claim directly against the seller. Under a sell-side policy, the seller is the insured party and can claim from the insurer to recover its losses arising from a successful warranty or indemnity claim instituted by the buyer. Generally speaking, buy-side policies offer greater protection to a seller, given that a buyer's recourse for valid warranty or indemnity claims lie against the insurer and not against the seller. In our experience, buy-side policies are more common than sell-side policies, although the type of policy procured may depend on the needs of the transacting parties and the benefits that they seek to obtain.
The benefits of W&I insurance include:
promoting seller certainty that a buyer will have no recourse to the seller after closing and, therefore, ensures a clean exit. In the context of private equity funds, a disposal is often done in connection with a winding down at the end of the fund's life or a requirement to return capital to investors. If the fund remains liable for potential warranty or indemnity claims for the duration of a warranty period, it may not be possible to wind the fund down or return an investor's capital. W&I insurance assists in freeing the fund from such contingent liabilities, depending, of course, on the extent of the cover obtained and the allocation of risk between the parties relating to claims that fall outside of the insurance cover provided;
allowing a seller to distribute the sale proceeds to shareholders or investors instead of having to retain funds or be paid the sale consideration in instalments to cover potential future warranty and indemnity claims;
significantly mitigating the risk of a seller being unable to settle a warranty or indemnity claim, should one arise. This is particularly relevant in the context of a financially distressed seller who has disposed of its investment for liquidity reasons and needs to use the sale proceeds immediately after the transaction closes;
protecting the ongoing relationship between a buyer and a seller where the seller remains invested in or employed by the target after the deal has closed. In these circumstances, a buyer may not wish to sour its relationship with the seller by instituting a warranty or indemnity claim and can, instead, recover from the insurer;
making a target more attractive for buyers and reducing execution risk, especially where a seller is disposing of its investment due to financial constraints; and
potentially driving down the purchase price for a transaction, as the seller may be willing to accept lower proceeds that are immediately available, rather than having to retain a portion of the purchase price in escrow, or having a portion of the purchase price held back for the duration of a warranty period.
There are also disadvantages to W&I insurance, including the cost of cover; that is, the premiums payable, and the fact that a policy will not provide complete cover for all warranty and indemnity claims. For example, insurers generally exclude cover for breaches of anti-bribery, corruption or sanctions warranties, or will have specific requirements of the transacting parties from a due diligence or disclosure perspective, if cover for these warranties is to be provided. Exclusions from the cover are discussed in more detail in the next instalment.
Giliam and Moolman are Directors in Corporate & Commercial | Cliffe Dekker Hofmeyr.