Understanding Representations & Warranties Insurance

Understanding Representations & Warranties Insurance

Until recently, representations and warranties insurance (RWI) was rarely incorporated in M&A transactions. Perhaps it was misunderstood? Or did the lack of competition in the marketplace hinder the relevance and significance of it? Either way, now that the product has improved and the awareness of the benefits has grown, the use of representations and warranties more commonly known as 'reps and warranties' insurance has become an essential tool in bridging negotiation gaps and closing deals that might otherwise fail.

In a recent webinar, “Understanding Representations & Warranties Insurance,”  Senior M&A investor Javier Enrile, highlights how reps and warranties insurance can be an integral part of negotiating transactions, winning bids, and finding a means of closing deals in today’s challenging M&A environment.

Prior to the webinar, we were fortunate enough for the time to sit with Javier to get a sample of what webinar viewers can expect to learn from his presentation. Here's what we learned from our private interview... 

ShareVault: Let’s start by getting a basic understanding of what reps and warranties are.

Javier Enrile: In the context of an M&A transaction, a representation is a statement of fact regarding the past, present and future conditions of the firm. A warranty is a promise of indemnity if that statement turns out to be false. If a representation is not true, it is “inaccurate.” If a warranty is not true, it is “breached.”

Reps and warranties are an essential part of M&A transactions because they serve as protection for the buyer. After a transaction is completed, the buyer inherits all the potential deficiencies of the firm. If there is no protection in the contract against those potential deficiencies, then there is no recourse for the buyer.

SV: What is reps and warranties insurance and why do you think it’s becoming a more popular facet of M&A transactions?

JE: Traditionally, both parties in a transaction are protected by placing a portion of the purchase price in escrow. That money can be released to either party post-closing based on certain triggers that are defined in the contract. For example, if there were financial representations made by the seller that turn out to inaccurately represent a fair picture of the firm, a portion of the money held in escrow may be returned to the buyer. On the other hand, if certain performance milestones are met by the seller, such as defined in an earnout structure, then money held in escrow may be paid to the seller.

Reps and warranties insurance is a different way of handling the same risk. When reps and warranties insurance is utilized in a purchase agreement, it means that the reps and warranties defined in the contract are underwritten by an insurer. Post-closing, if there is a breach in the seller’s representations – instead of making a claim against the seller and that money coming out of escrow – the buyer makes a claim against the insurer.

Reps and warranties insurance has been around since 2012, but in recent years it’s gained popularity for several reasons. For one, more insurance carriers have penetrated the market, and it’s become much more affordable. Another reason is the benefits it affords for both the buyer and the seller.

SV: What are the benefits for the seller?

JE: Benefit number one for the seller is security over the proceeds. For example, let’s say the buyer and the seller have agreed on a purchase price of $100M. Traditionally, a portion of that money will be held in escrow. If, post-closing, there’s a breach of warranty, then money will come out of escrow and be paid to the buyer. So, instead of getting $100M the seller may only get $80M.

When there is reps and warranties insurance in place, the proceeds go to the seller in full. There is no escrow, and there’s no scenario where the seller has to pay the money back for breaches of warranty; the insurer covers those breaches. So, while the seller has to pay the premium, they have the benefit of knowing that they’re going to get the full $100M.

SV: How does the buyer benefit?

JE: The main benefit for the buyer is reducing counterparty risk. Usually, if there’s a breach of warranty, the buyer has to make a claim against the seller. That involves risk because the seller could declare bankruptcy and claim they have no money. With the insurance, you’re shifting that risk. The buyer doesn’t have to worry about the seller’s ability to pay because the claim goes against the insurance.

The second benefit for the buyer is that when insurance is in place, sellers – knowing they are protected – will generally agree to give more coverage and broaden the scope of the warranties. That’s naturally good for the buyer.

The third benefit is relational. Very often the management of the firm that the buyer is acquiring continues with the business. They are colleagues. In that situation, if there’s a breach of warranty, then the buyer’s recourse is to engage in litigation. Essentially, they’re suing the folks they’re working with. When insurance is in place that claim is made against the insurer, which makes things much easier.

The final benefit for the buyer is that the insurance will typically cover fraud. Without insurance, the buyer’s only recourse is with the law. Again, the buyer has to sue the seller. When insurance is in place, and there’s fraud, the claim is simply made against the insurance.

SV: What are some best practices for seeking out expertise when negotiating reps and warranties insurance?

JE: It’s important to have good advisors because this is a tri-party negotiation. On the one hand, you have the seller providing representations. On the other, you have the buyer negotiating those representations. The seller wants those representations to be as narrow as possible. The buyer wants them to be as broad as possible. Then the insurer has to ensure that they fully understand what they are underwriting—they have to understand the risk.

So the expertise is needed in two areas: due diligence and negotiations. The quality of the due diligence is important because the insurance company will underwrite the risk based on the due diligence of the buyer. They review the due diligence the buyer has completed and assess the likelihood that the representations and warranties may be breached. So, the quality of the due diligence is critical because if the due diligence is poor, it will limit the scope of the insurance.

Next, there will be negotiations. In a typical deal, there will be hundreds of reps and warranties that will need to be negotiated. There will be certain warranties and representations that the insurer will say they can’t, or won’t, insure. Sellers will be less inclined to provide a warranty if it is not protected. So, buyers need to be savvy negotiators and engage experts with the skillsets to understand that.

SV: What about pricing? What are the typical terms?

JE: One of the key features of the insurance is the limit. What is the maximum that the insurance will pay? Typically this is ten percent of the purchase price. So if the purchase price is $100M then the insurance might pay up to $10M. The premium is typically anywhere from 2 to 3 percent of that limit. So 2 percent of 10 million is $200,000.

SV: What is the length of the terms of the agreement?

JE: The insurance is tied to the terms of the reps and warranties in the contract. Typically, general reps and warranties expire after three years. So, the coverage will be tied to that timeframe.

If you're looking to take a dive into the topic of representations and warranties insurance and learn how to leverage them, click below to view the presentation in its entirety.