The Indian mergers and acquisitions (M&A) market, which had seen one of the biggest booms in the last decade, is now witnessing a change in investor sentiment. Apart from a handful of major investments from global investors, the M&A market has seen very few large deals in 2020 thus far.
However, far from doom and gloom, the scenario could look a lot different once the Indian economy begins to reopen. Dealmaking could rebound as many cash-strapped businesses are likely to look for fresh capital or, if that isn’t available, may be acquired by investors seeking value.
Several sectors are likely to start seeing consolidation amongst existing players, and companies ready to invest are likely to acquire new-age technology companies.
While investors look for opportunities in the Indian M&A market, there are risks associated with such investments. Investors and dealmakers would want to ensure they have appropriate representations and warranties in the share purchase agreement to protect their investment from undisclosed issues, so that they have some recourse if it turns out the condition of the company is not as represented.
Investors would also want to see whether sellers making the representations and warranties have the financial strength to stand behind these and pay for loss in the event of a breach.
Economic downturns such as the present one impact the financial strength of sellers and their ability to provide meaningful indemnity to an investor in the event of a breach. It is in such situations that Representations and Warranties (R&W) Insurance can facilitate M&A deals, in addition to acting as insurance.
What is R&W Insurance?
In every M&A, the representations and warranties given in the share purchase agreement play an important role. The representations and warranties state the factual position of the target company at the time of the acquisition.
If it is discovered that such representations and warranties are not accurate or have been breached, this could lead the buyer to suffer a loss. The investor or buyer may seek to recover such losses.
In the event the investor or buyer only has recourse against a seller not having financial strength to support the warranties, the likelihood of recovery would be minimal. R&W insurance enables transferring some of these transaction-related risks to an insurer.
R&W insurance can either be bought by the buyer (a buy-side policy), or the seller (a sell-side policy).
In a buy-side policy, the buyer is the insured, and the policy will respond to the buyer’s losses arising from a breach of a representation or warranty.
In a sell-side policy, the seller is the insured and the policy is a third-party indemnity policy, defending and indemnifying the seller against claims made by the buyer for breach of a representation or warranty.
The key difference between the two policies is that a buy-side policy also allows the buyer to recover from the insurer in the event of fraud by the seller. This cover is not available under a sell-side policy as a policy bought by a seller cannot cover the seller’s own fraud.
A majority of policies placed for R&W insurance are buy-side policies as the buyer can in many situations avoid bringing claims against a seller and can claim under the policy directly. These policies also avoid the bringing of certain claims against sellers who are still involved in the target business (and so preserve relationships).
They also avoid what has the potential to be a difficult claim against a third party and substitute that with being able to bring a claim against an insurance policy with a professional insurance company counterparty which is experienced in dealing with such claims.
How it benefits buyers and sellers
Whether the dealmakers in an M&A transaction opt for a buy-side or a sell-side policy, there are benefits of R&W insurance for both parties. For a buyer the benefits include:
Improves counterparty risk: The buyer is able to address a number of concerns they may have with the seller’s financial ability to pay for loss arising out of a breach by replacing recovery against the seller with recovery against an insurer with a strong balance sheet and financial rating.
Provides comfort for debt finance providers: Having a policy in place provides the buyer’s debt financers with comfort, as the buyer has recourse to rely upon in the event of a breach of warranty. This ensures, in many cases, that the debt obligation will not be left in a questionable position.
Bid differentiator in an auction process: When there are several buyers lining up for an asset, the buyer who tables a buy-side insurance policy as a part of the bid can successfully differentiate themselves from others, as the seller could stand to gain from not keeping an escrow account or setting aside a liability fund for the coming years.
Extend duration of warranty cover: Some warranties by the seller may be capped for a short duration, either because the seller is unwilling to take a longer duration liability or in some cases where the seller may be a fund which is winding up and wants to clear its liability before the winding up process. In this case, a buy-side policy can provide extended duration of warranties coverage, which works in the buyer’s favour.
Expedites the sale process: The use of R&W insurance can help to move past certain key negotiation points which often hold up transaction processes, such as requirement for escrow, scope of warranties, limitation periods and caps on liability.
Protect a continuing relationship: R&W insurance can help to avoid pursuing a seller who has remained with the business as part of the management as the buyer, in many cases, will be able to make a claim under the policy instead of pursuing the seller with whom they have a continuing relationship.
The benefits for the seller include:
Getting a ‘Clean Exit’: Having an R&W insurance policy in place facilitates sellers looking to have lower contingent liability going forward, as the policy stands in the place of the seller and their obligations to pay damages or loss for a breach of representation or warranty.
Reduces or eliminates the need for an escrow: The R&W Insurance policy can act as a replacement for an escrow, hence providing the seller the benefit of utilizing the available funds, which would otherwise be tied up in the escrow. This can be particularly beneficial to private equity sellers who are looking to return money to their investors in a timely manner and wind down their funds.
According to most recent data with AIG, the joint venture partner in Tata AIG General Insurance Co., one in five policies has a claim notification. This shows a maturing M&A market which is more adept at identifying breaches of warranties and making notifications.
The data also indicate that the largest deals ($500 million enterprise value and greater) have the highest frequency of claims notifications.
Compounding the trend of increasing frequency of claims notifications is the increasing severity of claims. In 2017, 8% of the material claims paid were greater than $10 million. In 2019, this number was 19% of material claims.
This shows that there is not only an increasing number of larger claims, but that they are also increasing in value.
In an uncertain economic environment, with increasing claims notifications as well as increasing severity, it has never been more important for dealmakers to protect their investment and their interests from losses arising from a breach of warranty in a transaction. R&W insurance can be a very useful tool in risk management.
Rohan Negandhi is senior manager of financial lines at Tata AIG General Insurance Co. Ltd. Alexander Harmer is M&A manager for emerging market, AIG UK. Views are personal.