What it is and why you need it!
In mergers and acquisitions (M&A), navigating the intricate landscape of risk management and financial protection is paramount for buyers and sellers. One significant instrument that has gained prominence in recent years is representations and warranty insurance (RWI). As the name suggests, RWI provides insurance coverage for representations and warranties made by sellers in purchase agreements, offering protection for both parties involved in the transaction. For an explanation of Representations and Warranties, read our article linked here: “Understanding Reps & Warranties
in M&A Transactions.”
RWI has become increasingly common in transactions with enterprise values typically starting from $25 million and upwards. While not obligatory, its widespread adoption is rooted in its ability to streamline the negotiating process and mitigate risks associated with breaches of representations and warranties.
At its core, RWI provides insurance to the buyer, safeguarding them against financial losses resulting from breaches in the seller’s representations and warranties detailed in the purchase agreement. In the event of such breaches, the insurance company steps in to cover the majority of the damages on behalf of the seller. This arrangement alleviates some negotiation pressures surrounding representations and warranties, reassuring sellers that they won’t be directly liable for potential damages.
While attractive for the seller, this is also attractive for the buyer. In the event of a claim related to a breach of a rep and warranty, the buyer does not have to deal with the potential emotional reaction or relationship impact of going to collect from the seller. The need to preserve this relationship is heightened when the seller remains a shareholder or operator post-transaction. Instead, the buyer can be more clinical about their decision as they are really working through the claim with the insurance company, which is in the business of dealing with these types of claims.
Because of that, including RWI in M&A transactions introduces a higher level of scrutiny during the due diligence phase. With a third-party insurer involved, the due diligence process becomes more rigorous, ensuring all parties, including the insurance company, comprehensively understand the risks involved.
Making a claim under RWI mirrors the purchase agreement’s indemnification procedures. If a breach is discovered post-transaction, the buyer notifies both the seller and the insurance carrier, initiating the claims process. Typically, a retention amount—think of this as a deductible—typically 1% of the insurance coverage is set, with the seller and buyer sharing responsibility for part of the damages associated with a breach.
Despite the coverage provided by RWI, specific exclusions exist, both standard and deal-specific.
Standard exclusions encompass breaches resulting from covenant violations, purchase price adjustments, fraud, and other specified scenarios. Deal-specific carve-outs may include known issues or liabilities exceeding a certain materiality threshold, limiting coverage for such risks.
The RWI landscape has seen notable shifts, particularly in response to the COVID-19 pandemic. The increased number of deals post-pandemic has led to a more competitive market, resulting in softer terms for RWI policies. Lower premiums, reduced retention amounts, and more flexible negotiations around exclusions have made RWI more accessible, even for transactions with lower enterprise values.
While including RWI introduces additional costs and complexities, the long-term benefits often outweigh the initial investment. By providing financial protection for both buyers and sellers, RWI enhances deal certainty and facilitates smoother transactions. Moreover, RWI enables sellers to receive more upfront proceeds, replacing traditional escrow arrangements and freeing capital for
other purposes.
RWI has emerged as a valuable tool in the M&A landscape, balancing risk mitigation and transaction efficiency. As advisors guide clients through the intricacies of M&A transactions, incorporating RWI warrants careful consideration. It promises enhanced protection and peace of mind for all parties involved.