Insuring deals: another layer of fees or vital protection?

The pre-crisis M&A market largely ignored transactional liability insurance and instead tackled buyer or seller protection through representations and warranties in hefty legal documents and indemnity clauses. However, in the past two years, M&A practitioners and particularly private equity players have increasingly turned to insurance providers as a means of obtaining the protection so desperately needed in a continued uncertain environment.

London, which has swiftly become recognised as the ‘intellectual hub' of the M&A insurance market, has grown to such a size that it can now provide up to £300m of cover per deal. This means that it can offer protection for deals worth well over £1bn. According to some estimates the transactional liabilities insurance market doubled between 2011 and 2012. This staggering growth is of course a symptom of deal-doers' heightened perception of risk following the financial crises, which has led to ever-rising levels of uncertainty around transaction processes.

For private equity, growth in transaction liability insurance has been explosive because, crucially, it provides better guarantees for funds in need of returning cash to investors. Traditional indemnity clauses written into the share purchase agreement protect sellers against unexpected costs following the transaction, in which they can claim the added expense from the seller as it is seen to inflate the initial purchase price.

However, as swathes of funds near the end of their lives and come under increasing pressure to return cash to LPs, private equity houses exiting portfolio companies are less willing to provide the sort of indemnity cover buyers increasingly desire. "Insurance bridges that gap left by buyers needing protection and sellers unable or unwilling to provide it," explains Richard French, transactional liability broker at Howden. Most appealing to funds divesting assets is that a guaranteed return to investors increases their overall internal rate of return.

Power tools
Interestingly, a new trend on the buy side is also behind the impressive growth in the transactional liability insurance market. As buyout houses become more selective when it comes to new opportunities, therefore making processes for quality assets more and more competitive, buyers are taking out policies on potential deals to make themselves more attractive bidders. "Insurance is a very powerful tool when working with a fund in divestment mode," believes French. "We recently worked with a UK private equity firm bidding on an asset from an international buyout fund. The bidders recognised the fund was in a dilemma: that it needed to sell the asset but also reduce liability risk as much as possible. Our client used an insurance policy to reduce the seller's risk to a minimum and later emerged as the successful bidder."

Providing certainty in an uncertain market is all well and good but unsurprisingly it comes at a price, and with an already oversized advisory market around transaction processes, many private equity firms might well dismiss transactional liability insurance as an added drain on swelling due diligence expenses. However, as demand for this product grows, insurance providers have developed alongside those requirements.

Fees are more competitive in today's market, causing a significant drop in the cost of policies. "The lower costs have made insurance more accessible for smaller players and smaller deals; we're now seeing more lower mid-market firms and even venture capital firms when they exit assets," observes French. Fees are now typically between 1–1.5% of the limit purchased (rather than the transaction size), so for a deal worth £100m but with cover for only £10m of that, the cost of insurance would be around £100,000 to £150,000.

Furthermore, as the market becomes more competitive, insurance providers have been busily bolstering teams with experienced M&A professionals with a deep understanding of transacting. "Many brokers and underwriters are former corporate lawyers themselves and they are aware of time constraints – that getting things done quickly is fundamental for the success of this product," says French.

Indeed, as deal processes in recent years continue to stretch out for several months, insurance providers are keen to not cause further delays. According to French, indications can be provided within 24 hours and it typically takes five working days for the insurer to complete the underwriting, which can take place alongside the deal.

Where next?
Australia holds the title of most developed market for transactional liability insurance, with the majority of private equity deals taking up insurance and enabling buyers and seller to operate in a relatively risk-free environment. In the US, despite the product being available for several decades, awareness has been low. "That's changing now. There's a lot of noise around insuring deals," asserts French.

A key indicator of how much further growth there is to be had in this market is the increasing interest from corporate finance houses and investment banks. "Advisers recognise that insurance can play a very important role and are recommending that sellers consider purchasing an insurance policy to give to the buyer, as it gives the buyer the protection they need and helps avoid price erosion," explains French.

Transactional liability insurance is undoubtedly an extra layer of fees, but the added cost provides the holy grail of certainty in an uncertain market. And as deal processes continue to take longer and longer, the heightened use of insurance policies could see an end to lengthy processes. It may be wishful thinking but a further knock-on effect could be more confident deal-doers and therefore much healthier M&A volumes.

Is insurance on PE deals really necessary or just another layer of costs?

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