In the following guest post, Jonathan Legge, Senior Vice President at RT ProExec, takes a look at the ways in which the Representations and Warranties (R&W) underwriting process should be adapted to meet the needs of “strategic” R&W insurance buyers. I would like to thank Jon for allowing me to publish his article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is Jon’s article.
The early adopters of Representations and Warranties insurance coverage (R&W) were predominately private equity firms and their advisors. While there were other reasons why private equity firms quickly adopted R&W insurance, one of the most compelling advantages for the early adopters was that R&W allowed the private equity firms to avoid or decrease escrows. The reduction or elimination of escrows improved a private equity fund’s internal rate of return (IRR) hence improving the firm’s results and making it easier to raise the next fund.
Because private equity funds comprised the vast majority of buyers in the early days of the R&W marketplace, the few underwriters in the space at that time created an underwriting process that dovetailed with the way that private equity firms conduct due diligence. Private equity firms outsource key elements of due diligence to experts (legal, tax, insurance, environmental, financial, etc.) who provide reports back to the private equity firms on the scope and results of their due diligence. R&W underwriters are able to review the reports and get a clear view of the risk fairly quickly, which is critical given the frequently compressed timelines on these deals.
Over the past several years, operating companies have begun to utilize the R&W product more frequently. To differentiate these buyers from the traditional private equity buyers, the R&W industry refers to these non-private equity buyers as “strategic” buyers (because they are buying companies for operationally strategic purposes rather than investment purposes.) As strategic buyers and sellers have been using R&W coverage more frequently, we think it makes sense to look at how strategic buyers approach the M&A process and whether the current underwriting process works as well for strategic buyers as it does for private equity firms.
In a September 2019 article in Financier Worldwide (here), Paul Tiger of Cleary Gottlieb Steen & Hamilton highlighted some of the differences in due diligence conducted by private equity firms versus strategic buyers.
The first difference is that strategic buyers generally conduct a decentralized due diligence process, where the internal subject matter experts (financial, tax, HR, environmental, etc.) all conduct their own diligence review of the target’s operations within their scope of expertise. In many situations, the internal experts have personal knowledge of the target (which may be a vendor or friendly competitor) and they typically have a deeply ingrained knowledge of the subject matter. The challenge arises when the internal experts in their field are not experts in the M&A process. The internal experts may view the due diligence as a “kitchen sink” exercise where they include even the most minute issues in their due diligence report. Including issues that are not material can lead to unnecessary exclusions in the R&W policy.
At the other end of the spectrum, the internal experts may produce few or no written reports/memos that articulate what information was reviewed and what the findings were. This is a problem for R&W underwriters, because they are conducting “confirmatory due diligence” which is to say that they want to understand what due diligence the buyer has conducted and what the buyer found. In the absence of reports, memos and/or checklists it is difficult for the underwriters to understand the scope of the diligence that was conducted. This often becomes a critical and process-delaying issue. In the typical R&W underwriting process, the underwriters don’t ask diligence questions until the underwriting due diligence call, which often usually occurs two days before the deal is set to sign or close. As a result, there can be a significant number of follow up last-minute questions and/or additional unwanted exclusions.
A derailment of the underwriting process based on a perceived lack of diligence by a strategic buyer is particularly unfortunate because the strategic buyer’s internal experts are usually more than qualified to perform the due diligence, and they have significant insight into the target’s business. The crux of the issue is that the R&W underwriting process wasn’t calibrated to a strategic buyer’s due diligence process.
To be clear, this isn’t a right or wrong issue. The private equity approach and the strategic approach can both uncover the necessary information and lead to very successful M&A transactions. The issue is that the R&W marketplace needs to better delineate between the two different approaches and adjust the R&W underwriting process accordingly.
The ways in which R&W underwriters can help strategic buyers adjust to the R&W underwriting process include the following:
- Discuss the process and the information requirements with clients up front.
- Explain the client’s due diligence process to the underwriters to make sure that they are comfortable with the form and scope.
- Provide clients with detailed samples of the underwriting topics and questions that will be discussed during the underwriting call.
- Define up front what other insurance may be required (D&O, cyber, environmental, etc.)
- Utilize a robust coverage library to help the client and their counsel understand and negotiate coverage.
- Hold the underwriting call as early as possible in order to leave time for follow ups and responses.
For insurance brokers whose client is going through a strategic M&A transaction, the R&W placement process can be an opportunity to highlight capabilities or a frustrating exercise in a high stress environment. Successfully adjusting the R&W procurement process to conform to the underwriter’s expectations and the client’s diligence process can go a long way toward reassuring the underwriter and avoiding problems in the R&W underwriting process.