Representations and warranties insurance (R&W) is an effective risk transfer tool utilized by private equity firms and corporations involved in mergers and acquisitions (M&A). This insurance serves to protect both buyers and sellers in M&A transactions by transferring the risk of financial loss in the event of unanticipated inaccuracies or breaches in representations and warranties made in the purchase and sale agreement.
Generally, the negotiations over the allocation of risk assumed by the buyer or seller can be one of the most strenuous components when finalizing a deal. Additionally, in a M&A transaction, the buyer retains a portion of the sale price in a third party escrow for a set period of time to ensure funds are available for future indemnification. By using a representations and warranties policy, the seller is able to retain a greater portion of the sale proceeds and significantly decrease the necessary escrow fund. Plus, the buyer has peace of mind knowing an insurer is behind the deal for financial loss from unanticipated inaccuracies in representations and warranties.
R&W insurance is a highly customized insurance product and can be tailored to benefit both buyers and sellers in a transaction. Policies can be structured either as buy-side or sell-side depending on who’s purchasing the coverage. A buy-side policy is purchased by the buyer and provides first-party coverage allowing a buyer to recover directly from an insurer for losses due to a seller’s breach of a representation or warranty. A sell-side policy is purchased by the seller and provides seller with third-party coverage where the seller would tender claims from the buyer for alleged breach of representation or warranty directly to a seller’s insurer. Some of the key benefits to each party in the transaction are outlined below.
Benefits to Seller-Side Policies:
- Allows for a “clean” exit of the business by reducing risk of significant post-closing indemnity payments from future representations and warranties claims
- Eliminates or greatly reduces the need for an escrow fund required by the buyer for future indemnifications
- Provides financial certainty for seller post-closing (e.g. retirement)
- Locks in proceeds from sale for distribution to investors and/or creditors
- Expedites a sale and potentially increases the purchase price by eliminating obstacles to closing, such as indemnity negotiation
Benefits to Buyers-Side Policies:
- Supplements the indemnification provided by sellers for breaches of representations and warranties
- Provides reassurance when buying from financially distressed sellers
- Warrants a potential competitive advantage in a bid or auction setting by accepting a lower-than-market indemnification from the sellers and supplementing this indemnification with insurance
- Extends survival period of representations and warranties provided by sellers
- Protects relationships with sellers who may become buyers’ key employees or business partners after closing
- Provides additional security in cross border transactions
If you have further questions about R&W insurance, chat with an ‘A’ Team member for answers.