What About Us? Is Representations & Warranties Insurance Available for Middle Market Transactions?

This blog was originally published on LinkedIn by Owens Group Executive Vice President Joseph Ehrlich.

Last year, a private equity sponsor approached the Owens Group. They wanted to purchase a Representations and Warranties Insurance (“RWI”) in connection with a $17 million acquisition. The client’s goal was to get a “standard” indemnification package. They wanted to have some money—a couple of million dollars—available in case the seller breached any of its “general” representation in the purchase agreement and $17 million—an amount equal to the purchase price—in the event that it breached any of its fundamental representations.

Often, the buyers will look to the seller directly to provide this protection, but in this case, the seller was unwilling to stand behind its representations. The buyer, a Private Equity (“PE”) fund, wanted to buy the company, but at the same time felt that they owed it to their limited partners to have protection in case anything went wrong. They wanted (or needed) a ready source of funds available for indemnification. Naturally, they thought of RWI. After all, RWI has become a standard feature of transactions involving PE firms. The product is typically structured such that the buyer purchases an insurance policy that covers them in the event that any representations under the purchase agreement are breached by the seller resulting in a loss for the buyer.

So that PE fund came to us and asked: could they get RWI insurance for such a small deal?

You may have asked yourself the same question: is RWI available for middle and lower middle market deals? If you looked at the question previously, you probably found that it really wasn’t available or simple didn’t make economic sense in the context of middle market transactions: Insurers simply would not provide limits of coverage for a price that made sense for middle market deals.

The good news is that it is changing. Over the last several years, some existing markets have lowered their minimum premium and new carriers have entered the market. Some of the new entrants even strategically cultivate the middle and lower middle market.

In the case of the deal just mentioned, we were able to secure RWI for their $17 million transaction at an appropriate and acceptable premium.

The $250,000 Minimum Premium

As recently as a few years ago, the minimum premium for a R&W policy was around $250,000. That translates into a lot—maybe too much—of coverage for a smaller deal. Using a relatively common rate of 3% (which equates to $30,000 per million of coverage), the product generally didn’t make sense unless you were buying at least $10 million of coverage. That means that on a deal with a purchase price of less than $100 million, the product generally didn’t make sense.

Retentions: One Size Does Not Fit All

The problem wasn’t just with the outsized premiums: the self-insured retentions (commonly referred to as an “SIR”) were also inappropriately large for many middle market deals. An SIR works very much like a deductible. The first dollars of a loss are borne by the insured and then the remainder of the loss (up to the limit of insurance) is paid by the insurance company. (There are differences between an SIR and a deductible, but elaboration of those difference is unnecessary for the purposes of this article.)

Most insurance companies and on most deals, regardless of size of the transaction, required a minimum self-insured retention of $1 million. As with the premium, this is appropriate for a transaction with a purchase price of $100 million or more, but much less so for transactions that are smaller.

But minimum retentions have also changed in recent years. You can find carriers willing to write coverage with premiums of $100,000 or less and SIRs at $500,000 or less.

To be sure, there are still companies with minimum premium and retention requirements that are much higher than the companies referred to above.

Audited Financials

Another problem that frequently arises with smaller deals is the lack of audited financials. Most carriers require that the target company have them, but many smaller companies simply do not.

Here, there is more good news: Some carriers will make an exception and write coverage for companies without audited financials—under certain circumstances. Generally, the carriers that will make the exception only for smaller companies. These carriers reason that it may be understandable and even appropriate for a smaller company to forego the expense and complexity of preparing audited financials, but still believe that any company of a substantial size should have their financials audited.

The expectation is further limited to situations where the buyer performs an analysis the quality of the company’s earning, known colloquially as a “Q of E.” A quality of earnings analysis is a detailed report on a company’s revenue and expenses, prepared by independent third-party accounting firms, as part of the due diligence process in an acquisition. While less valuable to insurers than audited financials, they do provide a method of confirming important aspects of the target’s financial position. Of course, the financial statements representation in the purchase agreement will need to match the actual standard of review of the target’s financial statements. In other words, you can’t expect to insure to an audit standard if the target’s financial statements aren’t audited.

Quality of Diligence and Advisors

Especially for smaller deals, the insurers will gain a lot of comfort by the professionalism of the deal process. Things like the experience of the deal team, including the investment professionals, the advisors and attorneys, are significant factors to the insurer in its evaluation of the deal. In addition, the scope, or extent, of diligence will be evaluated. The insurer will ask itself questions like: Did the buyer try to cut corners in the diligence process or did it perform a robust and full diligence review? Are there written due diligence reports for legal, financial, and insurance? Without these, the hill to climb gets that much harder.

Carriers also like to see an experienced insurance broker associated with the submission. The rationale is that an experienced broker can help set realistic expectations and can make sure that the process runs smoothly and expeditiously.

Ancillary Considerations

In addition to the factors outlined above, other factors will be considered and evaluated, such as the industry of the target. Certain classes of businesses are more difficult to insure. Examples of difficult classes of business include financial services and healthcare. For transactions in these sectors, the size of the transaction and the amount of premium will loom larger than in simpler and more straightforward businesses like light manufacturing, food services and software.

There are also the other factors that are outside the control of the buyers and sellers, like how busy the carriers are with more lucrative submissions from larger transactions. It is simply “the way things are” that carriers will try and allocate their resources to the opportunities that they see as the most profitable and certain. When internal resources are scarce, big deals and repeat buyers will be favored over smaller deals from unknown sources.

The Takeaway

While RWI is available for middle market transactions, the product may not be available for every deal. There are a lot of factors, including the quality of the due diligence process and the industry of the target, that will determine if the product is available for any particular transaction.

With middle market companies, it is vital to plan ahead and leave plenty of time to canvas multiple carriers.