Rep and warranty insurance is changing the M&A game

Like any industry veterans, we’ve seen some promising sell-side transactions struggle to get over the goal line. When deals get derailed late in the game, “representations and warranties” (or “reps and warranties”) are often the culprit.

Picture this: a buyer offers you $40 million for your company. You accept the offer, only to learn a few weeks later that he wants you to put $5 million in escrow for 18 to 24 months. At the very least, things can get a little tense — and it may even cause you to put on the brakes.

That’s why we were happy to hear a consensus at the GF Data Roundtable: representation and warranty insurance is becoming an important tool that helps middle market transactions make it to closing.

WHAT ARE REPS AND WARRANTIES?

Let’s back up: almost every purchase agreement has a reps and warranties section. Before a deal gets done, buyers analyze and assess almost every aspect of a seller’s operations and finances. Even though they’ve had a chance to perform this “due diligence” with their own team and outside experts, they still require a seller to make reps and warranties about the business.

According to the American Bar Association:

• Representations are “statements of present or past fact. For example, ‘The financial statements fairly present the financial condition of the seller.’ If a representation is intentionally false, a plaintiff can make a common law claim of deceit (a tort) and allege fraudulent misrepresentation.”
• Warranties are “a promise of indemnity if a statement of fact is false. A promisee does not have to believe that the statement is true. Indeed, the warranty’s purpose is to relieve a promisee from the obligation of determining a fact’s truthfulness.”

Sellers make reps and warranties about assets, liabilities, taxes, environmental issues, employee matters — the list goes on and on. Essentially, the seller is promising the buyer that everything is in good standing, and if it’s not, the seller discloses any issues with “schedules” that describe the situation. In other words, these provisions place a duty on the seller to disclose anything that could result in a financial loss or other damages to the buyer.

So what if — after the ink is dry and money changes hands — something turns out to be different from what was represented? For example: perhaps the seller has some contract employees who really shouldn’t be contractors, and the IRS discovers this after the deal is done. The new owner may be responsible for penalties and taxes due — unless the seller made reps and warranties that their payroll classifications were compliant with federal wage and hour laws. In that case, the buyer is protected and can turn to the seller directly or through escrowed funds (another topic for another day) to offset financial losses.

The problem is, it can be difficult to make bullet-proof reps and warranties about everything. It’s like selling a house: no matter how great the inspection was, or how extensive the disclosures were, the buyer will always have a fear that something damaging and expensive will be found after closing. So it’s understandable that an escrow account helps buyers feel more protected. On the other hand, a seller doesn’t want millions of his dollars tied up for several years in escrow, especially when he was expecting that money to go straight into his bank account. Plus, the seller has a real concern that the buyer will chip away at the escrow over time — so he may not ever see that money again.

REPRESENTATION AND WARRANTY INSURANCE: A WIN-WIN

You can see why reps and warranties have the potential to derail a deal. Hence, the increasing popularity of substituting a rep and warranty insurance policy for an escrow.

Rep and warranty insurance (“RWI”) protects the buyer and the seller (and the sanity of their advisory teams). It’s been around for years, but traditionally, it was only provided by a handful of carriers and used in really big transactions. Now, happily, it’s made its way to the middle market, and there are many more insurers offering it on mid-sized deals.

RWI isn’t cheap, but it can be easier to swallow than a massive escrow held for two years. If it’s being put in place to address or augment the escrow issue, it’s typically the seller’s responsibility to have it underwritten and paid for, and it must be in a form and with a carrier acceptable to the buyer.

However, when participating in a competitive auction process for a target company, a prospective buyer can differentiate his bid from others by offering to substitute and pay for RWI, instead of demanding an escrow. Or, sometimes, the two parties will split the cost of the policy, since it can be viewed as a mutually beneficial arrangement that keeps a deal on track.

Sure, there are other things that can go wrong when you’re trying to close a deal. But reps and warranty insurance can eliminate one of the major variables — and in a lot of cases, it’s worth it.