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VideoRepresentations and Warranties Insurance: Due Diligence, Escrows and Seller Risk in M&A Transactions | Podcast
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Private Equity in Motion
Representations and warranties insurance (RWI) has become a common feature in M&A transactions, helping protect buyers against breaches of representations and warranties while reducing post-closing risk for sellers. In this episode of Weaver: Beyond the Numbers, Private Equity in Motion, Sean Muller is joined by Steve Kesten of BoyarMiller to discuss how RWI works, why it has gained traction in the market and how it influences purchase agreements negotiations. They also cover the impact of RWI on due diligence, escrow and holdback requirements, policy exclusions, premiums and deductibles, and what these considerations mean for buyers and sellers throughout the transaction process.
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Detailed Description of Representations and Warranties Insurance: Due Diligence, Escrows and Seller Risk in M&A Transactions
00:00:00
Sean: We’re continuing our sell-side series. Steve Kesten from BoyarMiller joining me again. Now we’re going to talk about — the last conversation we had was really kind of touching on representations and warranties and everything like that.
00:00:10
Sean: What we’ve seen over the last few years is representations and warranties insurance. What the heck is representations and warranties insurance, and why do we have it?
00:00:18
Steve: Representations and warranties are just general statements about the business that a buyer wants as protection that what they’re getting and what they’re paying for is what they think it is.
00:00:35
Steve: You have these lengthy representations and warranties. Could be pages on pages on pages. Sometimes 30 or 40 pages of representations and warranties about the business, about the ownership, about the company, about the capitalization, the organization, etc.
00:00:51
Steve: And if there’s a breach, meaning not necessarily that you did anything wrong as a seller, but that an unknown something happened prior to closing that makes that representation wrong or incorrect, then the buyer’s going to have a remedy.
00:01:07
Sean: Yep.
00:01:07
Steve: And that could be money taken back from the seller to cover the damages that were associated with the breach of that representation or resulting from the breach of that representation. Sellers are nervous about that, that they get paid all this money, but then a good portion of that money could be pulled back.
00:01:28
Sean: Pulled back or sitting in escrow or whatever.
00:01:30
Steve: Over the last 10 to 15 years, insurance companies who are very smart have come up with this new product that’s called representations and warranties insurance where a buyer can purchase a policy that if there is such a breach that occurs, then the insurance pays for it and the seller doesn’t.
00:01:48
Steve: The seller is kind of off the hook. They can walk away with a little bit of comfort that they’re not going to have somebody knocking on their door later, asking for money back because it’s something that they didn’t know happened prior to the closing.
00:02:02
Steve: Now, representations and warranties insurance is not going to cover things that are known to have occurred prior to the closing. The seller could still be exposed for those things, and that’s why a good M&A attorney will help negotiate limitations on that exposure.
00:02:19
Steve: It may not eliminate 100% of the exposure, but it will eliminate a great deal of the exposure. And what is really cool about it is that in a typical transaction, a seller has to leave some money behind.
00:02:34
Sean: Sure.
00:02:34
Steve: And those are escrows or holdbacks, and they could be significant: 10%, 15%, 20%.
00:02:40
Sean: Right, sure.
00:02:40
Steve: The insurance policy allows for the elimination of that escrow. Now there’s a time value of money benefit with being able to take that money at the closing instead of having to let it sit behind for possibly as much as two-plus years. And I said before, you don’t have to worry that you’re going to get dinged later or have your purchase price reduced, and the insurance takes the place of that.
00:03:10
Sean: When I deal with representations and warranties insurance (RWI), it makes due diligence more important, because now if you’re going to get RWI insurance, the insurance companies want a full report for diligence. It takes a little more work when we’re doing buy-side diligence because the insurance companies want to see what we have to offer. And then they offer — or seem to have at least on the tax side — a lot of exclusions. “Okay, you’ve identified this. It’s a known risk now. We’re not going to insure it.”
00:03:34
Steve: Right.
00:03:35
Sean: It doesn’t just walk away, but it minimizes.
00:03:37
Steve: Indeed. What’s changed the most as a result of the representations and warranties insurance policies is on the sell-side. We may not have to be quite as vigilant in negotiating the representations and warranties because we’re okay with them being stronger for the benefit of the buyer so that they can get full coverage under the policy.
00:03:57
Sean: Right.
00:03:57
Steve: That’s the game changer on the sell-side. On the buy-side, yes. There’s probably a little bit more vigilance on their side in doing due diligence because the insurance company is going to be looking over their shoulder to say, “Hey. Did you check this, did you check that? Because if we’re going to cover it, we want to make sure that full diligence has been done.”
00:04:17
Sean: Okay. Last question on RWI because you do see it come up, and we ask on the front end, is there going to be RWI in this deal or not? Insurance isn’t free. So, who pays the premium?
00:04:27
Steve: That’s negotiable.
00:04:29
Sean: Okay.
00:04:30
Steve: The policies that are most common are buy-side policies. So usually, the buyer is involved the most. They are negotiating with the insurance company. They’re also trying to reduce the number of exclusions. I mean, as a seller, of course, I’m trying to make sure that there are less exclusions as well. They are, as well. But the buyer typically pays for it, but it’s negotiable. And in many situations, the seller will pay half.
00:04:58
Sean: Okay.
00:04:58
Steve: And the seller and the buyer will split the deductible. If and when there’s a claim, half of the deductible would go against the seller, half of the deductible would go against the buyer. The deductible is typically about 1% of the insurance coverage, that you would split.
00:05:16
Sean: Okay.
00:05:16
Steve: Let’s say you get $10 million. Okay, I’m not good with math, so help me out, $10 million of insurance. 1% is …
00:05:27
Sean: It’s 100,000.
00:05:28
Steve: You’ll be splitting $50,000 each of the deductible. That’s typically how it works. But it’s negotiable. Buyers usually pay, but on a number of occasions, the seller will pay half.
00:05:45
Sean: Well, Steve, it’s been very helpful. Thank you.
00:05:46
Steve: You’re welcome.
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