Representations and Warranty insurance is the ideal way to protect both Buyer and Seller in an M&A transaction. If there is a breach of a representation or warranty in the purchase and sale agreement, they are protected. Both sides come out ahead because the risk is transferred to a third party: the insurance company.
In recent years, this type of coverage has grown in usage, from a few hundred policies written five years ago to an estimated 1,500 or more in 2017, as those involved in M&A have realized how a R&W policy can speed up negotiations and reduce risk.
In most cases, the policy is on the Buyer’s side (even if the Seller is paying for it), and the process to secure the policy is straightforward. There are just some simple steps required by the Insurer so they can put together the right policy terms and calculate the proper premium.
The major component of the insurance company’s process for putting together a policy is the due diligence call.
Why Underwriters Need the Due Diligence Call
In essence, the insurance Underwriters are going to get access to reams of information about the M&A transaction. They are looking for the reps and warranties in the purchase/sale agreement because those elements are what will be addressed in the policy. They also need more information to fully assess risk.
But they aren’t experts in these companies—or the industries they are in, for that matter. So, the due diligence call, which takes about one and a half to two hours, provides context and allows them to get clarification about certain risks and elements of the deal related to the insurance policy.
Without this call, there is simply a data dump, and the Underwriters are looking at it all in a vacuum. The due diligence call acts as a crash course to help them learn as much as they can about companies involved in the transaction and the industry they are in. There may be some issues in an industry that are of great concern and other practices that have no material risk and are of no concern to the Insurer.
This is where the due diligence call, which involves the head Underwriter as well as supporting staff and subject matter experts, comes in.
On the Buyer’s side, you might have the CEO and/or CFO and their M&A attorneys, as well as executives in charge of HR, accounting, and in-house counsel for any legal matters. (It’s not uncommon for the CEO to be absent; they are not as involved in the day-to-day operations and are therefore not as helpful to the due diligence process.)
How the Due Diligence Call Starts
The call typically opens with some basic questions directed at the Buyers to get the back story. It’s like asking a new couple you’re having dinner with how they met.
The Underwriters will ask:
1. What prompted you to do business together?
2. What is the purchase price?
3. How did you calculate that purchase price? (In some cases, where there were competitive bids, the Buyer valued the company at a certain amount but had to pay a premium to overcome other potential buyers.)
4. Is the deal cash, stock, debt, or is the Seller rolling over their own equity into the deal?
5. Are you keeping the employees?
6. Is the management team staying on?
7. Are you shutting down operations in a certain section of the company, or in a certain geographic location?
This sets the background and alerts the Underwriters to a potentially “choppy” post-close process where radical changes could disrupt relationships with customers or cause employee sabotage. Then we get into more detail.
The Nitty-Gritty of the Call
A due diligence call is not a “gotcha” situation; it’s a congenial atmosphere, and the Buyers don’t go into the call unprepared.
Before the call, the Underwriters send a checklist to the Buyers so they know what and who they need to bring to the meeting.
For their part, the Buyers can be very helpful to the Underwriters by tasking their M&A attorneys with putting together a memo detailing their due diligence efforts. This provides a roadmap for the Underwriters that they can use for the due diligence call agenda.
Here’s a sample of the types of questions typically on the due diligence checklist:
- How long has the accounting firm been auditing the company’s F/S?
- How does the company account for R&D (expensed, capitalized, etc.)?
- Does the company have any tax liens?
- Has the Buyer reviewed the company’s board minutes?
- What is the number of hourly (non-exempt) employees eligible for O/T and the number of salaried (exempt) employees?
If you want to go into more detail on each question, go here to download the full diligence checklist.
The Underwriters want to know that every important element of the business is included in the representations. The amount of detail depends on the risk and type of representation, in terms of:
- Financials and accounting (Are the books straight?)
- Taxes (Are federal, state, and local taxes up to date?)
- Sales tax (Has it been paid by the Seller?)
- Legal (Any lawsuits in process or potential lawsuits on the horizon?)
- Intellectual Property (Is it included in the deal, including technology but also recipes, logos, etc.?)
- Employee benefits (If employees lose them, they could sue the new owner.)
- Compensation (What have middle management and executives been promised?)
- Operations (Have you visited the Seller’s facilities and locations?)
- Insurance (Are property, officer and director, worker’s compensation, cyber liability, etc. policies continuing with no break in coverage?)
- Environmental (Were any issues discovered during the due diligence process?)
Underwriters Depend on the Buyer’s Due Diligence
Underwriters don’t do a deep dive on the due diligence performed and provided by the Buyer. They simply do a thorough read-through and ask questions as needed. It’s kind of like proofreading. The Underwriters do not conduct their own due diligence at all. They depend on the information provided by the Buyer.
Basically, Underwriters expect the Buyer to get into the weeds for them. They want to get a good feeling that the Buyer conducted thorough and effective due diligence.
In fact, sometimes the Buyer’s diligence team is so in the weeds that they forget to look at an important issue. That’s another way the due diligence call can come in handy.
The Underwriter can say, “Did you look at this specific exposure?” This opens the Buyer’s eyes to a potential liability.
Sometimes, there is important clarification. Not being experts in a certain industry, the Underwriters might bring up what they think is a material exposure but is actually not. Only by consulting with the Buyer and getting that industry context can they understand it’s not an issue for that industry or that business.
One example happens with tech companies, where data security is a top priority. The Underwriters might be concerned that there is no robust security system in place. But the Buyer could show that they don’t store any confidential records or information, so standard IT security is adequate.
Sometimes the Buyers don’t have an answer to an Underwriter’s question. In that case, the Underwriter writes the policy subject to that document or answer being provided by closing.
A Due Diligence Call Makes All the Difference
With the context and clarification provided by the due diligence call, Underwriters can accelerate their due diligence process. It makes things clear.
For that reason, while a Seller might take months to collect all the background information like financial statements requested by the Buyer, and the Buyer takes months to conduct their own thorough reviews, it only takes about a week for the Underwriters to conduct their own process: enough to write the policy to cover the reps and warranties.
Has a deal ever been killed because a due diligence call goes wrong?
There can be an issue where an exposure has not been thoroughly diligenced; the Insurer will excuse that particular representation, which won’t be covered in the policy. But in my experience, it’s not such an issue that the sale won’t go through.
In cases where R&W insurance coverage is part of an M&A transaction, the due diligence call is a necessary element. And it pays for the Buyer to be as accommodating as they can to make this part of the process go as smoothly as possible. It’s really in their best interest, as it allows the policy to be finished more quickly, with the correct coverage, and at the best premium.
For full details of the questions asked and information required during a due diligence call, go here to download a sample agenda.