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Minority stake acquisitions and W&I Insurance post COVID-19 revival

Financial, Executive and Professional Risks (FINEX)|Mergers and Acquisitions
Mergers and Acquisitions

By Beatriz Pavón | May 26, 2020

The COVID-19 pandemic has had an immediate and profound effect on international economic output.

In addition to the undoubted human cost, the Covid-19 pandemic has had an immediate and profound effect on international economic output, resulting in significant investor uncertainty as to valuations and a downturn in M&A activity. 

When green shoots of activity emerge (and that is a question of ‘when’ not ‘if’) the present uncertainty will undoubtedly evolve to opportunity for those with capital ready to deploy.

We anticipate that in due course an increased level of divestiture of minority shareholding will take place, across a broad spectrum of businesses, driven by cash-strapped minority investors looking to exit positions and increase their liquidity. Already a well-established tool for facilitating M&A transactions in many international markets, we expect Warranty & Indemnity (“W&I”) insurance to expand in significance as counterparty credit risk increases as a result of the Covid-19 crisis. The Willis Towers Watson (“WTW”) Transactional Risks Team has analysed relevant past transactions and collaborated with leading W&I insurers in order to bring our clients a summary of some key aspects to consider for W&I insurance in transactions involving minority stake acquisitions.

Disclosure and seller´s knowledge

Amongst the key considerations for a W&I insurer is the disclosure process undertaken by the seller(s) on every M&A transaction. Compared to an acquisition of 100% of a target, where the acquisition of a minority stake is concerned, it is often the case that the majority shareholder is not involved in the sale. This could potentially cause the insurer to approach the deal with caution when quoting terms for a transaction and also during the underwriting process. Depending on the percentage stake being divested, lack of involvement of the majority shareholder could mean that the minority shareholder does not have knowledge of some relevant information by virtue of being a minority shareholder or is not able to get access to such information. It is this uncertainty as to anything significant being missed from the disclosure process that can cause an insurer to have a decreased appetite for the transaction (as they do not have the ability to review the relevant information that supports the warranties provided in the acquisition agreement). Alternatively, the insurer may require a higher premium rate than if the entirety of the group were being sold, in order to reflect the increased risk profile.

Can the warranties be given by the management of the target?

In order to address the insurer´s concerns, provide comfort and maximise the coverage position, on recent transactions WTW have advised clients to provide comfort to the insurer by, where possible, involving the majority shareholder in the disclosure process and/ or agreeing with the management board their availability for Q&A by the buy-side. Where the transaction dynamics permit, the insurer often gains comfort where the warranties are given by the management of the target (albeit with limited or nominal liability) in the acquisition agreement or via a management warranty deed, given that it is the management of the company that is most likely to have knowledge of all the key considerations affecting the target.

Other relevant information to be provided

With particular focus on gaining comfort as to the acquisition of the minority shareholding, insurers usually ask to be provided with relevant corporate and company incorporation documents, such as any existing shareholder agreements that may reveal any special rights or liabilities attached to certain shares.

Are synthetic warranties an option?

Sometimes the minority seller or the management many not be in a position to offer any warranties to the buyer. In recent months we have seen an increase in the number of enquiries as to synthetic warranties from our clients, whereby the insured would negotiate a limited set of warranties directly with the insurer and the insurance covers warranties which were deemed given by the seller to the buyer, even though no such warranties were in fact given. This provides a significant increase in protection offered to a buyer. We have explored the possibility of synthetic warranties with the W&I insurance market as a possible solution on various recent transactions. Historically there is limited insurer appetite for transactions involving only synthetic warranties due to the increased risk profile as described above and lack of market practice in the majority of jurisdictions. However, insurers are showing increased appetite for offering synthetic warranties on deals in familiar territories.

However, as insurer interest and competition in some regions grows, we hope the market will soon evolve so as to cater for this emerging client need at least for some specific business sectors. 

Due diligence

This aspect is linked with the possibility referred to above, that some minority shareholders may not have access to some or all of the relevant information. The scope and depth of the due diligence exercise underpins the coverage position that an insurer is able to provide. A limited due diligence exercise may result in certain warranties either being excluded or partially excluded from cover on the basis of the insurer lacking comfort. 

The importance of the scope of the due diligence exercise matching the scope of the warranties cannot be underestimated for minority stake acquisitions, where in light of the possibly limited disclosure process and lack of involvement of the majority shareholder, the insurer looks to gain comfort through other available means. Our recommendation is to ensure that the scope of the due diligence is discussed with your broker at the outset and that the scope matches the warranties you desire cover for.

Policy mechanics

A buy-side W&I policy for the acquisition of a part of a business will cover the corresponding percentage of any relevant loss. If the insured acquired a 40% stake in the business, the W&I policy would cover 40% of any loss affecting the company which qualifies as “Loss” under the W&I policy.

How do insurers calculate the applicable retention to the policy?

Insurers will often apply the same proportionality principle to the policy retention expressing it as a percentage of the enterprise value (“EV”) of the target as a whole, rather than just the stake being acquired (transaction value “TV”).

The WTW approach is to seek the most competitive insurer terms for our clients. In our experience we see that the approach followed by insurers depends on the business activity of the target. For Real Estate and Energy sector deals it is frequent to get quotes expressing the retention as a percentage of the TV but for operational businesses we see that the applicable percentage is an intermediate range between the TV and the Enterprise Value.

Seller tax risks on disposal of a minority interest

On the disposal of a minority interest there can sometimes be a degree of uncertainty as to the seller’s tax treatment. The seller of shares in a subsidiary would often expect to benefit from a ‘participation exemption’ exempting the seller’s gain from tax. Such exemptions typically require the seller to have held a minimum percentage of the target company’s ordinary share capital for a given length of time. Whilst at face value this would appear to be a straight forward test, there is frequently uncertainty on the exact percentages for tax purposes, when one factors in whether share options, management incentive plans and loans with equity-like features should be included as ordinary share capital and when they were acquired (for example if the options were granted on one day and vested on another).

Where such uncertainty exists, achieving certainty by way of a standalone Tax Liability Insurance policy may be desirable. Such policies are generally taken out by the seller (as it is protecting their tax position) but we have also seen buyers propose such insurance solutions to a seller as a way of enhancing their bid. Pricing for such policies will vary based on the facts but they would typically be between 1.5% and 3.5% of the policy limit purchased. The Tax Liability insurance policy would cover the identified risk and protect the seller against any tax, interest, penalties and legal fees which arise following a tax authority challenge.

Trends

In a post Covid-19 M&A market, we expect the competition between W&I insurers to continue in line with the trends observed over the recent years

In a post Covid-19 M&A market, we expect the competition between W&I insurers to continue in line with the trends observed over the recent years, as insurers continue to grow their teams and expand their competence to local jurisdictions. As a result of this competition we expect greater flexibility from insurers in terms of the coverage position available and the policy pricing parameters to accommodate prevailing market needs.

Authors

Alexander Keville
Practice Leader Mergers & Acquisitions,
FINEX Global

Head of Transactional Risks - Southern Europe,
Transactional Risks Team

Director of Tax and Investment Structuring,

Transactional Risks Team


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