Taking the Stress Out of Distressed Transactions: Improving Outcomes with Risk Management Solutions
Navigating new forms of volatility
Distressed mergers and acquisitions (M&A) transactions are often run on a shorter timeframe and with the sellers being unwilling or unable (if the entity is under formal insolvency proceedings) to provide warranties and/or specific indemnities. These factors increase risk and may result in fewer offers, even depressed sale prices. Risk management solutions such as warranty and indemnity (W&I) insurance (in particular, warranties given on a synthetic basis), tax liability insurance and contingent risk insurance can be used to bridge the gap between sellers’ and buyers’ appetite for liability and risk, resulting in better disposal outcomes in distressed M&A transactions
Distressed M&A Transaction vs Typical M&A Buyout
In a typical M&A buyout situation, the seller and/or the management of the target entity would provide warranties under the sale and purchase agreement (SPA), disclosure would be given by the seller, as exceptions to the contents of the warranty schedule, and comprehensive due diligence would be conducted by the buyer to cover the scope of the warranties in the SPA. The buyer can insure against financial losses arising from breaches of the warranties by purchasing W&I insurance, giving a clean exit for the seller and a peace of mind for the buyer. W&I insurance typically covers fundamental warranties, business warranties, and tax warranties.
In a distressed M&A situation, the target entity is under financial distress and may be placed under formal insolvency proceedings. As such, the seller and the management of the target entity (in the case of formal insolvency proceedings, typically the administrators or liquidators of the company) are unwilling to and/or unable to provide warranties. This is a concern for potential buyers as they would not have extensive knowledge of the target entity. With no particular party standing behind the warranties, buyers may either hesitate in buying the target entity or engage in negotiations surrounding the offer price to account for there being no avenue for recourse.
W&I Insurance for Unknown Risks in Distressed Transactions
If the seller can still stand behind its warranties (or while the seller is unable to give warranties but the target management can provide some warranties by way of a warranty deed), W&I insurance can address the buyer’s concerns of unknown risks giving rise to breaches of warranties by providing protection from potential financial loss arising from such breaches of warranties. Even after conducting comprehensive due diligence, the buyer may still be concerned with the seller/target management not coming clean on their warranties (especially in distressed situations where the management could be seen to have contributed to the financial situation of the target). Further, if the sellers are financially distressed themselves, the buyer may also be concerned with eventual financial worthiness of the sellers in event of a breach of warranties or indemnities. In contrast, W&I insurers providing coverage on the warranties are rated highly on creditworthiness (e.g., rating of A and above on AM Best Financial Ratings).
Crucially, W&I insurance can help parties streamline the negotiation process – giving the buyers peace of mind that they are protected if there are breaches of warranties and enabling the parties to focus on the key commercial points of the transaction instead of being held up over negotiation of warranties.
What are Synthetic Warranties and How Can They Help?
Where the sellers and the management are not willing or able to stand behind warranties, some insurers are able to provide coverage for “synthetic warranties”. The warranties are “synthetic” in that the warranties are not given by the sellers but negotiated between the buyers and the insurers, outside of the SPA. The warranties are likely to be relatively standard and narrower in scope than typical W&I insurance as neither the buyer nor the insurer knows the business like the seller does.
Synthetic warranties can facilitate the distressed M&A transaction by providing the buyers with protection against breaches of the “synthetic” warranties, and at the same time allowing the sellers a clean exit, despite the sellers not being able or willing to provide warranties. Synthetic warranties can be applied as a mechanism to bridge the gap between the buyer’s and seller’s appetite for liability and risk.
For example, in a situation where the buyer is buying a target entity under financial difficulties, and the target entity is being held by a disparate group of shareholders, it may be difficult to negotiate meaningful business warranties. Without synthetic warranties, the buyer would not have protection for breach of what might have been insurable “standard” warranties, which includes fundamental warranties on title and capacity, standard operational warranties for the target entity’s sector, and standard tax warranties. In such a situation, a policy with synthetic warranties can be arranged – deeming the SPA to include “standard” warranties that could have been given at the closing of the transaction, if it was a “standard” transaction. The buyer would however still be expected to retain appropriate third-party professionals to conduct comprehensive due diligence in respect of the subject matter of all warranties expected to be covered under the policy.
Limitations and Drawbacks of Synthetic Warranties
In contrast to typical W&I coverage, synthetic warranties are usually narrower in scope, as neither the buyers nor the insurer knows the business like the sellers do. There would also typically be limited disclosure from the seller in such situations.
Higher premiums can be expected as compared to typical W&I policies after accounting for the risk profile caused by absence of warranties in the SPA (and thus the insurer’s subrogation rights and recourse for fraud), as well as the more limited disclosure generally available for distressed M&A transactions. Balanced against a scenario of entering into a transaction with no warranties or indemnities being provided, the potentially more expensive policy may be offset by the advantages of having synthetic coverage in place - including the attractiveness for sellers seeking a clean exit with no liability for breach of warranties, and buyers looking to offer more attractive bids.
In Asia, synthetic warranties are still in a relatively early stage of development, with a limited number of insurers with the appetite to provide synthetic cover. However, given the increased number of distressed M&A transactions and increased sophistication of the W&I solution, we anticipate more insurers entering this space. Additionally, in line with developments in the UK, it is foreseeable that the insurers that currently offer synthetic warranties may become more adept at underwriting such policies, reducing the time and expense associated with placing policies with synthetic warranties.
Additional Solutions for Known Risks in Distressed Transactions
In addition to W&I insurance (whether the warranties are synthetic or not) that covers unknown risks, there are also insurance solutions that cover identified known risks in the distressed M&A deals - namely tax liability and contingent liability insurance that can help remove roadblocks to a successful distressed M&A transaction.
Tax Liability Insurance
Tax liability insurance covers identified tax risks that are low in probability but high in value and impact. The loss covered arises from a successful challenge by a tax authority to the expected tax treatment of a historic transaction. Tax liability insurance also protects the insured from other related losses, such as costs incurred in contesting the tax challenge, accrued interest since the date of the transaction and gross ups. Obtaining tax liability insurance can limit the amount of loss for the known tax risk at the policy's retention amount, releasing more cashflow for the seller and creditors, and enabling deals to proceed even in financially distressed situations.
For example, where the target holding company (i.e., the seller) is undergoing an insolvency process and intending to dispose of the target for repayment to creditors, and the tax authorities identified a significant tax issue in its tax audit – the seller and the authorities may be unable to reach a consensus on the tax decision and litigation may be imminent. In this situation, with a strong “should level” tax opinion, a policy to cover losses arising from the litigation, freeing up cash that would otherwise be required to cover the tax payments should the tax authority prevail can be arranged. With the freed-up cash, the seller is better able to repay its creditors.
Contingent Risk Insurance
Contingent risk insurance covers specific identified contingent risks low in probability and high in severity (such as risk of adverse interpretation of a law/regulation, risk of not having good and clean title to shares due to past irregularities, etc). By providing financial protection against these specific defined risks, contingent risk insurance helps to break impasse in M&A transactions, including in the context of a distressed M&A transaction.
Case StudyA company was acquiring businesses from a group that was in financial distress. As part of the sell-side reorganisation, certain assets were being transferred into and out of the entities. There were concerns around the application of the law on “transaction at an undervalue” to the transfer of these assets. The buyer of the companies was concerned that, in the event of a post-sale insolvency of the selling group, creditors might persuade a liquidator or administrator to challenge these transfers, leaving the buyer with an unsecured claim against an insolvent entity. Aon was able to arrange for a policy covering the risk if the transactions undertaken by the target companies prior to the sale were considered “transactions at an undervalue” and set aside as being void. This meant that the insurance allowed the buyer to recover the value of the “clawed-back” assets, including any associated costs.
Better Disposal Outcomes
There are several solutions available to parties in a distressed M&A transaction to address the buyer’s concerns while providing a clean exit for the seller:
- W&I insurance where sellers and/or management are still able to provide warranties and W&I insurance but with synthetic warranties where sellers and/or management are unable or unwilling to provide warranties
- Tax liability insurance and contingent risk insurance can limit downside risks arising from known issues which could be dealbreakers in the distressed M&A transaction.
Overall, these solutions can provide buyer protection against both known and unknown risks, removing dealbreakers (that are more pertinent in distressed M&A transactions) and reducing the chance of the buyer pricing these risks into the target valuation, thereby facilitating better disposal outcomes in distressed M&A transactions.
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