Rep & Warranty Insurance: Product Specifics and How It s Used Ashley Behan, AIG Bruce Engler, Faegre Baker Daniels Craig Schioppo, Marsh USA Inc. Moderator: Michael Abbott, Faegre Baker Daniels 1 Agenda Introductions General Discussion of Transactional Risk Insurance and Marketplace Recent trends and advances Reps & Warranties Insurance Strategic uses Types of policies Pricing, deductibles and limits Underwriting process and timing Impact on M&A negotiations Tax and Contingent Liability Insurance Claims Experience Case Studies 2 Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 1
Transactional Insurance Products Facilitate mergers, acquisitions, divestitures and other business transactions In some cases, remove or reduce escrow or holdback in the transaction Provide access to the insurance industry s capital and allow the transfer of certain transaction-related risks to the insurance markets Transactional Insurance Products include: Representations & Warranties Insurance Tax Liability Insurance Contingent Liability Insurance Transactional Insurance Market Overview Continued Evolution: More innovative insurance solutions than ever Insurance market now offers: Broader coverage and better alignment with underlying agreement A more streamlined underwriting process Significantly increased limits of liability available Material reduction in premium rates and deductible levels: enhanced competition Ability to issue policies out of more countries than ever before Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 2
Transactional Insurance Market Overview (cont.) Insurance market now offers (continued): Key drivers of explosive growth Greater market awareness and acceptance: lawyers, bankers, end-users Competitive deal environment in middle-market M&A Buyers seek to distinguish bids Sellers demand limited recourse to enhance returns Insurance market evolution Speed of execution Sophisticated deal professionals and advisors Standardization of terms and expectations Transactional Insurance Market Overview (cont d) Already an established product in certain markets, has seen significant growth in North America over past 3 years: Marsh: 2014: over double the annualized volume from 2013 75 deals year to date. $1.5 billion in limits. 2013 $1.34 billion in limits / 66 closed transactions 2012 $1.43 billion in limits / 51 closed transactions 2011 $767 million in limits / 45 closed transactions AIG: Over 520 submissions in 2013 (~57% increase over 2012) Expecting between 800 and 1,000 submissions in 2014 Insured 86 deals in 2013 (~56% increase over 2012) Q1 and Q2 2014: about 78 policies written Middle market M&A emphasis and application Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 3
Uses of Transactional Risk Insurance Products Risk Management Uses Buyers Risk Management Uses Sellers Increase maximum indemnity / extend survival period for breaches of reps & warranties Ease collection concerns Provide recourse when no seller indemnity possible (i.e. bankruptcy; ESOPs) Reduce contingent liabilities Distribute sale proceeds Protect passive sellers Manage jurisdictional issues (i.e. cross border deals) Strategic Uses Strategic Uses Distinguish bid in auction Attract best offers by maximizing indemnification Protect key relationships LBO lenders desire backstop on indemnify for credit analysis Include R&W Insurance as the sole remedy in draft agreements in auctions/clean exit Maximize net sales proceeds and enhance IRRs Types of R&W Insurance Policies 1. Buyer-Side Policy Two Types of Policies: Insurance replaces sellers potential indemnification liabilities under acquisition agreement Can enhance indemnification terms set out in acquisition agreement Extended survival periods Increased cap Materiality scrape Covers fraud by the sellers Limited subrogation rights against seller and management team 2. Seller-Side Policy Sellers backstop their potential indemnification liabilities agreed to in acquisition agreement Mirrors indemnification terms set out in acquisition agreement Typically excludes fraud by the sellers Knowledge between sponsors and management sellers can be severed Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 4
R&W Insurance: Key Terms Policies are negotiated between insureds and insurer and specifically tailored to fit each unique transaction Coverage has become more insured-friendly Better symmetry with acquisition agreement Reduction in exclusions Coverage for pre-closing covenants Knowledge exclusion advancements Materiality scrapes Premiums Typically 2% - 4% of limit insured and lower outside of US Who pays? R&W Insurance: Key Terms (cont.) Deductibles Typically 1% - 2% of transaction value (no indemnity deals may be higher) Buy-side policies often use escrow account as deductible Seller-side policies use a negotiated amount Drop downs available and erosion available for loss outside coverage Up to $350MM - $400MM of limits available in the global market Can be used effectively in transactions from $15MM - $2B+ Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 5
Streamlined Underwriting Process 1. Execute NDA 2. Provide Submission to Insurer Requested information includes draft acquisition agreement, financial information, offering memo 3. Obtain quote within 2-4 days No cost to obtain quote 4. Pay underwriting fee Underwriting fees range from $10K - $30K+ (depending on nature/complexity of risk) 5. Underwriting process: 5-10 days High level review of due diligence process (if buyer-side) or disclosure process (if seller-side) Access to legal, financial, tax, other DD reports (if buyer-side) Conference call(s) with deal team 6. Policy negotiations Concurrent with underwriting process Work closely with outside counsel Impact on M&A Negotiations Acquisition agreement contemplating R&W Insurance draft for it Alignment and symmetry between acquisition agreement and policy Including advisors, brokers and underwriters early in the process Advisors and brokers can help deliver the right terms and package Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 6
Tax Liability Insurance Insures against the financial consequences of an intended tax treatment being disallowed by the relevant tax authority in situations where: there is no clear precedent or guidance; tax authority approval (e.g. PLR) is not available or cannot be received in the required time frame; potential downside exposure is significant relative to size of transaction; financial model for transaction does not allow for margin for error. Common uses: A tax liability policy is most commonly used in a transaction context and can be written to: insure the conclusion of a tax opinion; or backstop or replace the subject matter of a tax indemnity Coverage can be extended to cover disclosure risk Tax Liability Insurance: Key Terms Covered Items Additional tax Fines & penalties Interest Legal expenses Gross Up Key Coverage Issues Policy Term typically up to seven years Cost typically, 3% - 9% of policy limit, depending on underwriting analysis Deductible varies by deal, but often only applicable to legal expenses Underwriting similar to R&W underwriting process; a tax opinion is not required Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 7
Contingent Liability Insurance Contingent liability insurance covers one-off identified potential exposures that have not yet fully crystallized Recent Examples include: Successor liability Fraudulent conveyance Change in law risk Other legal, legislative or regulatory risks Cost, Limits and Deductibles vary based on particular risk Claims Experience Industry-wide, claims payments have ranged from $500k-$20M Insurers have dedicated claims professionals and long-established relationships with premier law firms and experts to offer high quality claims solutions Brokers and independent advisors serve as advocates for insureds Examples of claims: Financial Statements: Recently paid approximately $10mm for a financial statements related claim Accounts Receivable: Seller-side policy responds to a claim brought by buyer for breach of the financial statements R&Ws in connection with the target s issuance of over $1mm of gift certificates which had not been recorded in the financial statements Patent Infringement: Seller-side policy responds to claim brought by buyer for breach of the IP R&Ws resulting from a third party claim of patent infringement Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 8
Frequently Made Claims Representations relating to financial statements, compliance with laws, taxes and undisclosed liabilities are most frequently alleged to have been breached. 20% 15% 10% 5% 0% Type of w arranty breach Financials;AR;Inv. -18% Comp. With Laws/Lit. -17% Tax -14% No. Undisc. Liab. -10% IP -8% Contracts -5% Full Disc. -4% Emp. Ben. -4% Real Prop. -3% Other -16% Timing of Claims More than half of all claim notices are received within the first 12 months of the policy s issuance. Time Lapse Between Policy Incpetion and Receipt of Notice of Claim 20% 24% 56% 0-12 months 12-24 months 24+ months Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 9
Case Study: Buyer-Side R&W Insurance Buyer using insurance to enhance auction bid Background Issue Private equity firm competing in auction with several financial and strategic bidders down to final 3 PE firm seeks to distinguish its bid Seller s auction draft has no survival of reps Buyer would like to acquire the target but needs post-closing recourse for breach, including to support lender s credit assessment of the business for LBO Solution Buyer-side R&W policy Limit: 10% of purchase price to replicate typical escrow arrangement Retention: 1.5% of purchase price Premium: 3.3% of insured amount Policy in place at signing PE firm wins auction Seller maximizes amounts distributable to creditors/investors Case Study: Buyer-Side R&W Insurance at Seller s Insistence in Auction Process Background/Issue PE sponsor/management selling target company equity PE sponsor seeks to maximize net sales proceeds and limit post-closing contingent liabilities; PE firm does not want to suffer loss due to any management malfeasance Solution PE sponsor insists on no survival of the reps and encourages bidders to pursue R&W Insurance; fall back position is to provide recourse against narrow fundamental matters with a modest escrow amount (for policy retention) with the policy sitting above the escrow and sellers responsible for loss for fundamental matters after policy has been exhausted Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 10
Case Study: Facilitating a Deal/Closing a Gap Issue Buyer: private equity firm Seller: closely-held fund in wind down Gap: Seller liquidating portfolio at a marginal gain near end of fund s term; desire to distribute proceeds to limited partners without escrow or holdback Buyer insists on protection for postclosing issues, including breaches of representations, to fulfill fiduciary duties to its investors Seeks large holdback for 6 years Concerns about Seller s creditworthiness post-closing Solution Buyer-Side R&W insurance with broad coverage for Buyer Term: 2 year term for general representations; 6 year term for fundamental representations and tax indemnities Coverage: $20,000,000 Retention: $5,000,000 retention with dropdown to $750,000 6 months after closing; $5,000,000 matches 6 month holdback in deal (10% of deal size) Cost: $280,000 premium paid by Buyer as deal cost Case Study: Seller-Side Protection Sellers using insurance to limit potential indemnification obligations after closing Background Seller: Several VC Funds and Founders Buyer: US Publicly-Traded Company Target: Technology Start-Up Purchase Price: ~$480MM Issue Aggressive strategic acquirer demanding high cap on indemnity, long survival period for reps (especially IP) Buyer would not negotiate the reps; very Buyer-friendly reps VCs wanted to disburse money to their limited partners and not have to worry about clawing back proceeds Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 11
Case Study: Seller-Side Protection (cont.) Solution: Seller-side R&W policy Limit: $237MM (50% of purchase price) (6 insurers participated on this program) Retention: $57MM for the 1st year (~12% of purchase price (this was the amount placed into escrow by the Sellers)). $28.5MM from 1st year to 18th month anniversary of closing ~6% of PP (part of the escrow was released on 1st anniversary)). $4.75MM for the 2nd anniversary of closing (1% of PP). Policy period: 18 months for general reps, 2 years IP, 6 years for fundamental, tax and compliance with laws reps Presenters Contact Information Ashley Behan AIG (212) 458-3810 ashley.behan@aig.com Craig Schioppo Marsh USA Inc. (212) 345-6492 craig.schioppo@marsh.com Bruce Engler Faegre Baker Daniels +515 447 4720 bruce.engler@faegrebd.com Michael Abbott Faegre Baker Daniels +515 447 4720 michael.abbott@faegrebd.com Prepared in connection with the Faegre Baker Daniels 2014 Iowa M&A Conference 12