INTRO: Many businesses and buyout firms still have yet to capitalize on the value of a strong, creative, and entrepreneurial insurance balance sheet supporting a transaction, but that is beginning to change, says Kevin Maloy, senior managing director, mergers and acquisitions and special practices at Crystal & Co.

For a buyer or seller, the acquisition or divestiture of any business can be fraught with potential liabilities that survive the closing. Sellers, whether entrepreneurs, private equity/investor groups or corporate, all want to facilitate a clean exit to allow for disbursement of proceeds. Buyers want to ensure that liabilities assumed are adequately accounted for and indemnified to allow for maximization of the investment without the unexpected costs associated with an unforeseen or inadequately addressed liability.

The issue of addressing the needs of both parties in a negotiation often stalls, or even derails a successful transaction. Yet, from the perspective of insurable liabilities, positions at seemingly opposite ends of the spectrum can be addressed to satisfy both parties through the utilization of insurance capital.

While not often thought of as a creative solution for transactional problems, when used effectively, insurance capital can be used to address concerns of both parties simultaneously. Most transactional underwriting markets work within accelerated timeframes, and with the understanding that no two transactions are identical.

Financially stable insurers, such as AIG, Ace, CNA, Hartford, Zurich, various Lloyd's of London syndicates, and newer Bermuda insurers are all able to provide insurance capital to address the concerns of both parties in a transaction. Creative solutions can be built around transactions of varying types, with the same goal in mind: to help facilitate a successful transaction for both parties by addressing each parties' needs related to risk.

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A corporate seller divesting an operating subsidiary, particularly a publicly-traded company, will be hesitant or even unwilling to provide any indemnification for representations made in a purchase and sale agreement, or even assign any open accruals to a buyer of the division to address open claims obligations or potential environmental liabilities. In such situations, a potential sponsor buyer will look carefully at potential obligations assumed by an investment fund or organization, as there is no seller indemnity available.

In these situations, transactional risk products can serve two purposes. The first is mitigating assumed liabilities related to a range of issues, including breaches of representations for which no seller indemnity exists, environmental liabilities, and the capping of liabilities attributable to third-party or workers compensation claims.

The second use of these risk transfer vehicles is to enhance an acquisition bid. Many sellers without knowledge of or access to these risk transfer methods will likely account for assumed transactional and operational liabilities through a reduction in the purchase price. With proper diligence, a savvy buyer can utilize insurance capital to address assumed liabilities at a fraction of the potential cost. This not only could improve a purchase price, but also enhance the balance sheet of the post-closing operating entity, improving potential rate of return.

A private equity client was under letter of intent to acquire a division of a publicly traded corporation. As is common with publicly traded sellers, seller representations were structured not to survive closing. The buying firm's investment committee was uncomfortable purchasing a division of a business without recourse.

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A buyer's representations and warranties policy was used to provide financial recourse for breaches of the seller's representation on a blanket basis at a limit of 10% of the ultimate purchase price. Coverage terms mirrored more traditional survival periods at two years for general representations, statute of limitation plus 60 days for environmental, tax, ERISA, among other things.

Investors groups, hedge funds, and private equity firms will, under most circumstances, seek to transfer all liabilities of a portfolio company at the time of exit. Under these circumstances, issues related to post-transactional operational liabilities, such as environmental liabilities and liabilities related to portfolio company obligations below casualty program retentions, will be borne by the buyer.

With respect to transactional liabilities related to the purchase agreement contract, while investor group sellers can provide some level of indemnification for the seller's representations, the closer a portfolio company is to the end of a fund, the less likely a seller is to offer long-term recourse. Transactional risk can be a very effective method to satisfy the needs of both parties in such situations.

A private equity sponsor was engaged in the sale of the final investment in one of its funds, a medical supply company to a strategic competitor. The buyers were very conservative in their approach, and were asking for indemnification up to the purchase price of the company ($20 million), including full indemnification for fraud, as well as for fines and penalties associated with failure to comply with Medicare/Medicaid billing guidelines. The client requested a potential third-party risk solution.

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Several carriers declined to quote on the risk, based on the Medicare compliance and fraud exposure. Certain Lloyd's of London syndicates were approached as a way of seeking a more creative solution. As a result, terms were secured that met the needs of both sides: A buyer's form representation and warranties policy, which provided cover to the seller in the event of fraud on the part of the buyer, as well as included coverage for fines and penalties for Medicare/Medicaid billing noncompliance, which never had been offered before within the constructs of a representation and warranties policy. A six-year term was secured for a total one-time premium of $400,000, or 2% of the limits purchased.

One of the more effective, if under-utilized areas of risk transfer is fund closure coverage. This coverage allows a private equity firm or acquisitive corporate organization to transfer the risks associated with a varied group of open indemnities associated with multiple transactions. This allows for a company to effectively accelerate financial aims related to retained legacy liabilities at a fractional expense.

A private equity firm can use this coverage to accelerate disbursement of proceeds to limited partners in a given investment fund by materially reducing, if not eliminating limited partner responsibilities related to indemnification of divested portfolio companies.

Corporations that find themselves in the position of carrying a block of transaction-related indemnities arising from prior divestitures can use fund closure coverage to move their financial obligations onto a third-party balance sheet, thus improving their own balance sheet.

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A mid-market private equity firm was nearing the end of the investment cycle of its 2003 fund. As it finalized the sale of the last portfolio company of the fund, the firm considered ways to accelerate the distribution of proceeds to its investors. The main issue preventing an accelerated fund closure was the possibility of “clawbacks” made against the investors related to open indemnifications for sellers representations of not only the last portfolio company sale of the fund, but also for several open indemnification windows for no fewer than five previously divested portfolio companies.

The solution was a fund closure policy was placed that provided coverage for all open indemnities related to transaction agreements of the fund portfolio companies, thus allowing the fund to accelerate the distribution of proceeds to the limited partners without the worry of having to approach those limited for a capital call related to a breach of a previously made indemnity. A $10 million limit of coverage was secured for a single payment of $380,000, with a term consistent with the survival period of the most recent sale.

Many businesses and buyout firms still have yet to capitalize on the value of a strong, creative, and entrepreneurial insurance balance sheet supporting a transaction, but that is beginning to change. In most instances, insurance capital can provide mutually beneficial solutions to help consummate a transaction and also assist acquisitive businesses, buyout firms, infrastructure funds, hedge funds, and charitable trusts to clear liabilities that may otherwise present financial or operational challenges to their business.

Kevin Maloy is senior managing director, mergers and acquisitions and special practices at New York-based Crystal & Co., is a private equity specialist. He can be reached at Kevin.Maloy@crystalco.com or (212) 504-5846.