No matter how thorough the due diligence is prior to a merger or acquisition, sometimes deals go awry, such as when the post-acquisition revenue falls short of projections or the buyer incurs successor liability exposures such as unpaid income taxes or undetected environmental contamination.
Such complications can be especially hard on middle-market companies, which today are investing more of their own capital into mergers and acquisitions to ensure the investments yield attractive returns, sources say.
While M&A activity may have slowed during the first half of 2013, dealmakers expect an uptick in the second half as the economy improves, according to a recent online poll by Deloitte L.L.P., the New York-based firm that provides audit, financial advisory, tax and consulting services.
Though transactions in the middle market — valued at $1 billion or less — dropped 5% in this year's second quarter from the first quarter, 76% of the 1,800 professionals responding to Deloitte's survey in May said they were significantly optimistic about the M&A market for the remainder of the year.
As deal activity picks up, there is often a concurrent uptick in post-transaction litigation alleging misrepresentation. However, there are transactional risk insurance products to mitigate these post-acquisition exposures, often obviating the need to a file a breach of contract suit.
“In most purchase and sale agreements, the seller is going to make representations about the business,” said Kevin Maloy, senior managing director at Crystal & Co. in New York. “These include disclosures of all known liabilities, that the business is in compliance with state and federal tax regulations, isn't violating any environmental laws, that its insurance is adequate. The buyer, in turn, may ask to be indemnified for any unintentional breaches of those representations.”
This request can be satisfied either by depositing funds into an escrow account that can be used to indemnify the buyer for any liabilities that arise after the transaction, or through the purchase of transactional risk insurance, he said.
He described one scenario in which an unidentified private equity buyer's environmental diligence revealed that a site adjacent to the seller's main metal stamping facility had been ordered by a state agency to remediate its site due to releases of various hazardous chemicals. As a result, the business declared bankruptcy, but the buyer was concerned that if the pollution migrated off-site, either the state or third parties would make a claim against the business.
Because the seller was not willing to provide escrow for the issue, Crystal & Co. arranged an environmental insurance policy for a one-time premium of $105,000 that provided 10 years of pre-existing coverage for the site, including defense cost coverage for claims arising from third parties, including local, state or federal government agencies. By providing the $10 million of coverage, the deal closed because the buyer was confident there was an A-rated asset in place to deal with potential liabilities and the seller was not burdened by a long-term indemnification obligation.
Peter Rosen, a partner who heads the insurance coverage practice group at Latham & Watkins L.L.P. in Los Angeles, said he is seeing an increased interest among both buyers and sellers in transactional risk insurance to mitigate any downside risks stemming from deal activity.
“We have done a fair amount of placement transactions on behalf of our various corporate and finance clients on both the buy and sell side,” he said. “Let's say you're a private equity firm, and you made some representations and warranties and want to backstop with a policy so that if there is a claim, you don't have to deal with it any more from a financial standpoint. You've now passed the downside risk onto the carrier, and you can essentially close your books on the transaction.”
Jay Rittberg, vice president for mergers and acquisitions insurance at American International Group Inc. in New York, said the coverage also covers losses or liabilities stemming from criminal or fraudulent activity discovered after a deal closes.
“The seller is making representations that their company is complying with the laws, but there is someone in the business who has committed a crime or acted fraudulently,'' Mr. Rittberg said. “That can lead to losses for the buyer after the deal closes. There could be liabilities related to the actions of the bad actor. The (representations and) warranty policy would respond.”
Henry Jennings, senior vice president at Lockton Cos. L.L.C. in New York, said he recently used a transactional risk insurance product to protect the interests of a bank that financed a sale of a property where an underground storage tank had once been buried.
“The bank that financed the deal wanted an environmental liability policy. The underground storage tank was taken out, but it was unclear whether it was done clean,” Mr. Jennings said.
Likewise, Mr. Jennings said he placed legal contingency insurance to contain potential liability costs associated with open litigation.
“The selling company may have insurance, but the limits may not be sufficient for the buyer to feel comfortable if there is an adverse outcome,” he said.