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Private Equity M&A Key Deal Terms: Rollover

Equity, Bolt-On, Tuck-In and Platform Acquisitions,

Earnouts and MoreNegotiating and Structuring Private Equity M&A Transactions in a Changing Market

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THURSDAY, SEPTEMBER 5, 2019

Presenting a live 90-minute webinar with interactive Q&A

Danielle Asaad, Partner, Squire Patton Boggs, Cleveland and New York

John J. McDonald, Managing Partner, Tremont Street Partners, Greenwich, Conn.

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5

PRIVATE EQUITY M&A KEY DEAL TERMS:

ROLLOVER EQUITY, THE “BUY-AND-BUILD” STRATEGY,

EARNOUTS, SELLER PAPER, REVERSE BREAK-UP FEES AND

REP &WARRANTY INSURANCE

John McDonald

Managing Partner

Tremont Street Partners

[email protected]

Danielle Asaad

Partner

Squire Patton Boggs

[email protected]

6

STATE OF THE M&A MARKET

State of the Market

• Overall M&A activity in first half of 2019 vs. first half of 2018:

• M&A buyout activity rose 9%, with deal values equal to $913 billion – making it the best-performing first half for US M&A on record.

• M&A deal volume fell 21%, with 2,531 buyout deals.

• PE activity in first half of 2019 vs. first half of 2018:

• PE buyout activity fell 14%, with deal values equal to $111.1 billion.

• PE deal volume fell 19%, with 608 buyout deals.

• Exit activity rose 19%, with values equal to $148 billion, but volume fell 15% to 505 deals.

• Globally, dry powder has reached $2.4 trillion and fundraising figures are on pace to top 2018 with over $100 billion raised in first half of 2019.

• Median EBITDA multiples were around 11.44x in first half of 2019, compared to 13.39x in 2018 and 8.13x in 2010.

7

CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS

Current Trends and Issues: Buyout Activity

• PE buyout activity has slowed in the first half of 2019 as asset valuations and competition for quality assets continue to rise.

• PE sponsors are getting more aggressive in pre-empting auctions with certainty and speed of closing becoming key factors (in addition to price) influencing sellers in auctions.

• PE sponsors are relying on representation and warranty (R&W) insurance (discussed below) to reduce or eliminate seller indemnity or escrow requirements and distinguish their bids in competitive auction processes.

• Rising asset valuations are forcing PE firms to put in more cash in their leveraged buyouts because lenders are only willing to go so far.

• PE firms contributed 52% to the purchase price of companies they bought in Q2 2019, which is up from 45% in Q1 2019.

• This will likely translate into lower IRRs in the next five years or so for PE firms as they sell off the companies they are buying under current conditions.

• PE sponsors are relying on cheaper add-on acquisitions to counter higher platform prices or recapitalizing existing portfolio companies to hold onto them longer.

8


Current Trends and Issues: Exits

• Due to record high stock markets and the 2018 tax cuts, strategic investors have

substantial funds available to implement “buy-rather-than-build” strategies.

• Strategic buyers can exploit public-to-private EBITDA multiple differential through M&A.

• However, secondary buyouts continue to account for the bulk of PE exits as other PE

sponsors can offer a better mix of transaction speed and price than strategic buyers.

• More PE sponsors are deploying “dual-track” processes (auctions and IPOs) and increasingly exiting portfolio investments through IPOs.

• In 2018, 14% of private equity firms divested a portfolio investment by taking it public, which is up from 2% in 2017.

• Direct listings on stock markets, which enable companies to bypass the traditional IPO underwriting process, give the open market a greater role in setting the price and can provide PE sponsors with immediate liquidity for their shares, as contrasted with traditional IPOs in which existing investors are typically subject to lock-up periods.

9


Current Trends and Issues: Macroeconomic and Geopolitical Factors

• The Fed cut interest rates in July 2019 for the first time since the 2008 financial crisis and has indicated that additional rate cuts are forthcoming.

• Rate cuts made debt financing cheaper and lured investors looking for higher returns than what’s available from listed securities into private equity, adding to PE firms’ dry powder.

• Some PE sponsors are deploying dividend recaps despite the risks from the additional leverage.

• More and more PE sponsors are anticipating a downturn in the economy and are emphasizing recession planning when making platform and bolt-on acquisitions and operating their portfolio companies.

• Many PE sponsors have vivid memories of the effect of last economic downturn on their portfolio companies and don’t want to repeat that process. Lower debt-to-equity ratios could help their portfolio companies weather the storm.

• Uncertainty around geopolitical events such as Brexit and the U.S. trade war with China, combined with record high stock markets, have ratcheted up volatility.

10

INSTITUTIONAL INVESTORS’ SENTIMENTS

Institutional Investors’ Sentiments Toward Private Equity

• LP investors in PE funds are generally positive:

• 93% of LP investors felt that the performance of PE funds (as an asset class) met or exceeded their expectations over the past 12 months.

• 78% of LP investors were confident that PE fund performance will stay about the same or improve in the next 12 months relative to the previous year.

• 40% of LP investors were planning to commit more capital to PE funds in the coming year as compared to one year ago.

• But there are challenges:

• 79% of LP investors thought historically high asset valuations were a key challenge for PE firms in the coming year.

• In addition, LP investors thought that, in the coming year, PE firms will face increased competition for assets (59% of respondents), a challenging exit environment (38% of respondents) and an uncertain geopolitical landscape (33% of respondents).

* Based on information from a recent survey completed by Preqin.

11

WHAT’S TO COME?

The Remainder of 2019 and Into the Future

• Competition for deals likely to continue for PE firms as pension funds, mutual funds, sovereign wealth funds and other yield-hungry investors all pursue the same assets.

• Some institutional investors are building out their in-house investment teams and pursuing direct investments in companies without PE sponsors’ involvement.

• Co-investment rights, with reduced or eliminated fees, continue to be important to institutional investors that are seeking to deploy capital in scale.

• Competition for companies in sectors deemed more resilient to economic downturn (e.g., technology) is likely to increase even further.

• If the Fed lowers interest rates again (which it has signaled could happen in near future), PE sponsors may be able to borrow more debt at cheaper cost for buyouts.

• But macroeconomic and political concerns may affect the overall growth of PE:

• Fears of a looming recession.

• Ongoing trade dispute between the US and China.

• Increasingly tougher CFIUS regulatory scrutiny of international acquirers of US businesses.

• Uncertainty about timing of Brexit and Trump re-election.

12

KEY TERMS IN PRIVATE EQUITY M&A –ROLLOVER EQUITY

Rollover Equity - Introduction

• To enhance alignment of interests between the PE sponsor and the portfolio

company’s management team and increase their “skin in the game,” PE sponsors

often require management team members to roll over some of their existing equity,

rather than permitting them to “cash out” all of their target company holdings in the

buyout.

• Target management team members exchange a portion of their equity in the target

company for equity in the PE sponsor’s acquisition vehicle, which is usually a newly-

created parent company of the target company.

• Rollover equity meaningfully reduces the size of the PE sponsor’s equity check for

the acquisition, enabling it to invest its fund’s capital across a broader range of

portfolio companies, enhancing diversification for the PE fund.

• Rollover equity requires management teams to take ownership of the higher

valuations for target companies that they advocated in the sale process, while

creating an additional means of wealth creation for them upon exit if their projected

valuations of the target company are actually realized.

13


Amount of Rollover Equity

• Amount of equity rolled over by the target management team in a particular buyout

transaction varies depending on:

• Available debt financing for the buyout and resulting need for the PE sponsor to fill any gap in the capital stack for the acquisition.

• Amount of equity financing that the PE sponsor is willing to commit to the buyout and the ownership dilution in the resulting portfolio company that the PE sponsor is willing to accept due to the rollover equity.

• Scale of holdings of target company equity by management team members, as opposed to non-management target company equityholders (e.g., venture capital firms).

• Any co-investment by management team members (i.e., new money invested) in connection with the buyout, in addition to their rollover equity.

• Expected tax treatment of the rollover equity (typically structured to be tax-free rollover).

• Management team members typically rollover into 15-25% of the equity of the

portfolio company’s post-buyout equity.

14


Rollover Equity – Tax-Deferred Treatment

• A key structuring issue in any rollover is whether it can be accomplished on a tax-

free basis, so management stockholders are not taxed upon exchange of their

existing target company equity for portfolio company equity.

• PE sponsors typically structure buyouts to enable tax-free rollover for sellers.

• Successful tax-free rollover defers (but doesn’t permanently eliminate) capital gains

taxes resulting from appreciation in value from the management team members’

original acquisition prices for their target company equity until the subsequent

liquidity event for their portfolio company equity.

• Capital gains taxes are deferred (but not permanently eliminated) because the

management team members receive a carry-over tax basis in their portfolio

company equity issued in the rollover exchange.

• Management team members use that carry-over tax basis (subject to any

adjustments during their ownership period) to determine their taxable gain or loss

upon sale of their portfolio company equity in the subsequent liquidity event.

15


Equity Securities Received in the Rollover

• In buyout transactions, PE sponsors usually receive a combination of common

equity and preferred equity or a single class of participating preferred equity.

• Preferred equity has liquidation preference ahead of common equity.

• Participating preferred shares pro rata with common equity in proceeds upon sale or liquidation of the company after payment of its liquidation preference.

• Management team members often receive the same equity securities in the portfolio

company via the rollover as the PE sponsor holds. This is distinct from incentive

equity that management team members receive without being required to pay for it,

which is typically common equity.

• Management team members are usually required to execute a stockholders

agreement or LLC operating agreement subjecting their rollover equity to right of

first refusal, tag-along, drag-along and other transfer and voting restrictions, as well

as subjecting them to restrictive covenants like non-competes and non-solicits.

• Rollover equity is sometimes subject to vesting requirements.

16

KEY TERMS IN PRIVATE EQUITY M&A –THE “BUY-AND-BUILD” STRATEGY

The “Buy-and-Build” Strategy Employed by PE Sponsors

• Initial purchase by the PE sponsor of a “platform” company, followed by the

purchase of multiple (typically at least four) related and complementary companies

or businesses by that portfolio company through “add-on” acquisitions.

• “Bolt-on” or “tuck-in” acquisitions typically involve smaller target companies or single

product lines, divisions or operating assets, but the usage is not uniform.

• Buy-and-build strategy can be an attractive alternative to pursuing potentially slow,

expensive and cumbersome organic growth of a portfolio company.

• Smaller add-on companies often sell at lower EBITDA multiples than the larger

portfolio companies, making them attractive targets and enabling PE sponsors to

benefit from EBITDA multiple arbitrage.

• Increasingly popular because PE sponsors can pay higher prices in competitive

processes due to operating synergies between platform and add-on companies.

• Approximately 46% of total PE deals so far in 2019 were add-on acquisitions. By

comparison, roughly 36% of PE deals in 2018 were add-on acquisitions.

17


Why Has the “Buy-and-Build” Strategy Become So Popular Lately?

• It can enable PE sponsors to compete with strategic buyers in increasingly

competitive markets for target companies by emphasizing potential synergies and

efficiencies of scale following combination of a platform company with

complementary add-on, bolt-on or tuck-in companies.

• It is a way for PE sponsors to put their increasingly large stores of “dry powder”

capital to work and deploy an EBITDA multiple arbitrage strategy.

• Add-on acquisitions tend to be completed at relatively lower EBITDA multiples than platform

company acquisitions, which can help “average down” a high EBITDA multiple paid by a PE

sponsor for a platform company.

• Upon exit, the PE sponsor sells the portfolio company (which includes the platform company

and the add-on companies) for a greater EBITDA multiple than the sum of its parts.

• PE sponsors can use add-on acquisitions of companies with complementary

products or geographical distribution areas to diversify their platform companies’

offerings and acquisitions of suppliers or distributors to vertically integrate them,

helping to hedge against a coming recession.

18


The Benefits of Implementing a “Buy-and-Build” Strategy

• A buy-and-build strategy works especially well in fragmented industries with no clear market leader, as building larger and more efficient companies quickly (rather than organically) becomes a way to speed growth and increase returns upon exit.

• Cost Synergies:

• Combining multiple add-on companies with a platform company can reduce total overhead

costs and streamline and improve operational processes following integration of HR,

technology and back-office processes.

• Acquiring suppliers can help platform companies vertically integrate, capturing mark-ups on

raw materials and ensuring more reliable sourcing and consistent product quality.

• Revenue Synergies:

• Combining multiple add-on companies with a platform company can help grow revenue by

expanding product line coverage, increasing addressable markets in broader geographies

and implementing cross-selling strategies among the companies.

• Acquiring other market participants can help reduce competition and pricing pressures,

increasing profits for platform companies, but keep in mind antitrust concerns.

19


Requirements for Implementing a “Buy-and-Build” Strategy

• The market sector should:

• Be fragmented with a sufficient number of potential targets of the right size (i.e., smaller

than the platform company, but not so small that acquiring them doesn’t add value).

• Have a stable environment in which to pursue targets (i.e., not cyclical).

• The platform company should have a strong management team experienced in

integrating acquisitions, a robust balance sheet that can handle additional debt,

repeatable financial performance, and operational assets like IT systems and

distribution and sales networks that are set up to scale upon expansion.

• Typical target companies for add-on, bolt-on and tuck-in acquisitions consist of:

• Smaller stand-alone companies or product lines or divisions of larger companies.

• Fast-growing small companies that can use access to capital and operational expertise.

• Financially troubled companies with good products looking for a last-chance deal.

• Smaller businesses with particular products that are dominant in a niche market.

• Larger companies carving-out divisions or divesting subsidiaries not central to their growth

strategy.

20


Effects of PE Sponsors Employing “Buy-and-Build” Strategies

• In an incredibly competitive market for quality acquisition targets in which valuations

are at an all-time high, add-on acquisitions can be the only way for PE sponsors to

compete with strategic buyers and deploy their capital.

• Add-on acquisitions currently account for roughly half of all transactions by PE

sponsors globally and more than two-thirds in the US.

• The median add-on deal size in North America and Europe has almost doubled in

the span of the last two years.

• $41 million median in 2016 vs. $75.8 million in 2018.

• The median add-on deal size in 2018 ($75.8 million) is actually higher than the

median platform buyout deal size from 2012 ($71.7 million).

• Median time to exit tends to be about one year longer for portfolio companies that

complete at least one add-on acquisition. With the rise of add-on acquisitions, hold

times of PE-backed companies have increased to about five years on a median

basis (which is up from three to four years prior to 2008).

21


Top Ten Mistakes to Avoid When Implementing a “Buy-and-Build” Strategy

1. Failing to consider and plan for future add-on acquisitions when structuring the initial

acquisition of the platform company.

2. Relying on a platform company management team that does not have sufficient

acquisition and integration experience or is not fully supportive of the overall buy-and-

build strategy.

3. Trying to save money by having platform company management conduct legal and

business due diligence in-house, rather than using the PE sponsor’s advisors.

4. Overestimating the projected cost savings from realizing operational synergies

among the platform company and add-on companies by not taking into account the

costs associated with realizing these savings (e.g., severance costs).

5. Failing to properly incorporate the costs associated with integrating the employment

practices, policies and procedures of the platform company and add-on companies

(e.g., employee benefit and retirement plans).

22


Top Ten Mistakes to Avoid When Implementing a “Buy-and-Build” Strategy (con’t)

6. Failing to consider existing management arrangements at the platform company

when planning for treatment of add-on company management teams.

7. Assuming that antitrust review of add-on acquisitions will be minimal, when there

may be competition-reducing aspects that need to be considered.

8. Failing to consider effect of the add-on acquisition on the platform company and not

ensuring that the add-on company offers compatible products or services that don’t

undermine the performance or reputation of the platform company.

9. Waiting to put together an integration team and develop an integration plan for the

add-on company until after the acquisition is completed or having an integration plan

with unrealistic expectations and deadlines.

10. Letting price be the deciding factor for an add-on acquisition, ignoring problems

identified during due diligence and not walking away at the point when the

transaction no longer makes sense.

23

KEY TERMS IN PRIVATE EQUITY M&A –EARNOUTS

Earnouts Generally

• Earnouts are a mechanism used in M&A transactions where there is a gap between

the buyer’s and seller’s beliefs about the valuation of the target company.

• A portion of the purchase price is determined based on the financial performance of

the target company over a specified time period after closing of the acquisition.

• Can be attractive to PE sponsors because they help reduce risk of overpaying by

calibrating purchase price to actual financial performance of the target company.

• Typically structured as one or more contingent payments of purchase price payable after the

closing of the acquisition if specified earnout targets are satisfied within specified periods.

• If the target company fails to achieve the earnout targets within the specified periods, the

buyer either isn’t required to make the earnout payments at all or they are paid in smaller

amounts.

• In addition to addressing valuation gaps, earnouts also act as a form of seller

financing, in which the buyer effectively pays the purchase price to the sellers out of

the profits of the acquired company. That can be attractive because it reduces the

size of the PE sponsor’s equity check for the acquisition.

24


Earnout Period, Timing and Payment

• Length of the earnout period after closing of the acquisition is subject to negotiation

by the parties based on the target company’s business. Most earnouts last from 1

to 3 years after closing, but there are earnouts with shorter or longer periods.

• The amount of the earnout payments can be:

• A fixed dollar amount if the earnout target is met; if there are multiple earnout payments,

their amounts can be increased, decreased or kept constant during the earnout period.

• A multiple of the amount by which the target company’s performance exceeds the earnout

target.

• A percentage of the earnout target amount (for example, a percentage of an EBITDA target).

• Determined using another agreed-upon formula or method.

• Sometimes, missing an earnout target results in no earnout payment at all, while in

other cases earnout payments are proportional to actual vs. target performance.

• There are sometimes “catch-up” or “aggregation” concepts, in which the seller

receives an earnout payment if the target company’s performance in subsequent

earnout periods overcomes shortfalls in earlier periods.

25


Acceleration and Buyout of Earnouts

• Acceleration provisions cause all earnout payments to become immediately due

upon the occurrence of certain events before the end of the earnout period, such as:

• Sale of the target company or a substantial amount of its assets.

• Breach by the buyer of covenants relating to post-closing operation of the target business.

• Termination by the buyer of target company employees (but note that this can have adverse

tax consequences for the seller).

• Bankruptcy or insolvency of the buyer.

• These types of acceleration provisions protect the seller from changes that

adversely affect the target company's ability to satisfy the earnout targets or the

buyer’s ability to make the earnout payments when they become due.

• Earnout buyout provisions enable the buyer to pay a specified amount to satisfy all

of its remaining earnout payment obligations to the seller, which can be useful when

a buyer wants to sell the target company before the end of the earn-out period and

would like to avoid having to work around seller earnout rights that can impede the

sale process.

26


Avoiding Earnout Disputes

• A Delaware Chancery Court judge once remarked that earnouts “convert today’s

disagreement over price into tomorrow’s litigation over the outcome.” As a result,

great care needs to be used in defining the events that will result in earnout

payments to help avoid subsequent disputes.

• Parties can help avoid disputes by clearly stating in the purchase agreement the

accounting methodology that will be used in calculating any financial earnout targets

and attaching example calculations showing the earnout payment amounts under

different scenarios.

• Some other key issues to address in order to avoid earnout disputes include:

• The buyer’s obligation to support the target company during the earnout period by, for

example, making capital expenditures and/or routing business toward the target company.

• Any decision-making rights given to the seller regarding operation of the target company

business during the earnout period.

• Whether the target company’s operations must be conducted by the buyer in the same

manner during the earnout period as they were by the seller prior to closing of the

acquisition.

27

KEY TERMS IN PRIVATE EQUITY M&A –SELLER PAPER

Seller Paper Generally

• Seller paper is promissory notes issued by the target company to the seller as part

of the purchase consideration in an acquisition.

• Although seller paper can be a primary financing source for an acquisition, it is more

typically mezzanine debt financing that is a part of the capital stack constructed by a

PE sponsor for the acquisition, which is subordinated to the senior debt financing

obtained from an institutional lender.

• Seller paper can help facilitate M&A transactions by:

• Filling the gap between purchase price and amount of senior debt financing available.

• “Stretching” the purchase price beyond fair market value, while minimizing the risks to the

buyer and its financing sources.

• Helping incentivize the seller to stay actively engaged in the target company business after

the closing.

• Enabling the seller to defer taxes on a portion of the purchase price into future tax years

when its marginal tax rate is lower.

• Subordination provisions and default remedies are particularly important to sellers.

28

KEY TERMS IN PRIVATE EQUITY M&A –SELLER PAPER

Typical Seller Paper Terms

• PE sponsors often advocate use of seller paper by noting that it can provide the

seller with an attractive interest rate, as compared to other investments

opportunities in today’s low interest rate environment, which will be repaid by a

business that the seller knows very well.

• Typical terms of seller paper include:

• Seller paper is typically unsecured and is subordinated to the senior debt for the acquisition.

• However, monthly interest and sometimes principal payments can typically be made on the

seller paper as long as no event of default has occurred under the senior debt financing for

the acquisition.

• Typically constitutes 10% to 40% of the total purchase price paid by the PE sponsor for the

target company.

• Interest rates on seller paper are typically comparable to unsecured mezzanine debt: 6-10%

per annum.

• Maturity of seller paper is often the same as the senior debt financing for the acquisition: 5-7

years after closing, subject to acceleration upon a subsequent sale of the target company.

29

KEY TERMS IN PRIVATE EQUITY M&A –REVERSE BREAK-UP FEES

Reverse Break-Up Fees Generally

• Purchase agreements typically address the possibility of the buyer failing to close

the transaction. To guard against this failure and compensate the seller for a breach

by the buyer, the parties typically negotiate two sets of remedies:

• A pre-termination enforcement remedy, enabling the seller to force the buyer to perform its obligation under the purchase agreement to close the deal (“specific performance”).

• A post-termination monetary remedy entitling the seller to receive from the buyer either its actual damages incurred or an agreed-upon reverse break-up fee payment.

• Reverse break-up fees are typically triggered when the transaction fails to close

because of the buyer’s breach or its failure to obtain the necessary financing or

receive necessary antitrust or other regulatory approvals.

• Reverse break-up fees must be considered in conjunction with other remedies

provided in the purchase agreement, especially specific performance.

• Buyer-Friendly: The reverse break-up fee is payable only if there is a financing failure and,

once paid, the fee is the seller's sole remedy, even for the buyer’s willful breach.

• Seller-Friendly: The reverse break-up fee is payable only if there is a financing failure and

only limits the buyer's liability for such failure. The buyer remains liable for its willful breach.

30


Two-Tier Reverse Break-Up Fees

• Provide a lower reverse break-up fee that is payable in the event of a financing failure and a higher reverse break-up fee that is payable for a breach by the buyer when the financing is available or for all other breaches by the buyer.

• If there is no specific performance, the buyer has a “pure option” to decline to close the transaction, knowing that its exposure is capped.

• The seller must sue and affirmatively prove damages beyond the reverse break-up fee in order to obtain the higher damages amount.

• To ensure that the buyer uses appropriate efforts to obtain the financing and close the transaction, the seller should consider the following strategies:

• Tighten the buyer's financing covenants in the purchase agreement.

• Include a right in the remedies section or the financing covenants of the purchase

agreement entitling the seller to force the buyer to pursue litigation against the lenders if

they fail to fund.

• Make sure that payment by the buyer to the seller of the (lower) reverse break-up fee as the

seller’s sole and exclusive remedy is conditioned on the unavailability of the financing and

not merely that the buyer did not receive the proceeds of the financing.

31


Drafting the Operative Provisions for Reverse Break-Up Fees

• When drafting purchase agreements and other transaction documents for M&A

deals that include reverse break-up fees (e.g., PE sponsor equity commitment

letters, debt finance commitment letters), counsel should pay particular attention to:

• Representations and warranties concerning the buyer’s financing (e.g., debt and equity commitment letters).

• Covenants requiring parties to take actions between signing and closing of the transaction to facilitate the buyer obtaining the necessary financing and obtain governmental approvals.

• Closing conditions.

• Termination provisions.

• Remedies provisions (particularly provisions concerning equitable remedies such as specific performance).

• Third-party beneficiaries provisions.

• It is extremely important for counsel to draft the language in each section not just

individually, but as parts of a system in which the provisions need to work together

to result in the desired outcome, as cases have been litigated in this area in which

the outcome was determined by relatively minor language differences.

32

KEY TERMS IN PRIVATE EQUITY M&A –R&W INSURANCE

Rep & Warranty Insurance – Policy Terms

• Coverage: R&W insurance covers losses resulting from unknown breaches of

representations and warranties made by the seller or the target company in the

purchase agreement, as well as target company pre-closing taxes, third party claims

and defense costs.

• Policy Limits (Cap): Generally, 10% to 15% of target company enterprise value.

• Retention (Deductible): Generally, 1.0% to 1.5% of enterprise value (below 1.0%

tends to be for larger deals), but often dropping to 0.5% 12 months after the closing.

• Policy Period (Survival): Generally, 3 years for “general” representations and

warranties and 6 years for “fundamental” representations and warranties and tax

representations and warranties.

• Policy Costs:

• Premium: generally 2% to 4% of policy limits.

• State Taxes: generally 2% to 4% of premium amount.

• Underwriting Fee: generally $15,000 to $50,000 (covers carrier’s legal counsel costs).

33


How the Rep & Warranty Insurance Market has Evolved

2007 2018

Overall Market Around 5 underwriters 19+ underwriters

Premium 5% to 7%

of policy limits

2% to 4%

of policy limits

Retention 2% to 3%

of enterprise value

1.0% to 1.5%

of enterprise value

Exclusions Many ‘standard’

exclusions

Limited exclusions and

many can be narrowly

tailored

Underwriting process Very slow Can be completed as

quickly as a few days

34


Advantages of Rep & Warranty Insurance for Buyers

• Makes buyer’s bids more attractive to sellers in competitive auction processes

because it reduces or eliminates the seller’s post-closing liability to the buyer.

• Can provide the buyer with a broader scope or longer durational protection for

breaches of representations and warranties than they would otherwise have.

• Can ease collection concerns associated with the seller’s credit worthiness or other

circumstances (i.e., status as a PE fund, cross-border deals).

• In deals where target company management team rolled over equity into the

portfolio company, can reduce distraction/friction from the PE sponsor making

indemnity claims against management team selling stockholders.

Advantages of Rep & Warranty Insurance for Sellers

• Can expedite the sale process, by making it easier for the parties to negotiate the

representations and warranties in the purchase agreement.

• Can reduce or eliminate post-closing indemnity obligations for the seller.

• Can lead to shorter timeframe for PE sponsors to close out their funds.

35


Exclusions under Rep & Warranty Insurance

• Typical Exclusions:

• Breaches that are actually known at signing and interim breaches of representations that

arise due to changes in the target company business between signing and closing.

• Fraud by the seller or the buyer.

• Purchase price adjustments.

• Breaches of covenants.

• Civil or criminal fines or penalties, including violations of sanctions.

• Other Exclusions (some of which can be negotiated or limited):

• Underfunded pension obligations.

• Medicare and Medicaid billing.

• Environmental and asbestos liabilities.

• Net operating losses and tax attributes.

• Employee and independent contractor misclassification.

• Consequential and Multiplied Damages: Usually not excluded under the R&W

insurance policy as long as the purchase agreement is silent about them.

36


The Rise of the “No Seller Recourse” Deal

• Historically, R&W insurers required both the buyer and the seller in M&A

transactions to have “skin in the game.”

• The retention would be “split” between the buyer and the seller, with the buyer taking the

first half of the retention as a non-tipping basket under the purchase agreement and the

seller indemnifying the buyer for the remainder of the retention through a small escrow.

• There has been an increase recently in deals using R&W insurance as the buyer’s

sole remedy, particularly in transactions with deal values in excess of $200 million.

• In this structure, the seller has no indemnification liability for R&W breaches and the buyer

bears full responsibility for the retention and looks solely to the insurer to recover losses.

• Also, typically the seller will not provide a stand-alone indemnity for damages in excess of

the R&W insurance policy for pre-closing taxes or for matters excluded under the policy.

• Despite the added risk, many R&W insurers are offering substantially the same policy terms,

with only a modest increase in premium and/or retention to reflect the increased risk and the

added seller moral hazard resulting from the no-seller recourse structure.

37


AIG 2019 R&W Insurance Claims Study

• AIG reported an increase in claims frequency under R&W insurance policies.

• In 2017, for policies issued between 2011 and 2014, an average of 14% of policies

had a reported claim (or 1 in 7).

• In 2018, for the same policies, the average became 21% (or 1 in 5).

• In 2018, for policies issued between 2011 and 2015, an average of 18% of policies

had a reported claim.

• Deals worth over $1 billion had an average of 23% of policies with reported claims.

• Top claims are for breaches of representations and warranties related to:

• 20% - Financial Statements: accounting rules breaches, misstatement of accounts

receivable/payable and undisclosed liabilities

• 15% - Compliance with Laws

• 14% - Material Contracts

• 14% - Taxes

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