Warranty and indemnity insurance may remain a staple of European private equity, but are buyers changing course?
By Neil Campbell, Tom D. Evans, Sebastian Pauls, Maximilian Platzer, David J. Walker, Edward Coates, and Catherine Campbell
Warranty and indemnity (W&I) insurance has become an important component of European PE transactions in recent years. However, changing market dynamics and challenging macro conditions (which have cooled deal flow) mean that PE buyers are now more critically evaluating the merits of W&I insurance. The Eighth edition of the Latham & Watkins Private Equity Market Study indicates that the overall uptake of W&I insurance is beginning to plateau, having increased significantly between 2016 and 2019. From a high of 35%, overall usage of W&I insurance in European deals has dropped in the past two consecutive years.
As W&I insurance has matured and PE buyers have become more experienced consumers of the insurance (and of low or nominal liability caps for warranties), the emerging picture is one of a product with a nuanced value. Increasingly, deal-specific characteristics, structures, and issues are playing a role in the demand for and success of W&I insurance, including appetite for stapled policies.
Why seek a hard-stapled W&I policy?
Hot M&A markets led to expedited timetables, with the seller and its advisors typically seeking to frontload deal workstreams. This may include negotiating a hard-stapled W&I policy on behalf of the eventual successful bidder and aligning the commercial warranties with such policy — giving bidders comfort on their level of protection and the costs involved, and reducing the time required to finalise not only the policy, but also the catalogue of commercial warranties.
The attraction? More bidder comfort, more bidders, higher price, better seller terms, and a shorter sale process ultimately allowing sellers to receive their proceeds sooner. Further, the ability to negotiate the W&I policy and align it with a broader set of commercial warranties is advantageous in jurisdictions such as Germany, where discussions around sellers’ uncapped personally liability (for willful misconduct or similar) may otherwise arise.
Why are buyers pushing back?
A key challenge with hard-stapled W&I policies remains the cost — sellers cannot guarantee that the successful bidder will ultimately take out the policy provided, with the result that upfront costs will sit with the seller and the sell-side (including the target’s management team) will have wasted substantial time. Further, the benefits of frontloading processes with a hard-staple W&I policy are arguably becoming less important in the current market, where expedited timetables are more open to challenge by buyers favouring additional in-depth diligence processes before committing. Buyers are also becoming increasingly comfortable arranging W&I coverage after the deal has been signed and frequently have their own broker relationships.
In the current UK market, hard-stapled W&I is more typically seen on transactions where sector or deal-specific risks require bespoke W&I solutions, which are best considered by sellers at an early stage. In the majority of deals however, “soft-stapled” W&I remains the favoured approach, i.e., providing indicative W&I pricing and terms to bidders from a select number of underwriters, but leaving the negotiation and finalising of a policy to the successful bidder (and providing flexibility to the bidder whilst minimising the sell-side’s involvement and cost exposure to the W&I process). This remains the case, despite market momentum shifts in 2022. The picture in Germany is largely similar to the UK, with most deals favouring soft-stapled W&I — although recent deals have shown that bidders are typically comfortable accepting a hard-stapled W&I approach, if proposed.
Increasingly buyers are opting to forgo W&I insurance altogether — instead accepting that they will have no recourse against the sellers and choosing to spend the W&I premium costs elsewhere, while relying on the disclosure process, taking comfort from management roll-over / sellers reinvestment, and assessing / pricing any issues as they come to light. Despite the current slowdown, we expect stapled W&I insurance to remain a feature of European PE in the coming years. However, W&I insurance is not a panacea for all transactions, and dealmakers should structure processes accordingly.
— The seller approaches a broker and works with them to select an underwriter.
— A W&I policy is substantially negotiated and the underwriting process is initiated and advanced with that underwriter.
— The policy is presented to bidders as part of a “package” that they must agree to take out as part of the transaction.
— The broker produces a “non-binding indication” (NBI) from the underwriters’ responses, summarising the likely pricing, terms and coverage options available to bidders.
— A bidder who wishes to pursue a W&I policy must work with the broker to select an underwriter, and then negotiate the policy.