One way in which private equity funds ease the concerns of management and help induce them to give warranties is through the use of Warranty and Indemnity (W&I) insurance. A W&I policy transfers the risk from the managers to an insurer and allows the managers’ liability to be capped down to a low level in the SPA / Warranty Deed.

W&I insurance is not immune from the moral hazard risk that affects many types of insurance. For W&I insurers, the risk they face is that the management warrantors will be willing to take greater risks as the cost of such risk is borne by the insurer.

A thorough due diligence and disclosure process can be onerous. As such, if management has little or no liability under the SPA, managers may not be incentivized to carry out a thorough and potentially cumbersome disclosure process. This leads to the risk that known issues will not come to the attention of the buyer or the insurer. As W&I insurance is only designed to cover the ‘unknowns’, a sloppy disclosure process leaves insurers vulnerable to covering known but undisclosed risks.

A disclosure process can be onerous - W&I insurance is not immune from moral hazard risk

Management Warranties The perils of moral hazard It is well known by buyers that private equity sellers do not like to give warranties. As such, in the context of private equity transactions, the task of providing warranties often falls to the target’s management team. Understandably, managers may be anxious about remaining ‘on the hook’ for a potentially large liability, particularly when they are not receiving a significant amount of equity from the transaction.

Nonetheless, there are a number of ways in which insurers can get comfortable with management having low or no liability. The key point for W&I insurers is that they want to see that a thorough due diligence and disclosure process has been undertaken. The process should be conducted on an arm’s length basis as if the insurance was not being put in place. The particular dynamics of the deal will also impact an insurer’s view of the situation. For example, insurers gain comfort where:

1. The liability cap is low but not so low as to be meaningless to management. Typically, insurers like to see management on the hook for at least 1-2 times salary; or

2. Management is not receiving any consideration from the transaction but they are staying on with the target post completion and therefore aligned with the buyer.

There are limited circumstances in which insurers will be prepared to go one step further and provide cover for nil recourse transactions from which the management is receiving relatively significant cash. However, it should be stressed that insurers are hesitant to provide such cover and will only do so in circumstances where it is clear that a thorough disclosure process has been undertaken. Further, in these situations, insurers will expect a reasonable deductible to apply to the policy (in the region of a fixed 0.5-1% of the enterprise value), thereby incentivizing the buyer to fully establish the facts upfront on the basis it will be exposed to the deductible in the event of a claim. The final point to bear in mind is that if management’s non-disclosure of known risks amounts to fraud then, notwithstanding the £1 cap for management, the buyer will still be able to claim. In such a situation the insurer also has the right to subrogate against the warrantor, which means that the insurer can pursue the warrantor to recover the losses it has paid out under the W&I Policy as a result of the warrantor’s fraud.

W&I insurance can be of great assistance in getting management comfortable with giving warranties by greatly reducing their liability. However, the transfer of risk from management to the insurer does raise some concerns for insurers with respect to the conduct of the disclosure process. It should also be noted that prospective buyers may share insurers’ concerns, in that reduced liability for management may diminish the primary purpose of warranties – to elicit disclosure to allow the buyer to pay the appropriate price. As such, when considering the use of W&I insurance in the private equity context, it is helpful to bear the following in mind: (i) if management is taking significant equity from the deal, insurers like to see that management is on the hook for at least a portion of this equity; and (ii) it is of paramount importance that the insurers can see that a thorough and robust due diligence and disclosure process has been undertaken.

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Richard French & Caroline Rowlands Howden’s Mergers & Acquisitions team provides specialist insurance solutions for M&A risks

Caroline

Caroline is an Associate (Solicitor) in Howden’s M&A team. Before joining Howden, she qualified as a solicitor in a leading City law firm and has a BA in Law from the University of Cambridge.

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Richard

Richard is a founder and Director in Howden’s M&A team. Richard has a BsC in Economics from the University of Bristol.