Transactional Insurance:A Deal Tool Whose Time Has Come

August 2012 • Lockton Companies

MICHAEL P. LUSKPartner

Private Equity Industry Group312.849.8219

mlusk@mcquirewoods.com

CASEY C. ZGUTOWICZ Producer

312.498.9801casey.zgutowicz@lockton.com

Transactional insurance—such as representations and warranties, tax liability, legal contingency, and environmental liability insurance—first came to U.S. markets in the late ‘90s. Prematurely, some would say and, perhaps, rightly so.

Back then, the premiums tended to be high, the coverage, narrow. Underwriting often could not keep apace with the underlying transaction. How it worked seemed mysterious. As a result, many people in the mergers and acquisitions arena came to view it as something to be used only when all else failed.

But since those days, transactional insurance has grown up: Premiums are now lower while coverage is broader and on more favorable terms. Underwriting moves along at a much faster clip. What transactional insurance does and does not do are better understood. This could not have come at a better time for private equity funds.

Current Market Forces

In today’s competitive environment, private equity funds are in the fight of their lives. And now, more than ever, they should consider transactional insurance as another tool close at hand rather than an extreme measure.

One area where transactional insurance proves effective is in exit transactions generally and in secondary buyouts specifically. We expect

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more and more secondary buyouts to happen during the next few years. Many forces will drive this. Fund managers are trying to raise as many funds as were raised in 2007 at a time when investors are somewhat tight-fisted. To be competitive in this market, many of those managers urgently need their existing funds to make new investments or to exit older deals. To do so is no small feat.

Funds nearing the end of their life cycle need to sell some 3,400 portfolio companies bought from 2005-2008. U.S. private equity funds have a capital overhang of more than $430 billion that they are trying to deploy before their investment periods end. This is where secondary buyouts come in to provide some relief. And yet those buyouts can, and often do, have risk allocation issues proving difficult to solve. The fund buyer will want a market risk allocation package (i.e., survival periods, indemnities, escrows, and the like). The fund seller will want, if not need, to distribute maximum deal proceeds with minimal risk of indemnity claims or general partner clawback payments. This will translate into seller demands for short (if any) survival periods and no escrows or holdbacks. The parties end up at loggerheads. Here—or even before things reach this point—the seller should consider purchasing transactional insurance to solve risk allocation problems.

Basic Deal Tools

Two of the most frequently considered products are representations and warranties insurance and environmental liability insurance. Transactional insurance products such as these can enhance the efficiency of a transaction and provide benefits to both buyer and seller, including:

Representations and warranties insurance can be used to:

� Replace an indemnity—allows seller to make distribution or realize sale proceeds sooner without trailing liabilities.

� Attach excess of an indemnity—enhances indemnity or escrow.

� Backstop to an indemnity—ensures payment under the indemnity.

� Extend the timeframe of an indemnity—allows seller to recover escrowed amounts more quickly.

So, with these benefits now outlined from both perspectives, would you as a buyer, seller, or interested party find value in considering such a product?

You might be asking yourself: What is the risk that a rep and/or warranty wasn’t accurate? And if so, what type of exposure may it have to my company and/or me personally? Truth be told, claims happen and when they do they can be costly. Anecdotal evidence from escrow agents with whom we work suggests that the frequency and size of indemnity claims have increased since 2008.

Reps and warranties insurance protects

a party from financial losses resulting

from inaccuracies/breaches in the reps or

warranties made about the target company

or business in connection with transactions,

including mergers, acquisitions, financings

investments, and divestitures.

Buye

rs

� Enhance protection for known or unknown liabilities.

� Extend duration of the indemnity for known or unknown liabilities.

� Ease concerns about the Seller’s ability to pay under the indemnity.

� Distinguish a bid in an auction.

� Protect key relationships.

Selle

rs

� Reduce contingent liabilities.

� Distribute sale proceeds.

� Expedite sale/increase purchase price.

� Protect passive sellers.

� Address differing shareholder interests.

August 2012 • Lockton Companies

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Tools to Get to “Yes”

Besides providing risk allocation benefits, in a bid process, these products can also give a seller leverage and can give a buyer a way to distingush it’s bid. For instance, if submitted buyer bids have similar terms, the seller could perhaps require the purchase of a reps and warranties and/or environmental liability insurance product as a way to differentiate bids and provide needed comfort to all parties involved.

Another specific example of how transactional insurance can help is on the buyer-side of the bid process for a target company. It is no secret that, in today’s market, private equity funds and strategic buyers all want high quality deals and compete fiercely for them. Sellers in those deals want certainty of closing and want to take on less risk. But potential buyers often do not want to take on more risk. Or a private equity fund buyer may not be able to match a strategic buyer’s price. A fund buyer can enhance its bid by offering up the same or lower price than a strategic buyer but with a better risk allocation package (e.g., shorter survival periods, low to no escrowed amounts, lower caps). In our own recent experience, we are seeing this used more and more often as bid enhancement. And in a fair number of cases, it is helping private equity firms be successful to win the day.

The insurance market has responded to the increasing interest for this product from the private equity community and others. Basic features of reps and warranties insurance include:

� Price: Typically between 2 to 4 percent of the policy limit ($20,000 to $40,000 per million of limit). Premium is a one-time, up-front cost.

� Policy Period: Typically matches the survival periods in the underlying agreement for reps and warranties, up to a maximum of six years.

� Retention: Typically 1 to 3 percent of the transaction value.

� Can be purchased by the buyer or the seller in a transaction.

� Single issue or blanket.

� Aggregate limits of up to $300,000,000 available.

TAKE FOR EXAMPLE…

� Patent Infringement

h Seller-side policy responds to

claim brought by buyer for breach

of the intellectual property R&Ws

resulting from a third-party claim

of patent infringement.

� Accounts Receivable

h Buyer-side policy responds to a

claim brought by buyer for breach

of the financial statements’ R&Ws

in connection with the target’s

issuance of more than $1 million

of gift certificates, which had not

been recorded in the financial

statements.

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It’s important to note that reps and warranties insurance policies are all different and typical policy exclusions may apply, including:

� Purchase price adjustments

� A breach of which any of the deal team members had actual knowledge

� Any covenant/estimate/projection or forward-looking statement

Seek your attorney and insurance broker for proper counsel and advice on how best to structure and amend these policies.

Obtaining reps and warranties insurance coverage options no longer needs to be a long, drawn out process. Assuming you provide the required information (highlighted to the left) up front to underwriters and respond quickly to any follow-up questions, you should be able to obtain a formal/bindable proposal within two weeks of the initial request.

Risk allocation lies at the heart of every merger and acquisition transaction. Additional representations and warranties, broader or larger indemnities and escrows, purchase price reductions, earnouts, holdbacks, and any number of other devices are, and always will be, traditional ways to allocate risk. We submit that the time has come to admit transactional insurance among their ranks.

UNDERWRITER INFORMATION NEEDED

� Required Underwriting Information

for Term Sheet:

h Draft Purchase Agreement (and

Disclosure Schedules, if available)

h Audited Target company financials

h Offering/Diligence Memorandum

� Underwriting Process:

h Execute Confidentiality

Agreements

h Preliminary Indication (term sheet

can be provided within 24-48

hours)

h Terms include premium, retention,

key coverage provisions

h Diligence Agreement and

Diligence Fee (used to engage

third-party advisors)

h Binding terms delivered within

two-week period

h Policy Form Negotiation

© 2012 Lockton, Inc. All rights reserved. Images © 2012 Thinkstock. All rights reserved.

Lockton PECAP

Lockton’s Private Equity and Corporate Acquisitions Practice (PECAP) provides deal-related insurance and employee benefit due diligence to acquisition-minded clients to help identify key business issues, exposures, risks, and costs that may impact a transaction. PECAP serves our clients and the private equity community.

McGuireWoods

McGuireWoods’ private equity lawyers represent private equity and hedge fund clients at every stage of the investment cycle, including fund formation, as well as all aspects of acquisitions and divestitures.

www.mcguirewoods.com

www.lockton.com