Representation and Warranties Insurance (R&W) is a type of insurance policy purchased in connection with corporate transactions. It covers the indemnification for certain breaches of the representations and warranties in the transaction agreements. R&W policies are designed to provide additional flexibility in addressing these obligations, for example, by reducing or eliminating the need for an escrow by the Seller.
The Evolution of R&W in M&A
When R&W first became an option in mergers and acquisitions around 20 years ago, it was largely applied to deals that had major issues. It wasn’t utilized as a strategic tool because deal-makers and their counsel were skeptical and uninformed of the product, it had a limited track record of claims payment, it had a very high cost (approximately 8% of the limit), and it simply wasn’t designed to suit their needs.
Fast forward to today. The product has matured, become more affordable (2.5% to 3.5% of the limit), legal counsel is on board, and policy terms more closely match the needs of buyers. At the same time, sellers of privately held companies have dramatically driven up the demand for R&W by insisting that buyers use R&W in lieu of traditional seller indemnification.
Tax Privileges set REITs Apart
REITs enjoy special tax privileges, like the ability to deduct dividends. This allows appreciated assets to be distributed in a tax efficient manner. The certainty of this REIT qualification and related tax representations is of the highest importance in REIT M&A. If a REIT were disqualified, it would result in a significant adjustment to income.
While R&W addresses other general and fundamental representations in a purchase agreement, REIT acquirers are really concerned with tax matters. Negotiating the size and duration of an escrow as it relates to tax reps are often key points of negotiation because a six-year statute of limitation applies.
R&W benefits buyers by reducing risk and simplifying the negotiation of the most important issue in a REIT acquisition. R&W transfers the risk to insurance if the acquired REIT is disqualified, and can provide protection for the full six years.
R&W benefits sellers because it reduces or eliminates their escrow and indemnity obligations thus maximizing ROI.
R&W Catches Up with the Needs of REITs
While the rest of the M&A world was embracing R&W, REITs were still slow to adopt. Based on a recent uptick in submissions to key R&W underwriters, R&W insurance is now regularly a part of REIT transactions. We believe that the pickup rate has historically been low for essentially two reasons:
- REITs are often publicly traded
- R&W Insurance didn’t meet the needs of REITs
REITs are often publicly traded
Public company transactions are referred to as “zero-recourse” transactions where indemnification cannot be obtained from “the seller.” With potentially millions of stockholders, it is mechanically impossible to recoup a traditional indemnification. This results in the buyer assuming 100% of risk of liabilities that arise after closing that relate to the pre-closing period.
Many acquisitions, especially those involving privately-owned companies, are now mirroring sales of public companies. In these transactions, the buyer requires nothing from the seller in the form of escrow or indemnification.
R&W underwriters will regularly issue policies with no seller obligation in private company transactions. Therefore, it is possible to purchase R&W in a “zero-recourse” situation and give a buyer the protection that they desire through an R&W policy.
R&W Insurance didn’t meet the needs of REITs
In the intro to this post we covered the historical disconnect between the product and buyers. R&W underwriters have now tailored the product to meet a REIT’s unique characteristics.
- Sales of privately-owned companies typically require an indemnification equal to 10-20% of the total enterprise value – REITs typically only require 5% or less. On the surface it doesn’t seem like much for an insurance company to insure but REIT transactions are often valued at $1B or more, and $50MM is a substantial R&W limit.
- A $10MM R&W limit will get the attention of virtually every underwriter. At 5% indemnification, that equates to a transaction valued at $200MM. That makes R&W viable for almost any REIT.
- Underwriters have learned that the risk associated with REIT M&A is typically lower than most private company M&A and even many publicly-traded companies. This has resulted in a market price adjustment to something more commensurate with the exposure (typically in the 2% range).
- Like most insurance policies, R&W policies have a retention (deductible). A typical retention is 1% of the enterprise value, which is oftentimes split between the buyer and seller. R&W underwriters like the seller and buyer to “have some skin in the game” in the form of a retention. However, it is now expected that policies for REITs be structured without a retention on the REIT qualification and certain other fundamental representations. Underwriters are willing to accept this as simply what is necessary to write a policy for a REIT.
Using R&W insurance can limit or eliminate seller indemnity, meaningfully shorten the negotiation timeline, dramatically simplify negotiations, and differentiate a bid for an acquisition. It pays to get educated on the nuances of R&W in order to prepare yourself for using the product in the future.
About the Authors
Jennie Phillips is an Assistant Vice President in the ABD Insurance and Financial Services Property & Casualty Practice. Jennie focuses on ABD’s REIT industry segment. Jennie is proudly one of the few REIT brokers in the US who can provide customized insurance programs for large and complex real estate investment and lending needs. Jennie provides over 20 years of experience in commercial real estate insurance for public-traded or private REITs, including investment banking companies, developers, investors and tenants. She can be reached at firstname.lastname@example.org.
Josh Warren is a Senior Vice President and M&A Advisory Practice Leader at ABD Insurance and Financial Services. Prior to joining ABD, Josh spent 15 years at Equity Risk Partners, an insurance brokerage and consulting firm that concentrated exclusively on private equity firms, venture capital firms, and family offices. Josh was twice named a Power Broker by Risk & Insurance Magazine in the Finance – Private Equity category. He was also named to multiple “40 Under 40” lists, including Business Insurance magazine, Risk & Insurance magazine, and the M&A Advisor. He can be reached at email@example.com or 312-300-5759.