A new Seyfarth Shaw survey suggests that 2019 will continue to be a seller-friendly environment for middle-market M&A deal activity, with more deal participants using representation and warranty insurance policies.
“We are cautiously optimistic that 2019 will be another good year for middle-market M&A activity,” says Andrew Lucano (pictured), Partner at Seyfarth Shaw LLP, when discussing with Private Equity Wire the findings of the sixth edition of its Middle-Market M&A SurveyBook.
“We have closed a number of deals already in 2019 and right now, we are very busy on a number of pending deals and there are still more in the pipeline. All of the factors that spurred M&A activity over the last few years are still in play. Among other factors, we still have low interest rates compared to historical norms and PE firms still have record levels of cash waiting to be deployed. Moreover, with company valuations still very high, baby boomers that own businesses without a solid succession plan in place (and even some that do) recognise that now might not be a bad time to sell.”
The M&A surveybook, which analysed more than 160 middle-market publicly available private target acquisition agreements, details key M&A deal terms comprising the indemnity package to help guide buyers and sellers on current trends when negotiating deal terms.
Lucano says that the seller-friendly deal term environment in the middle-market for M&A has been in play for a few years now “and that trend continued in 2018”.
“Our survey results were essentially what we expected and what we experienced in 2018. One of the big things that really continues to stand out is the prevalence of representation and warranty insurance being used in deals, not only by PE firms but also by strategic buyers. The use of R&W insurance has a major impact on certain deal terms. For that reason, we broke this year’s survey into two pieces, analyzing deal terms in R&W insured deals separate from non-insured deals.”
By using a buy-side representation and warranty insurance policy, the buyer in an M&A transaction can recover directly from an insurer for losses arising from certain breaches of the seller’s representations and warranties in the acquisition agreement.
By transferring the risk of losses from the seller to an insurer, the buyer and seller can limit or even eliminate the seller’s liability for certain representation and warranty breaches, all without diminishing the buyer’s protection against such breaches.
Year-on-year, the survey found that R&W insurance was used in more than 40 per cent of transactions it analysed, up more than 10 per cent on 2017. This can partly be explained by the desire for buyers to make their purchase offers more competitive and attractive to sellers particularly in an auction scenario, according to the surveybook, with Lucano stating that the use of R&W insurance was effectively a win/win for both parties.
“It gives sellers the ability to sleep well at night knowing that the purchase price money they’ve just put into the bank is likely going to stay there because their liability is limited. And for buyers, it gives them a solid source of recovery in a highly-rated insurance company to make claims against.”
The survey found that the indemnity escrow amount (as a percentage of the purchase price) for non-insured deals – 10 per cent of the purchase price, on average – was dramatically higher than R&W insured deals, where the median escrow amount was 0.9 per cent which allows sellers to put more money in their pockets at closing.
For 40 per cent of insured deals, the average survival period for representations and warranties was 12 months (i.e., the time period where most typically in an insured deal, the seller has a small escrow amount at risk in the event of a representation breach). Interestingly, over a quarter (26.9 per cent) of insured deals had no survival period, where the seller had no obligation to indemnify the buyer for breaches of general representations and warranties and the buyer’s sole recourse for such breaches was to the insurance policy; this compared to 9.4 per cent for non-insured deals.
“No survival deals” can significantly simplify deal negotiations as the indemnity provisions are very limited if they exist at all.
For deals that included survival periods, certain representations and warranties are “carved out” from such survival limitations and survive for longer periods of time than the typical 12-18 months. Seyfarth’s surveybook found that the most common carved out representations in insured deals were: capitalisation (stock deals only), 68.4 per cent; due organisation, 65.7 per cent, with due authority and taxes both 62.7 per cent.
Similarly, in non-insured deals, these representations were also carved-out most of the time and the survey found that these percentages were approximately one third higher (mid-eighties) respectively, for non-insured deals.
Lucano explains that, “while fundamental representations such as these are most often carved-out from survival periods in non-insured deals, the nature of the company and due diligence discoveries will drive whether any other representations and warranties will be carved out from the survival period.
“While the typical representation and warranty survival period is 12 to 18 months, R&W insurance policies commonly provide for 3-year survival periods for general representations and 6-years for fundamental representations, which is another advantage to using a R&W insurance policy.”
With respect to 2019 middle-market M&A deal activity, Seyfarth and others see business’ desire to expand geographically, diversify products, enhance their technological capabilities and acquire talent as key drivers of M&A and Seyfarth also expects “add-on” acquisition activity to comprise a high percentage of deal value in 2019 as PE-backed platforms attempt to grow value by scaling up their business interests and creating synergistic advantages.
“The synergies provided by well-done add-on acquisitions add value and create opportunities that did not exist for many PE firms’ platform investments potentially resulting in even more successful exits. This is certainly an avenue for growth that PE firms, especially in the middle-market space, are likely to pursue in 2019,” concludes Lucano.
