Impact of COVID-19 on M&A, transactional risks and M&A insurance
October 2020 | TALKINGPOINT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
October 2020 Issue
FW discusses the impact of COVID-19 on M&A, transactional risks and M&A insurance with Tan Pawar, Dean Andrews, Sophie Wallace and Harry Leitch at BMS Group.
FW: Reflecting on recent months, how would you describe the impact that COVID-19 is having on M&A and thereby its impact on transactional risks and M&A insurance? What overarching trends are you seeing in the market?
Pawar: The growth of M&A insurance has been intrinsically linked to a multitude of factors that has allowed transactions to prevail in a favourable M&A environment over the last five to six years. It is of little surprise therefore that the impact of coronavirus (COVID-19) has meant there has been a material drop in M&A activity, and therefore a drop in transactions underwritten in the M&A insurance market. However, despite the economic challenges brought about by the pandemic, certain sectors, such as technology, media and telecommunications and financial services, have remained resilient. This has also brought into focus underwriting appetite. Most insurers historically were sector agnostic, however they are now far more cautious and selective of which deals they choose to underwrite, especially in sectors deemed most affected by COVID-19, for example travel and hospitality.
Leitch: Although the majority of deals went on hold back in March and any in the pipeline were removed, activity and market sentiment has picked up considerably. It is impossible to predict the deal landscape, but we can expect to see a number of themes emerge. Buyers will become more assertive, looking to take advantage of opportunistic acquisitions. The volume of stressed or distressed M&A will increase. Private equity has more money to invest than ever before and once portfolio companies have been protected and bolt-on acquisitions completed, these reserves will need to be deployed. Inevitably, apportioning risk between buyers and sellers will mean that warranties and indemnities will come under increasing scrutiny and we expect an increase in the use of warranty and indemnity (W&I) policies once the economy starts to heal.
“We are expecting to see a rise in stressed and distressed M&A transactions and for synthetic W&I insurance to play a key role.”
FW: In response to the pandemic, to what extent have you seen an uptick in demand for insurance to mitigate M&A-related risks?
Wallace: What we are clearly seeing coming out of the first half of 2020 is a gearing towards advisers and their clients requiring a new set of insurance solutions to mitigate M&A-related risk. We have seen an increase in queries relating to special situations insurance which has come directly off the back of concerns around the likely swathe of disposals of distressed assets, restructurings, disposal of non-core assets and intragroup reorganisations, either to rationalise struggling arms or in advance of a disposal. The M&A insurance market is picking up in the wake of the pandemic and we expect there to be a more cautious approach to buying businesses which, similarly to the last recession, correlates to more M&A insurance policies being bought with higher policy limits and broader coverage in order to give comfort to all parties during these turbulent and uncertain times.
Andrews: Despite a global drop in W&I submissions tracking the lull in M&A activity, June was one of the busiest months on record in terms of global tax enquiries. The number of tax enquiries being inverse to W&I submissions is reflective of a more general expectation that the arsenal of insurance solutions that is now afforded under the umbrella term ‘M&A insurance’ is going to be used more and more outside of pure transactional dynamics. This has largely been driven by enquiries from the US given its M&A slowdown has been slightly less severe than in Europe. In terms of sector, these continue to emanate primarily from real estate transactions, again as the slowdown in the real estate sector has been less pronounced than more general M&A.
FW: Are there any differences in the way buyers and sellers are using specific products – such as warranty & indemnity insurance, tax liability insurance and contingent risk insurance, for example – since COVID-19 took hold?
Andrews: It is too early to point to any meaningful data as to the impact that COVID-19 has had on the way in which buyers and sellers are using M&A insurance. The expectation, however, is that overall a greater proportion of the submissions across the range of M&A insurance solutions will emanate from distressed situations, for example sale of assets out of receivership, hive outs, debt for equity swaps, contractual disputes and refinancing of lending arrangements, to name a few. Therefore, the mechanics of the insurance solutions are unlikely to significantly change from what is currently offered, but the motivation for seeking the insurance in many instances will.
Pawar: M&A insurance, and in particular W&I insurance, grew extensively in the last five years in a bull M&A market environment. Sellers, and in particular private equity sellers, would run a sale process whereby they would sell a business with a £1 cap and the only recourse available to bidders was W&I insurance. Since the onset of the pandemic we have noticed that there are some parallels with the current crisis to how M&A insurance gathered momentum out of the last global financial crisis in 2007/8. Back then, the M&A market was in a similarly cautious holding pattern, as it is now, and despite this, M&A insurance began to be used more regularly, predominantly due to concerns buyers had around a seller’s financial covenant strength.
“While insurers will expect more zoned-in due diligence to be conducted, some have mandated, or will require an exclusion around losses emanating from COVID-19.”
FW: How have insurance providers evolved their M&A-related policies in recent months to adapt to market conditions? Have you seen any notable changes to products, coverage terms and pricing, for example?
Andrews: The most immediate impact on both W&I and tax has been on pricing. Compared to the last global recession, there are eight times as many M&A insurance providers globally, which has meant competition between them for a reduced number of opportunities has been very aggressive. There have been instances of UK tax risks being insured for as little as a 1 percent rate on line, which would have been inconceivable even six months ago. We expect there to be some correction with the broader impact of the pandemic hardening most insurance lines.
Wallace: Given the severe drop-off in deals coming across insurance providers’ desks, we are seeing the need for innovation and adaptability of M&A-related policies to meet the needs of insureds during these unprecedented times. Insurers are increasingly willing to discuss complex risk profiles and new products are being explored to ensure they incur their much-needed premiums, while also assisting clients with specific risks that have suddenly become apparent. M&A-related policies that are becoming popular are on secondaries transactions, public-to-private transactions and in special situations where there are distressed assets being disposed of. We expect that while insurers will be eager to underwrite deals which may mean that premiums stay low on the more vanilla policies, due to the complexity of some of the M&A world’s insurance requirements we also expect prices to rise in order for broader coverage to be gained.
Pawar: Even before the onset of the pandemic, frequent purchasers of W&I insurance were pushing the M&A insurance market to be more flexible on how capacity is deployed, especially in the context of a fund portfolio. It has traditionally suited insurers and underwriters to offer the product on a deal by deal basis, but the pandemic has accelerated these conversations and we are already seeing the market start to evolve and adapt.
FW: What changes have you seen to the way M&A due diligence is conducted? How is this affecting the process of assessing and providing transactional insurance coverage?
Pawar: The biggest challenge to M&A is overcoming the due diligence barrier. In the same way no one buys a house without seeing it and getting a survey, acquirers of businesses are not going to get the financing they require until diligence on a target is conducted. Insurers, too, will want to see a lot more focused diligence. While many businesses have embraced technology to aid with due diligence, buyers still need to meet management teams face to face and no amount of Teams or Zoom calls can replace sitting across a table from a vendor or inspecting a business for yourself. This is particularly the case for cross-border transactions or transactions with an international element, as getting on a plane and travelling across continents becomes more difficult. From an underwriting standpoint, insurers will expect to see more focused due diligence around the impact of the virus on a target business and would expect analysis to touch upon the demand for a target’s goods or services, the financial health of a target business and a clear review of the target’s customer and supplier contracts.
Wallace: The pandemic has put more focus on insurer appetite and which deals to underwrite. There has clearly been a shift away from certain sectors which would have been insured prior to the onset of the pandemic especially around retail, or casual dining. While insurers will expect more zoned-in due diligence to be conducted, some have mandated, or will require an exclusion around losses emanating from COVID-19. One should note that if insurers are satisfied that the appropriate level of due diligence has been conducted, and they are satisfied with the analysis, then they will not require a blanket exclusion. In the event that they still require such an exclusion, then it is important to ensure that such exclusion does not go beyond specific, business-relevant exposures and broad exclusions should be avoided. It is important that insurers make clear their position with respect to any COVID-19 exclusions before they are instructed.
“We expect to see a hardening of the M&A insurance market in the medium term as competition between markets intensifies and capacity shifts to those who can demonstrate the best claims record.”
FW: Given the devastating impact of COVID-19 on businesses and economies around the world, there are expectations for a rise in distressed M&A. What role do you expect transactional risk insurance to play in these unique types of deals?
Leitch: We are expecting to see a rise in stressed and distressed M&A transactions and for synthetic W&I insurance to play a key role in situations where the seller, the target’s management team or an insolvency practitioner are reluctant to give warranties on the distressed business. And secondly, where there are concerns over the creditworthiness of a seller to stand behind any future warranty claims. Founder or family-owned, non-private equity-backed businesses will be the first at risk, although it will not be long before even those supported by private equity will look to company voluntary arrangements (CVAs), and other forms of exit. The timing and quantum of the rise in distressed processes depends on what approach the treasury and HMRC will take and how banks conduct themselves on interest and capital repayments.
Andrews: Until now the use of ‘synthetic’ cover being offered by insurers has generally been limited to synthetic tax indemnities, or full synthetic warranty packages, only when assets are being acquired from insolvency practitioners. However, given the anticipated increase in businesses looking to dispose of assets, either to raise emergency liquidity or because the assets are underperforming, there may be extremely limited appetite by sellers to provide the usual guarantees relating to the target in light of what may be considered a discounted sale price. This shift in motivation for disposals impacting transaction dynamics provides an opportunity for insurers to afford acquirers of such assets with synthetic cover outside of the limited insolvency scenario. The availability of tax assets is expected to be much more frequently insured. Given the level of losses businesses have been building up, combined with the technical uncertainty raised by questions over the nature of businesses’ trade over the lockdown period, the financial certainty that comes with insuring their availability will be crucial.
FW: Based on your experience, what considerations do parties need to make when assessing their options for M&A insurance? How might these considerations differ in the context of a traditional transaction versus distressed M&A?
Pawar: It took some years for M&A insurance to become part of an M&A practitioner’s checklist and the M&A insurance market was able to accommodate most transaction dynamics even if diligence was a little light at times. Practitioners and parties to a transaction will need to think about whether due diligence scope is to be fulsome and takes into account the impact of COVID-19 on the business. Without this detailed analysis there will be gaps within the policy coverage. In terms of distressed M&A and in particular synthetic warranties, this can be more expensive and is more limited in scope than traditional W&I coverage. This is due to the more limited disclosure that is provided on these deals compared to fair disclosure that is required of warrantors who know the business. The other point is that given the warranties are given synthetically by an insurer rather than by the warrantors, there is no recourse in the event of fraud for subrogation rights for an insurer. A final point to note is that not all warranties that one would ordinarily expect to see covered can be insured under a synthetic policy. Given a lack of seller or management input, statement of opinions, warranties around third-party actions, or circumstantial and subjective language in warranties would not be covered, including information sweeper warranties and financial performance since the accounts date.
Leitch: We expect there to be a lot more focus on financial due diligence. Earnings before interest, tax, depreciation, amortisation – and coronavirus (EBITDAC) adjustments are likely to be seen for years to come. The other point to consider is timing. Distressed deals inevitably take longer to complete given the depth of due diligence required. There will be little appetite for insurers to take a view on certain areas of risk, so it is imperative that material issues are amplified at the outset so that it can be ascertained what the M&A insurance market can do to help cover such areas off.
“In the longer term, we expect M&A insurance to continue to play a vital role in M&A, especially given how ingrained it has become in the M&A ecosystem and the part it plays in unlocking M&A transactions.”
FW: Looking ahead, what developments around transactional risk insurance do you expect to see in the coming months? What short- and long-term changes might the COVID-19 crisis bring to this market?
Andrews: Businesses will need to assess the impact that COVID-19 has had on their operating structures, as seemingly immaterial changes may impact their transfer pricing analysis. A current example of this is Uber, which is conducting a wholesale review of its transfer pricing policy due to a COVID-19 driven restructuring which took place earlier this year. Transfer pricing risks are now frequently insured by the tax liability insurance market with cover being available on an ongoing basis. Furthermore, we expect to see a hardening of the M&A insurance market in the medium term as competition between markets intensifies and capacity shifts to those who can demonstrate the best claims record. The approximate 20 percent year on year increase in policies being placed has driven the dramatic increase in providers to service this. However, what the COVID-19 slowdown has shown is that we have probably reached maximum capacity in terms of providers and expect to see some capacity and markets fall away or exit this space.
Pawar: Over the summer, three major insurers decided to withdraw capacity from M&A insurance, with one ceasing to underwrite all non-US risks and the other two pulling their capacity from specialist M&A insurance underwriting platforms. We expect further capacity retraction towards the end of this year. The other aspect we have not mentioned is claims activity. There have been concerns about sustained losses being paid, particularly in the North American market. Despite the increase in claims frequency and severity, premium pricing has remained low whereas it has hardened across other lines of insurance. This has prompted some insurers to shift capacity where margins and returns are healthier. With the onset of the economic downturn, combined with low premiums and increasing claims, a correction in M&A insurance pricing is inevitable. Despite this, we remain optimistic about the outlook for M&A insurance. Evidence from the last global financial crisis shows that companies that make significant acquisitions during an economic downturn outperform those that do not. In the longer term, we expect M&A insurance to continue to play a vital role in M&A, especially given how ingrained it has become in the M&A ecosystem and the part it plays in unlocking M&A transactions.
Tan Pawar is managing director and global head of private equity, M&A and tax at BMS Group. He has been involved in the M&A insurance industry for almost a decade and has been instrumental in its evolution. Prior to joining BMS Group, Mr Pawar spent six years at a Lloyd’s of London broker where he co-founded the M&A team. Before that he was a divisional director in the transactions services team at Willis. He can be contacted on +44 (0)20 7480 0264 or by email: tan.pawar@bmsgroup.com.
Dean Andrews serves as head of tax liability insurance at BMS Group. He started his career at PwC where he provided tax advice to owner-managed businesses before moving to Eversheds Sutherland LLP where he focused on tax advice and private equity transactions. Mr Andrews has been a focused tax insurance broker for several years and has worked with tax advisers and their clients across Europe, the US, India and Australasia. He can be contacted on +44 (0)20 7480 0308 or by email: dean.andrews@bmsgroup.com.
Sophie Wallace is a divisional director of private equity and M&A at BMS Group. She joined BMS from a Lloyd’s of London broker where she spent over three years advising private equity funds, corporates and the wider M&A community on transactional risk insurance solutions. Prior to that, Ms Wallace qualified from CMS Cameron McKenna as a solicitor with experience in insurance litigation, corporate and construction. She can be contacted on +44 (0)20 7480 0378 or by email: sophie.wallace@bmsgroup.com.
Harry Leitch joined BMS in 2020 as a director and head of deal origination. He is focused on managing and developing relationships within the private equity and M&A community. Mr Leitch joined from Sterling Technology where, as sales director, he was instrumental in originating deal flow for the European mergers and acquisitions team. He can be contacted on +44 (0)20 7480 0346 or by email: harry.leitch@bmsgroup.com.
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