M&A and Private Equity Transactions: Analyzing and Mitigating Risk

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By Karen Beldy Torborg, Peter Walther, and Edwin Charnaud

A fragile global economy, an uncertain recovery in equity markets, and a business environment undermined by accounting and governance scandals have increased the complexity of dealmaking today. Corporate boards are exercising greater caution in assessing transactions and the risks associated with them. Private equity executives face increasing professional and personal liability for the performance of their funds and portfolio companies. And cross-border dealmakers must contend with legal, economic, and cultural issues that differ from country to country.

The hard insurance market has also affected dealmaking in the United States and Europe. Because of reduced underwriting capacity and higher insurance rates, direct premium costs and self-insured retentions have become more significant cost factors in acquisition calculations. In private equity deals, which generally have significant borrowed money in a transaction, debt providers are paying greater attention to risk and insurance costs, as well as the overall cost of risk associated with a target company.

In this challenging climate for dealmaking, rigorous risk and insurance due diligence enables sellers and buyers to reduce uncertainty about the true value of a business, and insurance capital solutions can remove obstacles to closing a transaction. In recent years, the insurance industry has developed a range of new products that, for example, substitute for escrow requirements or mitigate an asbestos liability or other traditional deal-threatening risks. These insurance products also provide dealmakers with an additional tool to gain competitive advantage.

Due Diligence

Risk and insurance due diligence identifies the current cost of insurance and self-insured retentions, reviews current and historic liabilities, assesses the adequacy of insurance cover for potential risks faced by the company, and estimates insurance costs for the entity after the acquisition. In sum, due diligence focuses on large risk and insurance issues that could have a material impact on a transaction.

Particularly in a hard insurance market, many companies will self-insure, taking higher retentions in workers' compensation, for example, or product and general liability risks. This approach to risk requires a company to carry accruals for potential self-insured liabilities that have been incurred but not yet paid. Due diligence estimates the amount of the outstanding liability, determines the adequacy of reserves, and identifies the potential need for post-closing collateral. Who will bear the cost of these liabilities when they eventually have to be funded? Is there sufficient liquidity in the transaction to support potential collateral requirements? These factors, which impact a deal's purchase price as well as its capital structure, need to be considered well in advance of agreeing on terms for a transaction.

Examples of a risk that may not be insured properly — or at all — are the environmental exposures found in a wide range of industries. By working with a company and understanding its industry, risk specialists evaluate pollution exposures and estimate the cost of transferring or capping environmental liabilities. The apportionment and management of these liabilities have become important features of many deals.

The due diligence process includes a pro forma estimate of the appropriate insurance cover for the new entity. Will insurance costs increase or decrease? Are there gaps in current cover that will create future expenses? Spin-offs, for example, loose economies of scale. The appropriate risk management and insurance program structure for a larger company is likely very different from a stand-alone entity.

Due diligence also evaluates directors and officers liability (D&O) programs for the buyer and recommends post-closing coverage based upon exposure to public equity or debt markets, asset size, and industry class. Private equity funds often require that portfolio companies purchase D&O liability policies. With increased demands for disclosure and more litigious investors, private equity executives sitting on boards of portfolio companies can be held professionally and personally liable by stakeholders in their funds and portfolio companies for insolvency, for example, or health and safety compliance breaches. Customized insurance solutions can protect managers, general partners, or advisory board members against alleged wrongful acts and errors and omissions.

Transactional Risk Solutions

Insurance solutions for transactional risks help facilitate corporate acquisitions and private equity deals. These solutions can be as simple as a run-off D&O liability policy for the seller. D&O policies generally have a change in control clause that automatically converts the policy into run-off — i.e., the policy stays in force for the remainder of the policy period but provides cover only for claims made during this period. A run-off policy provides D&O cover similar to the previous insurance and protects past directors from future claims.

Insurance products developed over the past six years have helped buyers and sellers bridge the gap between their respective views of contingent risks. These products include insurance solutions for representations and warranties, tax liability, and litigation. In 2001, the last year for which data are available, annual premiums for transactional risk products totaled approximately $250 million. (This figure does not include environmental policies.)

Insurance can also serve as a strategic tool for bidders in a transaction. For example, two companies may each bid $100 million for a business. The first bidder may desire an escrow of $20 million over the three years as a potential recourse. The second bidder may choose to purchase insurance protection and, accordingly, may not require an escrow, which could make its bid more appealing.

Tax Indemnity Insurance can guarantee a specific tax benefit associated with a transaction. Because of the subjectivity of the U.S. Internal Revenue Code, a party in a transaction may seek protection from an adverse IRS ruling on an anticipated tax benefit. Backed by a professional tax opinion, which estimates rather than guarantees the outcome of an audit, tax indemnity insurance can reimburse a company for a denied benefit.

Section 355 of the Internal Revenue code provides for tax-free treatment of spin-offs that meet corporate business purposes (as opposed to tax planning). The complexity of the section's requirements has prompted many companies to seek private letter rulings from the IRS. Earlier this year the IRS announced stricter standards for issuing 355 private letter rulings. In the absence of such rulings, tax indemnity insurance can provide protection for businesses shedding non-core assets that qualify for tax-free treatment.

Litigation Insurance has been compared to insuring a claim after it occurs. A relatively small group of insurers specialize in assessing and valuing open litigation in such areas as securities, intellectual property, and product liability. Once the merits of the litigation and probable losses have been evaluated, an insurance policy can serve as an asset on a company's balance sheet to potentially mitigate or cap the liability. The 'ring-fencing' of such an exposure can assist buyers in estimating future cash flows.

In the private equity community, particularly in the United States, many principals, investors, and advisers perceive that given the large number of transactions that have occurred, most of the traditional 'cash-flow friendly' targets have already been acquired. Increasingly, private equity deals involve more distressed assets and more complex financial structures. This, in turn, means more exacting due diligence and nontraditional insurance capital solutions to close deals successfully.

The U.S. and Europe

The M&A and private equity markets in the United States and Europe share many characteristics in their approach to due diligence, transactional risk products, and cover going forward. There are, however, a number of key differences. For example, in most European countries, the equivalent of workers' compensation is a government benefit and, therefore, is not the significant transactional issue it is in the United States. (The U.K. has employers' liability, which is similar to workers' compensation in the U.S., but has a different financing structure.)

Traditionally, European buyers and sellers have viewed some transactional risks as a business risk they would prefer to self-insure rather than initially fund the cost of transferring that risk to an underwriter. In Europe, one can observe a growing appreciation for transactional risk insurance products. Moreover, an increasing number of dealmakers in Europe view these insurance capital solutions as a competitive tool when bidding for companies.

Underwriters in the United States have tended to price transactional risk more aggressively in the last few years. Further, in the U.K., the markets and capacity for such products are more developed than in continental Europe. The global trend is that these solutions are evolving into effective tools of corporate finance.

Managing directors Karen Beldy Torborg, Peter Walther, and Edwin Charnaud are members of Marsh's global Private Equity and M&A Services practice. The authors gratefully acknowledge the contributions to this article by Marsh senior vice presidents Jonathan Legge and Cristiana Baez-Safa.