Market Trends: BFL CANADA Commentary on Q4 Transactional Risk Trends and what we can expect in 2021
Q4 deal volume was robust; with continued momentum into 2021 underway
In Q4, we saw a rise in deal flow driven by capital, hungry to deploy after a historically slow Q2 due to the COVID-19 pandemic. There were also strong motivations to close deals by year-end ahead of possible changes to the US tax regime in the 2021 calendar year.
We witnessed a large amount of deal flow in technology-enabled businesses and food and beverage. Multiple businesses that fared well or excelled through the pandemic remain strong.
With the surge in deal flow and demand for Representations and Warranties Insurance (RWI) outstripping supply throughout December, pricing was elevated, and turnaround times for quotes challenged our typical 48-hour turnaround time. Pricing continues to remain higher year after year in the US and to a lesser extent in the Canadian RWI marketplace, with continued US-centric claim activity on the rise. We expect modestly higher pricing in a hardening RWI market to remain.
The COVID-19 Exclusion Is Not Going Away
Going back to March 2020, underwriters took a broad exclusion to COVID-19 for the RWI policy’s purposes, focusing on business interruption and supply chain concerns. Through the summer of 2020, as certainty returned for debt financing and the ability to understand how a business was impacted, completed deals started to occur with more regularity. Those completed deals could include an element of contingency to bridge valuation gaps given the buyer’s inability to assess future cash flow generation impact. During this time, insurers adapted their COVID-19 exclusions. Certain insurers would assess the COVID-19 exclusion on a case-by-case basis during underwriting, assessing the impact the virus had on the business (employees’ health, work from home disruptions, impacts to customer or supplier relationships, etc.), and endeavour to narrow or in certain instances drop the exclusion.
There were instances of bound policies associated with target companies in the software sector with no COVID-19 exclusion. In sectors such as manufacturing and transportation—which were undoubtedly impacted to some degree—a slimmed-down exclusion limited to the transmission of the virus or compliance with laws enacted directly as a result of COVID-19 was considered a good outcome.
Fast forward to Q1/21, and with the sustained second wave ongoing and its unknown impact on businesses, it is increasingly rare to drop or materially narrow the COVID-19 exclusion.
Insurers will often quote with a standard exclusion given the limited information provided at the quoting stage and look to underwrite the impact of COVID-19 on the target in good faith.
Nimble solutions to support client needs
Intellectual Property (IP) representations: Many software buyers seek to have Intellectual Property (IP) representations made fundamental, or extend survival from 3 years (standard coverage for general representations under an RWI policy) to 6 years for an additional premium, given that this is where the majority of the value and potential risk resides, should there be an unknown breach.
We have also worked on solutions for clients where solely the IP + software and data privacy representations were underwritten, which would result in a lower premium and underwriting fee.
Sell-side policy: Sellers can be pushed into a corner on the negotiation of certain representations or the indemnity package or have the feeling they are up against a much larger buyer and require added protection. Although a buy-side R&W policy is more comprehensive, we have supported selling clients where a buy-side policy was not possible. However, they still sought protection against an off-market IP indemnity.
- Pivoting to a third party “sell-side policy” backstops the indemnity in the SPA;
- Survival of the policy would follow that in the purchase agreement;
- The policy would exclude fraud;
- RWI coverage would likely be narrower than a buy-side policy with it not having access to buyers’ diligence, but it has been a viable solution for certain sellers.
Fundamental top-up coverage: We continue to see certain clients seek or buy additional fundamental representations (+ tax representations) coverage attaching from the indemnity cap to a higher amount or up to the full transaction value. Other buyers have looked at pushing out fundamental representation coverage to 7 years to alleviate vendor concerns or support board decision-making.
Increased Appetite for Public Deals
We have witnessed an elevated appetite for public deals driven in part due to the increase in Special Purpose Acquisition Corporations (SPAC), reducing time and cost to direct list and raise capital. Public target-insured deals remain a fraction of the RWI deals being done. However, there is a noticeable increase in desire and supportable terms from insurers year over year.
Unlike a private transaction where an escrow holdback is eliminated or significantly reduced through the placement of RWI, in a public deal, the RWI is not replacing anything. However, the buyer may be interested in pursuing an RWI policy to have recourse if there are breaches to the representations, which die at the close of a public deal. Buyers would seem to be pursuing the added benefit of some security.
BFL’s M&A team took a public target to market this past summer and received favourable terms, and we believe this could fit certain transactions. A few things to keep in mind:
- Insurers will want to understand the disclosure practises of the seller. The ability to provide a materiality scrape depends on the nature of the representations and warranties and the granularity of disclosure;
- Excluded from cover are claims by shareholders or derivative lawsuits (including fiduciary duty claims) arising out of or related to the transactions contemplated in the transaction docs (including dissenter rights and bump-up claims);
- It is important to ensure that the buyer’s diligence is robust enough to support RWI; and
- It is possible to commence RWI underwriting for a deal that is not in exclusivity (auction scenario). However, there would be a pre-exclusivity fee that applies (usually in the range of ~$75K to $100K), which is non-refundable, but if coverage is purchased, this amount is credited to the premium.