Recently, the M&A market has cooled since it burned red-hot in the aftermath of Covid. What impact has the slowdown in M&A activity had on insurance products related to mergers and acquisitions?

On this episode of Deal-by-Deal, host Greg Hawver is joined by Matt Heinz of Lockton to discuss developments in M&A insurance products. Specifically, Matt talks about why it’s actually a good time to be a buyer of rep and warranty insurance in M&A deals, how rep and warranty insurance premiums are now (compared to 2021), and the various aspects of M&A deals that can be insured.

Tune in as Greg and Matt bring you up to speed on transaction insurance in the current M&A environment!

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Name: Mathew Heinz

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

You are listening to Deal By Deal, a McGuireWoods podcast. Deal by Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join McGuireWoods Partners, Greg Hawver and Jeff Brooker as they explore middle market private equity M&A to provide you with timely insights and relevant takeaways.

Hello and welcome to Deal By Deal, a podcast for independent sponsors and other private equity professionals. My name is Greg Hawver. I'm an M&A partner at McGuireWoods in our Chicago office. And for this episode of Deal by Deal, I'm excited to be joined by Matt Heinz of Lockton. Matt and I bumped into each other actually last week at the McGuireWoods Healthcare Conference in Chicago. And as we were chatting, we thought of the bright idea of, "Hey, why don't we record a podcast?" The last time Matt joined the podcast, it was December, 2021. We were in the middle of a white-hot M&A market and we talked about deal terms for RWI at that time. And so this episode is going to go over the current state of the market, which has changed significantly in some respects. But before we dive into that, Matt, could you tell us a little bit about yourself and your practice?

Yes, and thank you for having me back, first of all, Greg. I've managed to get a little bit of sleep since December of '21, which was in short supply at the time. Real quick background. So I am a recovering M&A lawyer. I practiced a long time ago now at this stage. I practiced from oh '03 to '08 at Proskauer to start my career and then moved into the insurance world about 16 years ago now. So I've been at this for quite a while. First as an underwriter at AIG, then as a broker at Aon for a decade. And the last three years here at Lockton. We place insurance around all manner of risk tied to M&A transactions and actually our offerings now expand beyond M&A to balance sheet tax risk for some of our corporate clients, tax credits insuring the availability of tax credits to tax equity investors, the transferability of tax credits now under the Inflation Reduction Act, really a whole host of risks that were kind of born out of M&A originally, but have now expanded to really any sort of transactional opportunities with our clients.

Lockton team now, we are, I think by volume, the largest broker, the most prolific broker in the market. Pretty proud of that and proud of our team. We've got about 45 people. A bunch of us are former M&A lawyers, a bunch of tax lawyers, a few litigators on staff. We handle claims for our clients as well in connection mostly with threat policies. We see less or fewer claims, I should say, on tax and the litigation side, but pretty much a full service shop for anybody that's doing deals or thinking about doing deals and pretty proud of what we do and how we do it.

Yeah, yeah, and I can confirm that Matt and his team are great to work with. We've been in the trenches on multiple deals. They're one of the leaders in this space, and if you're out there doing a transaction, I would say it's very important to have a strong broker on your side. If you're an investor, it'll make your life easier. It'll make life easier for your M&A lawyers 'cause Matt rolls up the sleeves and fights the good fight with us on exclusions and things like that. So fully endorse Matt and his team.

Before we dive in to maybe what's changed in rep and warranty insurance, maybe let's take one quick step back. Most listeners will know about RWI, but at a very high level, I will quickly define it from my perspective, and Matt, you refine the definition, but rep and warranty insurance is an insurance product that has become a part of M&A practice, bridging a gap, if you will, in that the model 15 years ago or 10 years ago in an M&A transaction is that a seller would leave behind in a third party escrow around five to 15% of the total deal proceeds. And those proceeds would sit there for 12 to 24 months, and those would act as security for breaches of reps and warranties, breaches of covenants, any indemnity obligations and the like.

Sellers did not love leaving behind large portions of sale proceeds. And so private equity firms, I think were some of the first to utilize this product where instead of leaving behind those proceeds, you can engage with an insurance company who will ensure breaches of reps and other unknown items that are covered by the reps and warranties in the purchase agreement. So this product has really greased the wheels of the M&A world and in competitive situations, and really most M&A deals, I would say above the 50 million to 40, Matt might tell me a different number, but above a certain dollar value, you're going to see rep and warranty insurance unless there's kind of a special circumstance. So Matt, maybe if you'll confirm my definition wasn't way off and maybe talk about what's changed over the last two years.

Yeah, so definitely confirmed, and the thing I would say about that is nobody woke up one day and said, "Man, M&A deals are far more risky today than they were yesterday. We should find an insurance product that will help us ease that risk burden." The reality is insurance is designed to cover low frequency of high severity events right across really the entire insurance, most insurance. And then looking at M&A and sort of the history of indemnity claims, that's kind of what we were dealing with in thinking about risk transfer in the M&A setting. And the whole, I think evolution of our product has been built around efficiency. So like you said before, Greg, saves you guys as lawyers time on a deal, and also political capital, negotiating capital, not having to talk about indemnities and caps. Buyer can get a little bit more coverage from our market than they would probably be able to get from a seller. And seller, as you said, can walk away from a deal with all of its cash at closing as compared to the legacy model.

And one other, just while we're talking conceptually about RWI, and we might hit on it at the end of this podcast, but in not all circumstances, but a lot of circumstances, it saves the buyer the trouble of going directly against the seller for an issue. So we're seeing it more on minority transactions where you want to be getting along well with your partner, and so you can bring a claim against an insurance company for the most part as opposed to your new partners.

That's absolutely right. Any deal where you've got a significant component of management coming out over who are either responsible for the preparation of the reps and the financials and the deal process on the sell side, but also those folks had equity, right, and they're also sellers in the deal and are standing behind, at least in part, the indemnity in addition to whatever financial sponsor or other shareholder might've been involved, makes all the sense in the world for a buyer to avoid the awkward situation where they'd have to go back to those folks who are now tasked with running and building and growing the business for the benefit, try to avoid that conversation with them, that awkward conversation where you're asking for some money back, right, tied to the prior deal. So for a whole host of reasons, this makes sense and I think it's been worn out.

You mentioned before, the percentage of deals that we do, my guess would be for deals above 50 million in enterprise value, and we can go up just about as high as the M&A market can support probably a $50 billion deal, maybe a little bit less impact on a deal like that, but we've got a billion plus of capacity in the market. So even if we're talking a 20 to 30 billion deal, we could still place enough insurance to move the needle there, but deals above 50 million that are pure private equity to private equity trades, my guess would be over 80% of those deals are now insured of the marketplace. Slightly lower percentage with our corporate client base, our strategics, some of whom are still wedded to traditional indemnity constructs, but more than half, still a majority of deals with corporate buyers I would say have insurance as the indemnity alternative as well.

Absolutely. So over the past months and years since we spoke, it has been a slower M&A market in the lower half of the middle market where we operate probably the most here at McGuireWoods. What have you been seeing in the RWI space? How has that sort of muted activity flown into what you're working on, Matt?

So I mean, very simply, it's created more competition amongst our carriers. Fewer deals, smaller deals, fewer premium dollars available in the marketplace for carriers to capture has led to increased competition amongst the carriers to capture those dollars, those dollars that are available. I mean, I've mentioned before, I've been at this now, show my age a little bit, but I've been on the insurance side for 16 years. This is easily the best time in my career for insurance, to be a buyer of rep and warranty insurance. Rate is as low as we've ever seen it, retentions or deductibles on the policy. There has to be some risk borne by the insurer before the insurance kicks in, as with most insurance policies. Retentions are as low as we've ever seen them, carriers traditionally-

And what are those kind of ballpark ranges as far as premium and retention?

Yeah, so I'll provide a comparison to kind of frame it for you. When we were at the end of '21 in that white hot market that you were talking about, we saw premiums from carriers upwards of 5% rate online. So that means 5% of the limit of liability that's being put up on the deal, and usually that limit of liability is about 10% of enterprise value. So if you just run the string on the math on that, you're talking about roughly 50 basis points, 50 to 60 basis points of enterprise value, right? In today's market, those premiums from carriers are down in the two and a half percent range, if not even below on many deals. And so after taxes and fees and everything, you're talking about total cost in this sort of 3% range for most deals. So 30 basis points. Again, assuming we're covering 10% of enterprise value, 3% of that 10% is about 30 basis points on enterprise value.

So close to half if not even less than half of the rates that were being charged back in the bonkers 2021 range. And again, when I get into the market, many, many years ago, rates were kind of similar. We were kind of sitting around that figure 2010, 2009, somewhere in that range, but in that two and a half percent range. The reality was back then we were excluding things like diminution in value and multiplied damages. Retentions were much higher. The policies were not nearly as broad, hadn't been negotiated as extensively thousands of times over as they are now. So it was a very different looking product that could probably support that lower premium. The challenge that we're seeing with rates this low, and I mean, it's a great thing for my clients obviously, but carriers who I have to deal with and work with all the time, they're struggling right now from a pricing perspective. They're staring at the same level of claims that they've seen historically, which are not insignificant at all.

We see claim and notices on about 20% of the deals that we do, believe it or not. The number that pay out above the deductible or their attention is a lower number. But a lot of our carriers are struggling with profitability right now, given where rate is sitting. '21 was a great year. I think everybody hopefully made money and underwrote smartly that year. In the year since it's been a bit of a struggle. And my suspicion is, and carriers have definitely been beating this drum for a while, we do our job for our clients who are insured obviously and try to negotiate premium on every deal, but the reality is for this to be a viable product line for a long period of time as it has been, there's probably going to be some rate increase when the market picks up.

As more deals come to market, carriers are waiting for a reason to sort of improve their profitability outlook, the only lever they have to do that really, because we are pretty consistent on claims is through premium uplift. So as I said before, best time in history to be a buyer right now, if we see hopefully some rate cuts and some increased M&A activity coming over the next six to 12 months, I think folks who are buying rep warranty insurance can probably expect the rate to go up a little bit.

Yeah, I mean, following up on that, are you seeing new carriers come into the market or are you seeing carriers exit this market?

That's a great question and there has been new capacity and there have been new carriers entering the market over the last two years. We've got well above 20 carriers right now that can write a primary rep and warranty insurance policy, which is compared to about six that we had 10 years ago. So really, really sort of increased and expanded marketplace from a carrier perspective. But that increased capacity and the increased number of carriers that we're seeing also just lends itself to that competitive marketplace, and that's played a large hand as well in keeping rates down for quite a while. So.

Great. Yeah, and we'll avoid too much of a crystal ball on this episode about which way the M&A market's going to go. I feel like I've been cautiously optimistic for 18 months, and so I don't know if anything's changed, but-

You and me both. You and me both. Yeah.

Right. Well, it's good to know that the capacity is there if and when the market turns. Are there other nuances that have changed over the past 18 months or so, new terms being excluded or included in these RWI policies?

Yeah, I'd say the terms are fairly straightforward and what we do is pretty predictable. I will say this, in a time of increased competition amongst carriers, it's the best time to ask for stuff on the margins, to ask for a more aggressive coverage position. And we're seeing things that were always kind of available, but somewhat negotiable, become more available with less negotiation. Things like coverage around interim breach matters that pop up, new breaches that occur and are discovered by our client, by the insured between signing and closing, limited appetite for that in the market historically, a bit more appetite for covering that in the current market. Much more common place to get a nil retention or zero retention on things like fundamentals. If you think about the traditional indemnity structure, you'd have dollar one recourse as a buyer for a breach of a fundamental rep, ownership authority capitalization.

And for taxes, on the fundamental piece, at least, we are now seeing nil retentions with some frequency to match that historic indemnity approach. Not so much on tax because we do see claim activity on taxes. There can be death by a thousand cuts. And so carriers typically would ask for some sort of retention to cover that possibility.

Does that zero retention on fundamentals, does that cost extra in the policy?

Depends on the carrier, depends on the client, depends on the deal and how much premium they're getting otherwise, and-

Whether you're using Matt Heinz and Lockton too.

It depends on leverage and who's negotiating it and how much you can twist the arm. But we can get that as a throw in. I mean, look, it is an added risk to the carrier, so I think they're within their rights to ask for some additional premium, but it's also a very competitive marketplace. And so until things do turn, we generally have pretty good success with negotiating those things.

I will say, as opposed to drastically different deal terms, we're seeing increased appetite for structures, deal structures that were not historically insured or certainly not insured at the same pace that they are now. You mentioned minority deals. We could do really interesting stuff in a minority deals around preferred securities. We're doing a lot more in the secondary space. So private equity funds, a sponsor dropping an asset or assets into a continuation vehicle that they will continue to manage by bringing in new LPs and new capital to support the continued evolution of that portfolio company in the continuation vehicle.

There's an indemnity and hold back construct historically on those deals. Whenever I hear that money's being held back in a deal to protect against some sort of unknown risk, my eyes light up and I think that's an opportunity to use insurance. We could probably do that more efficiently than the clients and the lawyers beating each other over the head with a bat around that issue. And so we've had a lot of success in the secondary space. Tax market has expanded greatly in tax. So the biggest hurdle to the expansion of our tax product line has always been lack of awareness and lack of knowledge by tax professionals or deal lawyers contending with a tax issue in the context of an M&A transaction. It feels like awareness has really expanded and we're seeing a lot more activity both in the M&A context but also in the tax credit space as I mentioned before, and also litigation insurance.

The market has taken a couple of hits. There have been a couple of deals or cases that have ensured over the last, I would say 18 months that have gotten sideways for the carriers. It's more of a volatile product line, less predictable than the rep product line, but we're seeing tons of increased carrier appetite and demand for litigation solutions. So yeah, a time of low premium and low deal activity, that's when we want to innovate and ask carriers to do something a little bit different to generate either a new stream of premium or to get them some additional premium to handle something that was viewed as too risky to insure previously. When things are going bonkers like they were at '21, carriers frankly are not going to spend much time thinking about innovation just because they're trying to cast as wide a net as possible to handle the low-hanging fruit in all of the deals that are percolating regular way, so to say.

That's super interesting, and I really like your point of anytime as a deal lawyer or as an investor, you're thinking about holding back money from the proceeds to secure yourself against a risk, think about calling up your broker to see if there's a way an insurance policy can cover that. Maybe just to illustrate what are some common tax situations or tax credit situations where you're seeing those products be used?

Yeah, so tax credits, I mean the vast majority of what we do in that space is tied to renewable energy tax credits, wind and solar tax credits and tax equity investors coming into a deal or supporting a new development and looking to lock in the availability of whatever tax credit is going to be kicked off by that project. And so it's coverage around qualified basis issues, potential recapture issues, looking into the future. Interestingly, again, with the passage of the Inflation Reduction Act and increased ability to transfer those tax credits, we're seeing a lot of carrier innovation and interest around expanding to those transfers as opposed to the initial tax equity investment. Other stuff in the M&A context, pretty common to see S-Corp issues pop up, particularly as you're talking about mid-market and lower half of the mid-market. Any sort of founder deal where the initial business was set up through an S-Corp, and now the business has grown 20 x over 10 or 15 years or something like that, there could be a significant potential impact there if there was some sort of error in the S-Corp classification or ongoing qualification as an S-Corp.

In the real estate space, any sort of re-deal and any deal that really has a tax characterization tied to one of the entities trading hands and potential for a large tax liability, should that tax characterization have been incorrect, we've got an opportunity to underwrite to that.

Other specifics, I mean, NOLs, the transferability of a NOL to a buyer, the buyer's paying some sort of value or delivering some sort of value for the availability of an NOL post-close, that's something we can underwrite, any sort of pre-closed tax restructuring, split-offs, spin-offs, anything again, where there has been a prior transaction meant to achieve a certain tax outcome, and in the course of doing the present deal, there's been some sort of question raised around the viability of that tax outcome, whether through the analysis or through the underlying steps in the transaction that needed to be completed in order to achieve that tax outcome.

Super helpful and illustrative. Really appreciate, Matt, you spending some time with us here. This was a really informative update. Again, Matt and his team at Lockton are fantastic and can guide you through any of these issues. And so Matt, thanks again for your time.

Really appreciate it. Always love talking with you guys and working with you guys. And until we meet again.

Talk to you later. Bye.

Thank you for joining us on this episode of Deal by Deal, a McGuireWoods podcast. To learn more about today's discussion and our commitment to the independent sponsored community, please visit our website at mcGuirewoods.com. We look forward to hearing from you. This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.