Reps and warranty insurance is gaining a more prominent role in the M&A deal process, finding its way into 30 percent more deals in the last five years as buyers look to reduce risk in areas such as data security, environmental matters and compliance with COVID-19 regulations.
One positive impact of that on the deal process, according to Waller Lansden Dortch & Davis LLP Partner Tyson Bickley who spoke at the Nashville Smart Business Dealmakers Conference, is efficiency.
"Reps and warranties insurance has become so much more efficient, especially from a cost standpoint," he says. "In certain deal sizes — it doesn't for probably sub-$20 (million) to $25 (million), maybe, but for those other deals, you go to a seller, especially if you're a private equity firm that's trying to set itself apart, you go to those sellers and say, There's no longer going to be a $5 million or $10 million escrow. You're going to get that money, but let's split the premium or we'll pay the premium. You'll have a small retention. It's a lot more attractive than having significant indemnification liabilities as we used to have," Bickley says.
It has, however, added to the diligence because there's another party that needs to have its turn at due diligence, which is something both buyers and sellers need to plan and be prepared for.
LFM Capital Managing Director Chris Lin says the insurance has made the negotiation process a lot easier, especially for small business owners and family businesses because they're often concerned that they'll lose their escrow given the indemnifications they're signing. Having reps and warranties insurance is a way for them to not worry about that.
"It does make the last five days of close a little bit hectic as you're wondering what is the carrier going to come back with for exclusions, and you're waiting on this other party to get things across the finish line," Lin says. "But overall, it's made things a lot more straightforward for those deals where it can qualify."
COVID, he says, from a diligence standpoint has added a new wrinkle in the deal process.
From a legal perspective, Bickley says for the last year and a half, PPP loans and different government grants offered and accepted during the early years of the pandemic had been a big focus for companies when it came to M&A, with many wondering if those need to be paid off to be able to close a deal. Questions such as what's outstanding are still being asked as parties seek to understand all the liabilities. And there are still questions about what interruptions to the business occurred during the pandemic. But, he says, that's evolved more to questions about a company's supply chain and what has happened with earnings. Still, from a purchase agreement standpoint, he says they've added reps to address various government programs and COVID matters.
Resource Label Group Senior Vice President and General Counsel Hunter Rost says he's heard a new term, COVID-adjusted EBITDA, creep into the acquisition lexicon. The concern is how a company fared over the past 12 months, how COVID impacted performance compared to what would have been normal if the workforce hadn't been out or supply chain issues didn't exist.
Lin says he's seen COVID-adjusted EBITDA, especially because of labor shortages and supply chain issues. But he says he's seen in more companies a greater concern about COVID increases rather than decreases.
"There was a shutdown in 2020 and then all the demand got shifted to 21, so you're trying to understand how much of that demand is the normal steady state," Lin says. "Obviously, there's some cost issues to factor in there as well. There's a little bit of selection bias as well because the companies coming to market are generally the ones that have been doing pretty well and the ones that haven't been doing pretty well are probably holding back to recover in performance. But if I were to look back at the past 12 months or past six months, there's probably been more concern about increases in EBITDA due to the second order effects of COVID, rather than decreases that need to be added back to a more normal state."