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Reflected in the afterglow: M&A insurance and related solutions

Piers Johansen

Aon M&A and Transaction Solutions

Tuesday 29 October 2019


The application of insurance solutions in M&A (including warranty and indemnity (W&I), tax and contingent risk insurance – together, M&A insurance) finds firmer footing in Europe, the Middle East and Africa (EMEA) in 2019. W&I insurance continues to blaze a trail, heightening awareness of the value arbitrage offered through a relatively cheap cost of insurance capital and prompting more transaction principals to consider risk transfer when looking for their edge in a deal. Corporate insureds continue to convert to M&A insurance and traditional infrastructure investors become more risk transfer focused as they compete for ‘core plus’ assets. Given the disruptive impact of technological change, the need to evaluate cyber and data protection risks is hard to dispute for many transactions and, properly approached, can actively protect deal value.

Macro-dislocation … while M&A insurance takes firmer root

Recent analysis indicates that deal activity by value (US$391 billion) in EMEA withered in the first half of 2019, declining 38.8 per cent compared with the corresponding period in 2018 (US$638.9 billion) as political and economic uncertainty sapped deal confidence in EMEA and stronger levels of activity in the US mopped up investor appetite (source: Global & Regional M&A Report 1H19, Mergermarket).

For transactions that are still being executed in EMEA, however, the demand for M&A insurance seen by Aon remains resilient by comparison, both in terms of deal volume and the aggregate amount of M&A insurance placed by Aon on such deals (see table 1).

Table 1: Deal count and aggregate M&A insurance limits placed by Aon in EMEA on transactions up to US$500 million EV and above US$500 million EV (2019 H1 vs 2018 H1)
 

0-500 EV
(US$mn)

500+ EV
(US$mn)

Total
(US$mn)

 

Deal #

Limit (US$bn)

Deal #

Limit (US$bn)

Deal #

Limit (US$bn)

H1 2018

143

3.9

23

5.3

166

9.2

H1 2019

139

4.1

26

5.0

165

9.1


Source: Aon M&A and Transaction Solutions EMEA
EV: enterprise value, in US$mn
Limit: amount of M&A insurance placed, including title insurance, in US$bn

This resilience is reflective of M&A insurance rooting itself more firmly and being recognised by transaction principals and advisers as not only a deal-enabling, risk transfer mechanism but also a master key for accessing value in other ways, a notion echoed recently by a senior private equity executive: ‘W&I has been a real pathfinder in boosting people’s awareness of how insurance solutions can be deployed in transactions’ (source: Aon’s C-Suite Series - M&A ‘Leave nothing on the table: Unlocking off-radar transaction value’, published in collaboration with The Financial Times in 2019).

Indeed, our data in table 1 indicates that the upper end of the deal value spectrum – acquisitions of targets with enterprise value of US$500 million and above – experienced the greater proportion of M&A insurance growth by deal count year-on-year – 26 (2019) versus 23 (2018), compared with deal activity at the lower end of that spectrum: 139 (2019) versus 143 (2018). This year-on-year uptick in deal count – notwithstanding a shrinking of M&A activity in the region generally – is, as we see it, indicative of a cross-pollination effect of M&A insurance across the transaction value spectrum, as the aforementioned deal-maker awareness filters further into larger, cross-border transactions.

While the aggregate amount of M&A insurance placed by Aon in H1 2019 (US$5.0 billion) for transactions at the upper end of the deal value range was down slightly, compared with H1 2018 (US$5.3 billion), figures for the latter period included a relative outlier €1 billion individual W&I insurance policy limit.

Across the deal value spectrum generally, we note the commentary on W&I insurance growth published by the law firm Latham & Watkins (Private M&A Market Study 2018), which concluded that 32 per cent of all transactions in their review from 2016 to 2018 used W&I insurance, up from 8 per cent, 13 per cent and 22 per cent respectively in the previous three editions of their survey. Anecdotally, we attended a client seminar on M&A insurance this year that was presented by partners and associates from one ‘magic circle’ law firm (to whom we had pitched the same topic some years before!), a further indication that M&A insurance has become formally recognised across further parts of the deal community.

Onward corporates march

One topic discussed in our article for this publication last year was the rise of the corporate buyer of M&A insurance – as distinct from private equity (PE) or other types of financial investor – which we saw as a key driver for the continued growth of M&A insurance. So far this year, we have seen a surge in corporate insured activity, with the aggregate amount of M&A insurance placed by Aon for its corporate clients in H1 2019 (US$4.7 billion) significantly exceeding the half-year 2018 level (US$3.0 billion) and approaching the 2018 full-year figure of US$5.7 billion.

Indeed, as M&A insurance has progressed further along the deal value spectrum, our experience suggests that corporate buyers have, since the start of 2018, managed to compete more effectively on all but the largest (upwards of US$5 billion) of deal size categories that involved M&A insurance placed by Aon, most of which – across those deal sizes as a whole – were structured as auctions (see table 2).

Table 2: Type of insureds for M&A insurance placements by Aon in EMEA involving transactions of US$0.5bn+ EV, split by auction/bilateral transaction (2018 FY to July 2019)

Individual deal size EV (US$)

0.5-1bn

1-2bn

2-5bn

5bn+

Total

Deal count

37

16

12

3

68

Auction

23

8

4

2

37

Bilateral

14

8

8

1

31

Sub-total

37

16

12

3

68

Corporate insured

21

8

5

0

34

Private equity insured

13

6

3

3

25

Other financial investor insured

0

2

3

0

5

PE real estate insured

3

0

1

0

4

Total

37

16

12

3

68

Source: Aon M&A and Transaction Solutions EMEA
EV: enterprise value, in US$bn

Auctions: saying and doing – two different things

Continuing with the auction theme, we noted last year the increase in seller-initiated insurance solutions, as vendors sought to seize the initiative by presenting M&A insurance arrangements in various forms of readiness to bidders to help foster competition and, thereby, enhance commercial terms and expedite deal execution, analogous to ‘staple finance’ arrangements in the debt market. Our experience of this development has been echoed in research since published by the law firm Allen & Overy, which observed that it was ‘. . . seeing interesting innovations in the W&I market [b]ut the biggest change has been the move towards the so-called “stapled W&I”. . . ’ (source: M&A Insights Q1 2019).

Easier said than well executed, seller-initiated W&I insurance solutions rely heavily on good communication and collaboration among advisers – both corporate finance and legal – from the outset. We have seen some processes run into difficulty due largely to communication issues, including where seller or its advisers have not conveyed the availability of the solution to bidders properly, or not managed to articulate clearly enough the nuances of how the solution should operate, or otherwise managed a process that led to confusion among bidders once the ‘flip’ to the buyer occurred.

Our advice to clients and advisers alike is that the W&I process should not be viewed as an adjunct to the legal documentation workstream – otherwise, it risks becoming a silo and a drag on the deal timeline. The seller’s auction objectives are important for the W&I insurance broker to understand, as are the nature and background of the likely bidders, hence the emphasis on quality of communication across the advisory teams. Sufficient time – and, as necessary, management bandwidth – should be allowed for discussing the approach to vendor due diligence and sell-side underwriting, where appropriate.

Two insured ‘mega-deals’ do not a trend make

We hinted in last year’s article at the dawn of the insured ‘mega-deal’ following the placement by Aon of a €1 billion W&I insurance limit to support the buyer on a €10 billion acquisition. Our experience in 2019 followed a similar pattern, with a significant W&I insurance limit being placed by Aon in EMEA on another €10 billion acquisition, the latter a rare bright spot for EMEA in-bound deals in H1 2019. While M&A insurance placements on these ‘elephant’ transactions clearly remain the exception rather than the rule, the demand for - and supply of – M&A insurance solutions at the upper echelons of the deal value range are self-evident.

‘Synthetic’ W&I insurance – shiny new toy?

Featuring mostly in real estate sector transactions rather than acquisitions of operating businesses, ‘synthetic’ W&I structures seek to create buyer recourse against an insurer by importing a set of warranties directly into the W&I insurance policy, bypassing the seller and a conventional disclosure exercise altogether. (For clarity, this is distinct from individual ‘synthetic’ features of cover, such as extended warranty periods or dis-application of a de minimis claim amount under the W&I policy separate from the sale and purchase agreement, or cover in the form of a ‘synthetic’ tax deed in the absence of one coming from the seller.)

Insurer views on ‘synthetic’ W&I policies outside the real estate sector are decidedly mixed, not least owing to the absence of a conventional disclosure exercise by sellers against the warranties. For clients, the attraction is the ability to compete aggressively by presenting a fully executable share purchase agreement to the seller with only ‘fundamental’ warranties.

While disclosure concerns can be addressed in appropriate, but not necessarily all, circumstances, and mindful of the range of insurer views on the concept, we see a ‘synthetic’ W&I structure as a solution with relatively narrow application depending on the transaction, and the nature and geography of the business being sold, rather than as a broader market development or direction of travel per se. That said, with the right fact-pattern and a fulsome buyer due diligence process, a synthetic structure could provide the winning formula, so the potential benefits should not be underestimated.

Depth and fragmentation as new tax insurers emerge

Tax insurance offers protection against the additional tax, interest, penalties and defence costs that could arise if a position taken in a company’s tax filings is successfully challenged by a tax authority. It is used in a wide range of contexts (including public and private M&A, restructurings and tax disputes), although Aon’s data suggests that M&A remains the main driver for using this product – about 90 per cent of tax insurance policies placed by Aon EMEA since 2015 have been connected to M&A in some way.

2018 was a significant year with a trend developing – and continuing into 2019 – of new tax insurers entering the market. By the beginning of 2020, we expect 20 separate tax underwriting teams across Europe to be offering cover.

Competition among these insurers appears to be driving them to adopt a more specialist approach and develop appetite for ‘niche’ areas that focus on the size of risk – either, large (above €150 million) or small (less than €1 million), or by jurisdiction (eg, Germany, The Netherlands, United Kingdom, Spain or the Asia Pacific region). We see this as a welcome development and likely to result in quicker and more efficient review, underwriting and execution.

This influx of new market entrants has increased the aggregate amount of capacity, enabling Aon to structure and place a tax insurance programme for more than US$1.5 billion on a single matter in 2019. As tax environments become increasingly complex, tax insurance remains an attractive proposition for clients to help them protect deal value and achieve better deal certainty by transferring their tax risk cost-effectively.

Are you – claims – experienced?

In respect of the past three full years in EMEA, we have seen more than 100 notifications from clients relating to potential W&I insurance claims, representing between 13 per cent and 26 per cent of the policies placed in a given year, with more notifications made by corporate insureds (24 per cent of policies taken out by them) than PE insureds (15 per cent of policies taken out by them). In respect of the same period, we have helped clients negotiate payments on claims resulting in payments of approximately £10 million from multiple insurers and remain actively involved pursuing a number of other ongoing claims where a settlement resolution is expected in the near future. The matters comprised both first and third party claims involving a variety of breaches of warranties, including in relation to financial statements, tax, and regulatory matters. In addition to these claims, Aon has helped resolve numerous other claims where losses resulted in an erosion of, but did not exceed, the applicable policy retention.

Traditional infra players compete for ‘core plus’ assets

The mix of competitors for M&A assets is broadening demand for deal-related insurance solutions, particularly among traditional infrastructure investors whose investment approach incorporates a lower expected rate of return and – as such – carries a lower tolerance of risk. As the more traditional infra players embark on M&A acquisitions classed as ‘core plus’, including peaking power plants, pre-schools and data centres (to name a few), a recalibration of their risk appetite and approach is required.

Some examples of areas where we see these types of infra client looking to protect deal value include – in addition to W&I insurance –specific solutions for cybersecurity and data protection threats, linked to increasingly onerous regulation for Critical National Infrastructure, and General Data Protection Regulation (GDPR) requirements where assets have a business-to-consumer component, identified taxes issues (such as real estate transfer taxes, non-resident capital gains taxes, issues around financing structures), ‘voluntary termination’ solutions in PPP/PFI contracts and meter failure solutions for the smart metering asset class.

Cyber security and data protection – hiding in plain sight

In our article last year, cybersecurity and data protection were among previously identified hot topics for M&A, and GDPR had only recently come into effect. High-profile media reports since demonstrate the significant impact that weak cybersecurity measures can have on business value, a notable example being the £183.4 million fine proposed by the UK Information Commissioner’s Office (ICO) on British Airways in July 2019 for poor security arrangements that allowed a widespread hack of its customer data. That fine, the first proposed by the ICO under GDPR, amounts to about 6 per cent of the operating profit before exceptional items for British Airways’ parent, International Airlines Group (€3.2 billion according to IAG’s 2018 audited accounts, applying a European Central Bank GBP/euro exchange rate of 1:1.1179 as at 31 December 2018).

Perhaps unsurprisingly given the pace of human behavioural change, but curiously given the potential adverse impact from a business perspective, the law firm Freshfields refers to a ‘growing complacency’ among deal-makers in its 2019 Cyber Security in M&A report. Notwithstanding an acknowledged awareness of the potential negative impact to business value and reputation, a significant proportion of deal-makers polled in the Freshfields survey appeared not to evaluate or quantify cyber threats:

The results show that 78 per cent of respondents believe cyber security is not analysed in great depth or specifically quantified as part of the M&A due diligence process, despite 83 per cent saying they believe a deal could be abandoned if previous cyber security breaches were identified and 90 per cent saying such breaches could reduce the value of a deal.

Given the extent to which technological and digital innovations have transformed business, we see cybersecurity and data protection due diligence as a key workstream on most M&A transactions, a view echoed by one senior private equity executive: ‘There’s an increasing view that every deal we do now is a technology deal, regardless of sector.’ (source: Aon’s C-Suite Series - M&A ‘Leave nothing on the table: Unlocking off-radar transaction value’). This sentiment is echoed in the Freshfields report: ‘Cyber risk presents a significant threat to the operations, reputation and bottom line of virtually every company, regardless of industry.’

Aon’s cyber and data protection specialists already work with clients to run automated security scans, based on information available in public and ‘dark web’ domains, across their portfolios to help identify high-risk investments that may require investigation for potential cyber or data security compromise. Among other measures, this can include quantitative cyber incident modelling to determine the financial loss exposure to the business based on multiple factors, such as its customer records, sector and operating geographies.

We recently advised one client on the acquisition of a people-focused business in EMEA and ran a similar external analysis of the target’s cybersecurity systems, based on a review of publicly available information and a ‘dark web’ trawl. While the cybersecurity systems themselves did not exhibit areas of concern (particularly, no evidence of data compromise or material technical vulnerabilities), we did identify limited, low value-impact instances of ‘human error’ where personal data had been inadvertently mishandled by the target company’s employees. Most importantly, in proceeding with the deal our client could take comfort that the target company was not subject to material cyber or personal data vulnerabilities which, had they been present, could otherwise have had a major impact on transaction value given the dynamics of the target’s business sector. Separately, the output of Aon’s cyber security and data protection due diligence was acceptable to the W&I insurer on that deal, which was prepared – in that instance – to remove the general GDPR exclusion from the W&I insurance policy (other than in relation to those limited, identified instances referred to above), creating a collateral benefit for the client by way of improved W&I insurance cover.

It is a common misconception that cyber security analysis falls within the scope of an IT due diligence review, but this is short-sighted. The former requires a holistic, horizontal read-across the business value chain by specialists who understand key revenue drivers and how these map to potential areas of operational, technical and regulatory weakness – including the aforementioned ‘human factor’, a theme also picked up in the Aon and Freshfields reports referred to above. On the other hand, a typical IT due diligence review is performed by IT generalists and focuses more vertically on auditing areas such as traditional IT infrastructure, data centres and IT governance to determine whether the system is fit for purpose and scalable.

An appreciation of the difference between these two workstreams is key for both M&A sellers and buyers to prevent legacy cyber or data compromise issues derailing a sale process or even coming back to haunt post-completion, given the potentially drastic consequences that can arise in either case, as identified in the Freshfields and Aon deal-maker surveys.

Marriott International Inc’s acquisition of Starwood hotels group in 2016, and subsequent notice issued by the ICO of a proposed £99 million GDPR fine, is a case in point. A cyber incident in November 2018 had exposed personal data in 339 million guest records globally, which the ICO believed to be a legacy vulnerability that began when the Starwood hotels group systems were compromised in 2014, prior to the acquisition. The Information Commissioner said:

The GDPR makes it clear that organisations must be accountable for the personal data they hold. This can include carrying out proper due diligence when making a corporate acquisition, and putting in place proper accountability measures to assess not only what personal data has been acquired, but also how it is protected (ICO Statement: Intention to fine Marriott International, Inc more than £99 million under GDPR for data breach, 9 July 2019).

Indeed, as one private equity specialist more recently observed: ‘Cyber due diligence helps you understand exactly what your tech footprint is, and what exactly your digital surface area is to external audiences. It helps to see if someone left the equivalent of a digital back door open’ (source: Aon C-Suite Series – Cyber ‘Prepare for the expected: Safeguarding value in the era of cyber risk’, published in collaboration with The Financial Times in 2019.)

Innovation in M&A

Aon has responded to challenges presented by clients and advisers in recent years to support and enhance M&A deal-making in both private and public M&A transactions. The most recent private M&A innovation in EMEA was the structuring and placing of a deferred consideration surety bond for the private equity firm Warburg Pincus, in support of its 2.5 billion Israeli shekel cash acquisition of Leumi Card from Bank Leumi and Azrieli Group, which completed in early 2019.

The deal’s commercial terms included the payment of consideration to the sellers by Warburg Pincus in three instalments: at closing and on the first and second anniversary of completion. Given the deferred consideration structure, Warburg Pincus sought to optimise the cost of capital that Bank Leumi was required to hold, for regulatory capital reasons, against the post-completion credit risk of Warburg Pincus for the deferred consideration period. A bank guarantee had been identified as one way of achieving this.

An insurance (more specifically, a surety) solution was able to enhance Warburg Pincus’ proposal to the sellers by arbitraging a lower cost of insurance capital versus bank capital and optimising the capital relief available to Bank Leumi given the highly rated insurer/surety covenant (a combination of AA and A). Aon structured a substantial deferred consideration surety bond from London with six surety providers, navigating the dynamics between the sureties’ commercial and legal requirements for issuing bonds and Warburg Pincus’ fund and M&A deal structure.

Final thought – the edge

Why the continued expansion of M&A-related insurance and other approaches to protect deal value? For some – notably tax and, to a certain extent, contingent risk insurance – it is perhaps a question of their reflected status in the afterglow of W&I insurance’s stellar growth in recent years, as deal-maker confidence explores further ways to identify and capture value by transferring risk to the insurance market. Other solutions are driven by external factors, such as an increasingly digital and inter-connected business environment, or regulatory changes, including a more robust, harmonised data protection regime across the European Union and European Economic Area. Either way, the common theme is a willingness – and ability – to apply more innovative deal solutions in pursuit of that winning edge.

A further illustration of the conditions for invention can be seen in the polar change in business value from tangible to intangible assets in recent decades. According to Ocean Tomo, an independent merchant bank focused on intellectual property (IP), the financial value of tangible and intangible assets has completely reversed during the past 40 years: in 1975, tangible assets comprised 83 per cent of the S&P 500 market value, whereas, in 2015, intangible assets made up 84 per cent of the S&P 500 market value (source: Intangible Asset Market Value Study, 2017). Transaction and portfolio solutions that respond to this quantum shift, recognising the need not only to focus on protecting IP (both offensively and defensively) with insurance and technological (eg, blockchain) solutions but also the ability of IP-rich clients to utilise this intangible asset in a more conventional way – whether as security for debt financing or to drive corporate strategy – represent further examples of the ability to tap hidden value in an increasingly IP-led Internet of Things economy.

  • The author gratefully acknowledges contributions to this article from other members of the Aon M&A and Transaction Solutions team, including in particular: Johnathan Beechey, Claire Fleetwood, Charlie Garrood, Giulio Greco, Alistair Lester, David McCann, Ian McCaw and Alexandra Taylor. Reference to Warburg Pincus is included with their kind permission.

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