Introduction
In the complex world of middle market mergers and acquisitions (M&A), representations and warranties insurance (RWI) has emerged as a critical tool for both buyers and sellers. It serves as a safety net, providing financial protection against breaches of representations and warranties made during the sale of a business. While relatively uncommon a decade ago, the American Bar Association's 2023 Private Target Deal Points Study indicated that 55% of deals used RWI. Understanding RWI and the typical areas of focus makes it easier to prepare for and navigate the underwriting process.
In this blog post, we’ll explore what RWI is, with a particular focus on the underwriting process and the unique considerations related to human capital or human resources.
What is Representations and Warranties Insurance?
Representations and warranties are statements made by the seller about the condition of the business being sold, covering everything from financial performance to compliance with laws, to the status of key contracts. RWI provides coverage for financial losses resulting from breaches of these statements, offering protection that can smooth the negotiation process and reduce post-closing disputes.
For middle market transactions, where the stakes are high but resources may be more limited than in larger deals, RWI can be particularly valuable. It enables sellers to reduce their exposure to potential post-closing liabilities, while also giving buyers confidence in the accuracy and completeness of the seller’s disclosures.
The Underwriting Process
The underwriting process for RWI is both rigorous and detailed. It involves a thorough review of the transaction documents, including the purchase agreement, due diligence reports, and any other relevant materials. Here’s a closer look at the steps involved:
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Submission of Information: The process begins with the submission of a completed application form, along with all relevant transaction documents. The more comprehensive and detailed the information provided, the smoother the underwriting process will be.
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Initial Risk Assessment: Underwriters conduct an initial review to assess the overall risk associated with the transaction. This includes evaluating the nature of the business, the structure of the deal, and the specific representations and warranties being made.
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Due Diligence Review: Underwriters work closely with the buyer’s due diligence team to understand the scope and findings of their review. This step is crucial as it helps identify any areas of concern or potential breaches that may need to be excluded from coverage.
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Negotiation of Terms: Based on the risk assessment, the underwriter will propose terms and conditions for the policy, including coverage limits, exclusions, and pricing. For example, we've seen carveouts in RWI policies for off-shore employees because the underwriters lacked confidence in the employer's payroll compliance practices. This is a collaborative process where both the buyer and the underwriter work to reach a mutually agreeable policy structure.
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Final Policy Issuance: Once terms are agreed upon, the policy is issued, providing coverage from the closing date of the transaction. It’s important to note that the process is time-sensitive, often requiring close coordination between all parties involved to ensure the policy is in place before the deal closes.
Human Capital and Human Resources Considerations
In the context of middle market M&A, human capital or human resources (HR) is a critical area of focus during the underwriting process. The human element of a business can significantly impact its value and operational continuity post-transaction. Here are some key HR-related considerations that underwriters pay close attention to:
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Employment Practices: Underwriters scrutinize the seller’s employment practices, including compliance with labor laws, the status of employee contracts, and any ongoing litigation related to employment disputes. Issues such as wrongful termination claims, discrimination allegations, or wage and hour disputes can represent significant liabilities. In fact, it's typical to be asked for schedules of U.S. employment eligibility verification (I-9/e-Verify) audit findings or documents related to employee separations and severance payments.
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Key Personnel: The retention of key personnel post-transaction is often crucial to the success of the deal. Underwriters assess the risk associated with the potential departure of key employees, as well as the presence of non-compete agreements and retention bonuses that may be in place to ensure continuity.
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Cultural Integration: The cultural fit between the buyer and the seller’s workforce is another area of concern. Underwriters may consider the potential challenges of integrating different corporate cultures and how this might impact employee morale and productivity. Underwriters have requested employee retention and turnover analyses, including explanations provided by the employers where these rates are significantly higher or lower than expected.
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Benefit Plans and Obligations: The seller’s benefit plans, including pension obligations, health insurance, and other employee benefits, are closely examined. Underwriters look for any unfunded liabilities or discrepancies in the management of these plans that could lead to future claims. We've worked with sellers to terminate defined benefit plans, provide IRS certifications and copies of required employee communications as part of the underwriting process.
Summary
Representations and warranties insurance has become an indispensable tool in middle market M&A transactions, offering protection and peace of mind for both buyers and sellers. The underwriting process, while thorough, ensures that all potential risks are adequately assessed and covered, with a particular emphasis on the human capital aspects that can make or break a deal. By understanding and addressing these HR-related issues, parties to the transaction can achieve a smoother transition and a more successful outcome.
The best way to ensure an uncomplicated and efficient underwriting process is to conduct a thorough due diligence (if you are a buyer) and to voluntarily audit your human capital practices prior to marketing your organization (if you are a seller). This enables you to identify challenges that may impede your RWI process and/or remediate items that could be cause for an exclusion. It also helps to keep your deal process on track to a timely close.
In today’s competitive M&A landscape, leveraging RWI can be the difference between a deal that fosters growth and one that leads to unforeseen challenges. Whether you’re a buyer or a seller, it’s essential to work with experienced professionals who understand the intricacies of RWI and can guide you through the underwriting process with a focus on the unique human elements of your business.
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