Five pitfalls to avoid in W&I insurance on continuation vehicle deals

Warranty and indemnity insurance (representation and warranties insurance to our US readers) is increasingly viewed by secondaries players as a valuable facilitation tool on continuation vehicle deals. Recourse to insurance was unusual in the early days of these deals, though around two-thirds of deals seen by Stephenson Harwood now include the use of W&I insurance.

The advantages are clear:

• Time efficiency – reduced negotiation around risk allocation
• Conflicts – giving investors recourse against insurers with A+ rated balance sheets instead of requiring the sponsor to claim against its investor base
• Tail liabilities – allowing selling funds to cap their liability as low as $1, allowing a distribution to investors with no clawback risk

W&I insurance benefits all parties on a GP-led transaction, but equally it is not a liability blank cheque. Preparation and a careful approach are essential to avoid delays to the timetable, a caveated insurance policy, or both.

Realistic warranties

Be realistic about the scope of the warranties that the insurance policy is being asked to cover – not a boilerplate shopping list because ‘we are relying on insurance’.

Most deals now refer to a market standard set of limited ‘secondaries’ warranties focused on fundamental issues around title, capacity and transferability. These can be supplemented with some high-level comfort on the underlying assets, which are qualified by the actual knowledge of the GP deal team.

A subset of deals, generally dealing with a single asset, include a full suite of M&A warranties. This happens where (i) vendor due diligence has been commissioned, (ii) the underlying management team is involved in providing disclosures against such warranties.

In brief, deal parties need to carefully consider the appropriate level of warranty cover being sought at the outset, commensurate to the underlying process.

Due diligence

A core principle of W&I insurance is that the scope of coverage must be matched by underlying diligence.

The level of diligence will typically be driven by the concentration of the portfolio of target assets.

On portfolio deals, due diligence will typically be focused on title and transferability matters (including third-party consents and regulatory approvals) and tax structuring.

For single asset deals, there is commonly a full scope vendor due diligence report arranged by the GP, often in the context of a parallel (or earlier) M&A sale process.

Generally speaking, and consistent with the usual position under W&I insurance, a broader due diligence exercise translates to broader warranty coverage under the W&I policy, a more straightforward underwriting process and ultimately a more valuable insurance product.

Disclosure

An exhaustive sell-side disclosure process is required to achieve the best policy coverage.

The disclosure exercise serves to qualify the warranties by reference to known facts and circumstances that make elements of the warranties inaccurate.  Evidence of a disclosure exercise gives the underwriter the necessary comfort to provide coverage on an absolute basis.

Disclosures can be organised as either a schedule to the sale and purchase agreement, a separate disclosure letter, or at a very minimum, a written Q&A process to be carried out with the sell-side deal team to act as a proxy for a traditional disclosure exercise.

Consideration should also be given to who is carrying out the disclosure exercise. For most continuation vehicle deals, this is usually limited to the GP deal team; for those seeking comprehensive warranty coverage, this would also include underlying management team members.

Underwriting process

As with any transaction workstream, preparing the groundwork early ensures that the underwriting process fits seamlessly into the timeline to signing. This is incumbent upon the GP and its counsel; where insurance is subsequently required later in the process by the lead investor’s counsel, it can result in delays.

This preparation phase includes early engagement with the insurance broker, populating a well-organised data room and finalising due diligence reports and sell-side disclosures in good time ahead of the underwriting process.

The underwriting process can usually be completed within two weeks and largely involves a review by the underwriter (and its legal counsel) of the transaction documents, due diligence reports, disclosures and data room documents. The output of this review drives the underwriter’s ability to provide the insurance.

Specialist broker and underwriter

Similarly to the legals governing CV deals, the insurance package includes a number of features unique to the secondaries market, so recourse to a specialist provider is key.

A subset of W&I insurers and brokers have meaningful experience in arranging W&I insurance packages on GP-led deals. This is key given the industry-specific approach to items such as Excluded Obligations, conflict mitigation and reduced diligence. Working with a provider who can navigate the issues without disrupting the deal process helps reduce friction and expense.

Conclusion

Sponsors are increasingly turning to insurance in the context of their continuation vehicle deals, with a group of specialist providers gearing up to meet this uptick in demand.

W&I is now ubiquitous in the buyouts universe, and we believe it will ultimately become a staple feature of continuation vehicle transactions, given the obvious advantages for all parties involved.