COVID-19 is causing large declines in stock markets, tightening in debt markets and a drastic decrease in M&A deal volume. Considering that private equity investors were starting the year with a record level of 𝐥𝐢𝐪𝐮𝐢𝐝𝐞𝐳 , it is only a matter of time before these funds look for opportunities to acquire undervalued and/or distressed companies. Many of these transactions will require M&A insurance, but it is an unknown whether insurers will continue to have the same appetite to offer the broad coverage they had been offering at current (historically lower) prices. This article seeks to address the impact of COVID-19 on market dynamics, policy terms and claims.
The impact of COVID-19 on policy wordings
Exclusion from COVID-19
The most immediate impact we are seeing on policy terms is the introduction of a new "COVID-19" exclusion. Thus, in the negotiation of terms for operations pending signature, insurers are including this COVID-19 exclusion and this with more or less broad/restrictive or scientifically sound wording. It is important to get the insurer's commitment to remove this broad exclusion once, during the underwriting process, the actual scope of COVID-19 on the target company's manifestations and business is understood. In other words, it will be vital to ensure that the exclusion is removed or, at least, drafted in a sufficiently restrictive manner to prevent insurers from using it unjustifiably to avoid claims.
Due diligence and COVID-19 representations
As might be expected, insurers are demanding a robust review of the impact of COVID-19, particularly with regard to financial forecasts, valuations, supply chain management, potential material contract disputes and labor issues. Representations that previously could be relatively easily assured, such as occupational health and safety compliance and the absence of adverse material changes since the date of the reference accounts, are now being scrutinized more closely during the underwriting phase of the insurance; with insurers seeking to downgrade these representations or include exclusions if due diligence does not provide sufficient comfort. Now more than ever, a proper due diligence scope review exercise is key to ensuring full coverage under R&Ws policies.
We are also seeing buyers taking a closer look at the insurance program on target companies to see if the risks essential to the business are adequately insured. Obtaining coverage under the R&Ws policy for those representations that speak to the adequacy/sufficiency of the target company's insurance program has suddenly become a critical issue. Obtaining this coverage is subject to performing insurance due diligence, something that only about 50% of private equity firms currently do.
A buyer-marketer?
Our view is that, at least in the short term, COVID-19 will be a disruption to this seller-market and return a greater degree of control to buyers. As a result, buyers may begin to pressure sellers/managers of solvent companies to grant R&Ws in a more meaningful way than has been customary over the past five years (where limiting sellers' liability to one euro was acceptable). In turn, this could lead to an increase in the amount of deductibles on R&Ws policies (buyer mode) or even an increase in demand for R&Ws policies in their seller-policy mode. In addition, we anticipate that buyers may be less willing to negotiate with sellers for known risks, especially tax risks, preferring to opt for protection in the risk-specific insurance market (particularly in an environment where the seller's financial stability may not be guaranteed or where the seller would rather take on a policy payout than maintain long-term liability). That said, with the record level of liquidity available to funds at the beginning of the year, it seems inevitable that, in the medium term, we will return to a seller-side market.
With respect to the transaction documents, there is no doubt that material adverse change (MAC) clauses will become more prevalent. From a policy standpoint, it will be essential to ensure that policies remain in force if the parties agree to proceed with the closing of the transaction following the occurrence of a material adverse change (although any loss arising from the event giving rise to the material adverse change event would not be covered by the policy).
We also expect to see an increase in purchase and sale contracts with deferred pricing mechanisms and earn-out structures. From a policy standpoint, when determining the appropriate coverage limit, the final potential price and not the initial purchase price should be considered, as a coverage limit based solely on that initial price could unduly restrict indemnity in the event of a claim (as that limit does not represent the actual size of the business and, therefore, the risk). In addition, with a stronger buyer-market and in the face of ongoing instability, we anticipate that repeat business R&Ws at closing will appear more frequently in buy-sell contracts. While insurers are willing to provide coverage for repeat R&Ws at closing, it will be key to include an adequate bring-down mechanism in the transaction documents and to demonstrate that sellers have done a thorough job of updating their disclosure exercise. Securing new breach coverage (i.e., coverage for breaches arising from events that occur during the interim period and are discovered in the interim period) will be extremely difficult in the current situation, especially for transactions of a non-real estate nature.
The impact of COVID-19 on claims
Increase in claims
Economic downturns often lead to an increase in insurance claims as companies seek to mitigate their losses. It stands to reason that the same could be true for M&A insurance. We have seen in recent years a generalized increase in the number of claims in this type of policy. This is mainly due to two factors. Firstly, the greater willingness of policyholders to file claims against an insurer rather than the sellers or managers and, secondly, because the claims process under the policy is much more streamlined than traditional contractual claims processes.
We expect a considerable increase in claims on material contracts. It is reasonable to believe that buyers, their portfolio companies and, of course, their customers will be taking a closer look at the relevant contracts to assess whether the terms and conditions of the contracts are being complied with. While the COVID-19 outbreak is a post-contract event, it is likely that some of the issues identified constitute pre-contract breaches and that policyholders will be seeking restitution on these matters through their R&Ws policies. This more detailed analysis on the performance of these contracts would likely not have been performed in the absence of the COVID-19 outbreak.
As being covered under the umbrella of an employment relationship may now be much more attractive, third party subcontractors and other "non-employee" collaborators are also likely to carefully assess whether their relationship qualifies as an employment relationship in order to obtain the greater protection offered by this status. As a result, labor claims (typically around 10% of total claims) may increase in the coming months, although this risk may be mitigated by the governments' planned emergency economic relief and measures.
Application of damage multipliers
When claims are made, proving that there has been a breach of the manifestation in question is usually relatively straightforward, while proving the loss suffered is often more difficult. As insurers face more claims, they will require more evidence to prove the correct valuation of the target company. For example, if an EBITDA multiple is based on comparables in the market, and the market has changed rapidly, it will be important to retain evidence/assumptions of how the multiple was calculated at that time for the valuation model.
Policy limits and assessment of insurer's rating
Even before the COVID-19 outbreak, several policyholders who received large payouts under their policies found that they had taken out limits that were still insufficient. This started a trend whereby buyers were taking out 15-25% of the target company's value as a policy limit (as opposed to the hitherto traditional 10%). As more distressed deals are sought to be insured and private equity funds allocate a higher proportion of equity in their deals, we expect this trend to continue through 2020 and 2021.
In the face of higher policy limits and a potential increase in insolvency ratios in the market, we anticipate that ratings will begin to play an even more important role in insurer selection. While all insurers in the M&A insurance market are rated A- or higher, a greater preference for insurers rated AA- or higher may begin to develop. Of course, this should be taken into consideration with the degree of coverage offered by such insurers and the efficiency/ streamlining of their underwriting processes.