Representations and warranties insurance (RWI) — a tool used in an M&A deal to cover for breaches in a seller’s reps and warranties — is gaining ground as these products get more sophisticated and the risks involved are better understood by the market.
“The use of RWI is becoming more and more prevalent in lower mid-market deals,” says Howard Berkower, a partner at McCarter & English, LLP.
But it wasn’t always smooth sailing. “There were a couple of issues when insurance firms started providing this product. People were skeptical about whether they would pay out,” he says.
In time, skeptics have been proven wrong. “Time and experience with the product have given confidence to the transaction marketplace and transaction professionals are no longer concerned about payout issues,” Berkower says.
It was not only the attitudes toward RWI that evolved. The product itself also underwent a transformation. According to Berkower, as insurance companies gained underwriting experience with the product, they have been able to reduce its cost, making RWI available at lower transaction levels.
Popularity with PE Firms
When selling their portfolio companies, PE funds want to make as clean a break as possible and distribute cash proceeds quickly to their limited partners. “RWI gives PE funds the opportunity to do so and [avoid the need for an] escrow or holdback of cash proceeds,” McCarter’s Berkower says.
It is not surprising then that PE firms are one of the biggest users of this product currently, especially for those that are closing down a fund and liquidating their last portfolio investment.
This becomes a problem because if there is a significant amount in escrow, the limited partners cannot get paid in full. “The returns that the private equity sellers realize will be lower if 10% of their investment is in a low or non-interest bearing escrow account,” Barton’s Wang says. “These firms often can show a higher return just by buying a policy and paying the 2% to 4% premium plus the cost of closing the deal. They can then use the 10% they were supposed to put in escrow toward another investment.”