A survival guide to M&A without warranties
Some quick background: according to the market practice, the seller of a company or an asset is expected to give the buyer a set of representations and warranties regarding various aspects of the target, including accounting, tax legal and operational issues (“R&Ws”). If any of these representations and warranties reveals to be not truthful, the buyer is entitled to an indemnity from the seller, subject to qualifications and limitations.
Sooner or later you will meet a seller refusing to grant any R&Ws. The sale will be on an "as is" basis. That could happen for many reasons. The seller, or the subject managing the sale, is a public entity, a court or a bankruptcy receiver. Or there is an auction process in place and there is a truly unique asset for sale. Or the seller just ignores, or pretends to ignore, the market practice, which may happen in non-sophisticated jurisdictions or when buying a family-run company.
Be prepared. Here an approach I use to navigate through uncharted waters.
1 The return of the due diligence. While due diligence has become a commodity, where no warranties are involved do not tighten your pockets. Make sure that the due diligence team members your advisors are sending are not fresh out of university. Lower the value thresholds of the documents to be reviewed. Be sure that the smallest subsidiary of the target group is searched. Expand the scope of the due diligence process to involve technical experts to assess the regulatory compliance, the conditions of real estate properties, the presence of environmental issues in production plants, the manufacturing processes and so on. Go beyond the paper.
2 Close encounters of some kind. Although it does not sound cost-efficient, I realized that it is worth spending as much time as possible at the seller’s premises and with the company managers. De facto issues cannot be detected though documental reviews. This is as true for the buyer as it is for its consultants, including lawyers and accountants. And do not forget the IT guys (find out why here). If a picture is worth more than a thousand words, a personal experience is worth more than a thousand due diligence reports.
3 Never say Rep again. Are R&Ws as reassuring as we think? Enforcing R&Ws often involves disputes and no security to get the money back, unless a substantial portion of the price is held by a third party (a so-called escrow agent – not to be confused with an escort agent). In any case, it will not be quick. Therefore, if you cannot obtain R&Ws by the seller, get them from somebody else. Part of the R&Ws’ range can be covered by company house certificates, mortgage reports from notaries, accident reports from insurance agents and litigation reports from external consultants of the target company, including trademark attorneys and lawyers. Banks can release statements confirming the balance of facilities as well as the cash available. Clients and suppliers can give assurances about the absence of disputes. Employees can be asked to issue statements about the absence of claims.
4 For a few Euros more. Mitigating the risk by playing with the price structure is essential, but if you are taking part to a bid you also want to be competitive. Therefore, instead of just lowering the price, the buyer can offer a deferred or variable price depending on the future performance of the target company, typically in terms of Ebitda margin. By working on the Ebitda definition, a smart buyer can capture material profit and loss deviations from the reference financial statements, although in absence of R&Ws. Also broadening the price adjustment spectrum may be instrumental to intercepting deviations to the reference net debt.
5 The great escape. When R&Ws are not involved, having the ability of getting out of the contract if something goes wrong between signing and closing is a great tool. A material adverse effect (“MAE”) clause is what you need. The issue here is to define what material really means. Value thresholds
6 The usual suspects. Make friends (or hostages, depending on their viewpoint). Involving those who know the target company well in your future plans or in those of your broader organization will put them in a cooperative mood and you will get to know more than any set of R&Ws could tell. Employment and consulting arrangements are key to lock-in sellers, directors, top managers and key employees.
7 True lies. Psychologic warfare sometimes works. Induce the seller to make a complete disclosure by emphasizing the consequences of intentional deception under the applicable law. This tactic should be deployed both in the contractual documentation and in face to face meetings.
Copyright Giorgio Mariani 2016. All rights are reserved.
OTHER ARTICLES PUBLISHED ON LINKEDIN BY Giorgio Mariani:
Make due diligence great again!
How to escape from a joint venture
The way back from the closing dinner (M&A integration issues)
20 features of Italian M&A agreements (that foreign investors should know)
The golden rule of writing any contract (Part 1)
The golden rule of drafting any contract (Part 2 - Tips)
A NOTE ON THE AUTHOR: Giorgio Mariani is an Of Counsel at the international law firm Simmons & Simmons since 2008. He specialises in cross border M&A, real estate and commercial transactions in the TMT, infrastructure, energy and fashion industries. He acts as M&A legal advisor for industrial groups under special insolvency administration (Amministrazione Straordinaria).
Director at Sandison Kennedy
7yGiorgio, Federico Cottone is correct - W&I insurance is available in the UK also. There are various providers but Marsh PEMA is certainly one to contact in London (disclosure - ex Marsh employee!). It will not always be cost effective. It will usually not extend out to matters disclosed to the buyer (or discovered in DD) or to matters where a specific indemnity is obtained (ie. for a known liability, although other insurances can be used to cover that gap. An example might be for environmental issues). Also, although the seller can insure to cover warranty claims, my understanding is that W&I insurance policies can be taken out by a buyer eg. on an auction sale. Of course, as with everything insurance related, it isn't a silver bulllet. An insurer will normally expect the seller to be exposed to some risk to ensure there is a full disclosure process against the warranties and that the negotiation of the warranties is done on a proper basis. That leads nicely back to your point about not skimping on the DD process. I think that there does tend to be an over-reliance on warranties - the mind-set being that any shortcomings in the DD will be swept up by the warranties. I couldn't agree more that the warranty claim process can be far from straightforward. It is far easier to negotiate a price-chip on a commercial basis following an issue discovered in DD, than to explore the minutiae of a warranty claim after the event. One of the challenges can, of course, be the attitude of clients. I agree with your point that sometimes DD doesn't benefit from being commoditised. However, have clients become used to 'rock-bottom' prices for DD?
Managing Director at Oberon Securities, LLC
7yGiorgio, In the US we have R&W insurance. There are several providers. I do not know if it exists in Italy or other EU countries. Some of the US R&W insurers/agents have European offices. I used R&W insurance for one deal I closed back in 2007, with the buyer paying the insurance premium. The market has evolved since then. More recently, I got an R&W proposal from an insurer on another transaction, where the seller (my client) had one major shareholder who did not want to give any R&W. The purchase price was about $30mm and the insurer quoted a policy with a policy cap of about 25% of the purchase price, and with an up-front premium payment of approximately 3.5% of the cap. There was an escrow and a small deductible that combined to total about 2% of the purchase price. We did not use R&W insurance as the troublesome shareholder changed his mind. I have learned that the insurance providers like larger transactions, and it can be difficult to get R&W insurance on small deals. The $30mm deal was small for the insurers I talked to.
Infrastructure Power & Utilities at Marsh
7yyou can also use insurance capacity provided by Warranty&Indemnity coverage that safeguard the Buyer from losses deriving from a transaction.
Senior Accountant at CMG
7yDefinitely this is robust guiding in reality, I copy all your postings and collect it as a tool book for my work! Tremendous contribution to our sector, Giorgio! Thank you for sharing!