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More safety for private equity transactions

The acquisition of corporate risk is a fundamental characteristic of the private equity industry. But risk negotiating can be complex and can cause deals to fall through, according to Halder Invest. Halder provides a comprehensive overview of ways to avoid the transfer of risk becoming a deal breaker.

Simplify negotiations with warranty and indemnity insurance
What could link insurance with investing in a firm? At first glance, they could not be further apart. Private equity investors take on corporate risk, and taking out an insurance policy points into the opposite direction - towards risk containment.

Practical experience shows that both aspects can be perfectly compatible. Buying and selling stakes in companies may involve risks that cannot be easily assumed by any of the participants concerned. In extreme cases, they can become "deal-breakers", and at the very least they complicate ongoing negotiations, thus costing valuable time.

How to avoid deal-breakers
Buyers and sellers are equally affected. As soon as the price of a participation has been agreed in principle, an investor generally expects extensive warranties from the seller to cover a wide range of risks: starting with the accuracy of financial statements, the completeness of the submitted information, extending to the fulfilment of tax-related and statutory obligations, as well as including industrial disputes or patent disputes.

A seller can usually eliminate or restrict some of the risks identified by the buyer by providing more information. For risks already known, price discounts can be negotiated or warranties with precisely defined claims can be agreed. However, there remains a residual risk: Following the company sale, previously unidentified problems may arise that prompt a warranty case. As a result, the seller is often either unable or unwilling to issue a meaningful guarantee.

A classic example: ownership and management succession for a company founder by means of an MBO. Often, revenues from the sale are an important element of the personal financial means for the retiring owner and his family - larger warranty claims of an investor would jeopardise this base.

Once the risks of the investments in a company are covered, the investor must ask the next question: can potential warranty claims actually be honoured? If the seller is based abroad or has insufficient or uncertain funding power, doubt starts to arise - an unacceptable situation for the investor.

If this stops the transaction, the seller may be affected very negatively. A potential investor may at least face increased costs: It's not just time spent unproductively, but also costs for external advice and other services which are incurred before the deal is closed. Even if the worst is avoided, disagreement on risks tend to be disruptive, slow down the transaction process and disturb the atmosphere of negotiations.

"Importing" a tried and tested solution
The solution to the problem is to transfer such risks to a specialised third party. It has been available in the UK for many years and is employed in more than 150 participations per year - warranty and indemnity insurance. This solution is not yet well established in Continental Europe, but interest is growing. Bringing in insurance coverage helps to avoid deal-breakers and to simplify valuation matters.

In principle, warranty and indemnity insurance is a simple instrument offered by specialised insurance brokers and agencies. Customised solutions can be complex in individual cases. International insurance companies provide the cover.

Flexibility for individual cases
Apart from the buyer, all participants in a transaction can take out insurance: sellers, individual shareholders and guarantors. In principle, all risks mentioned in a contract of sale for which a warranty is provided can also be insured against. In this context, a total amount covered is agreed for all insured warranties. At present, the upper limit is about € 30 million. Insurance policies generally have a term of two to three years. If taxation aspects are included, this can be extended to six or seven years. Insurance premiums are currently between 1.5 per cent and 3 per cent of the amount covered, and are paid on a one-off basis when the policy is taken out.

The limits of security
Warranty and indemnity insurance is no panacea. Here too, liability for specific risks can be excluded. Typical examples are warranties regarding the accuracy of financial statements with no audit certificate, or commitments on future events, e.g. a certain trend of company earnings. Environmental risks can be difficult to insure against. However, manageable risks in this area are often covered after examination of the individual case.

Warranty and indemnity insurance requires even greater care and transparency from the contracting parties. Before insurance is taken out, all risks to be covered by the policy must be disclosed and stated in the contract of sale. Insurance becomes effective when the primary provisions of the sales contract have been exhausted. For instance, in the case of defective products, a claim will be made against existing product liability insurance. Warranty and indemnity insurance applies in the event of claims which are not covered by product liability insurance in place.

What happens if warranties are breached and financial losses are incurred? In this case, insurance claims are settled in the conventional manner. The insurance company assesses the warranty claim and represents the interests of the policy-holder. Associated legal costs are dealt with as part of the amount covered. If the claim is justified, the insurance company pays to the claimant.

Better deployment of capital, clean valuations
As one of the first private equity investors in Germany and the Benelux countries, Halder has used warranty and indemnity insurance in management buy-outs and exits in order to absorb specific transaction risks. Paul De Ridder, Managing Director of Halder in Germany, says ,,This gives us the additional advantage of making capital deployment more efficient. Previously, purchase price payments often languished in trust accounts until the warranty periods had expired. Now, at least some, if not all the money can flow as soon as 'the ink is dry'. If the seller is a corporation, no or very few reserves must be formed on the balance sheet."

Another significant advantage arises indirectly. The company valuation can be built up ,,cleanly" on the basis of future expectations, attainment of specific benchmarks etc. When using warranty and indemnity insurance, the investor can largely dispense with risk discounts, which predominantly concern the history of the company. As a result, the quality of the business model is the most important driver of the purchase price. Consequently, the focus turns to what actually draws investors to a target firm: the earnings potential of the new portfolio company.

Halder invests equity capital in medium-sized businesses. Halder has been active for more than 15 years and concentrates its activities on Germany, the Netherlands and Belgium. Its focus is on firms with positive earnings and sales of at least E25m up to E250m, which hare run by a professional management team.