2020 was a rollercoaster year for the M&A insurance market.
When all of Australia and New Zealand went into its first lockdown in March
2020 there was a predictable drop off in M&A activity and the WTW team
saw a number of competitive processes or proprietary deals fall over or go
on hold. Likewise, the M&A insurance market went on hold with only a
small number of deals that had been in process pre lockdown working through
to signing. Even worse, several deals that had signed pre-pandemic fell
over prior to closing.
Lockdown two in Victoria had less impact given that NSW and the other
states remained open for business and deal activity began to trickle back
to life from late May, into early June.
The key driver for deal activity re-igniting was various PE firms being
bold when others were fearful. From late May we saw a number of Australian
PE firms looking at opportunistic or strategic bolt-ons for existing
portfolio companies. Certain industry sectors were over-represented in deal
activity e.g. technology, healthcare and renewables.
Momentum began to build in M&A activity from June and the M&A
insurance market had a bumper second half of the year. The final quarter of
2020 was the biggest (by deal volume and deal size) experienced by the WTW
team. This was led by the prevalence of competitive processes with
investment banking teams handling a large number of exits for PE funds and
also corporates and family businesses.
Impact of Covid-19
The initial W&I insurers’ response to the COVID-19 situation did create
some curious results. As the pandemic developed, M&A insurers took the
position that they required a specific exclusion for any loss arising from,
or increased by, COVID-19. Larger global M&A insurers were the most
inflexible, driven by their London and New York teams which had more
extreme experiences with COVID-19 compared to Australia and New Zealand. As
the region’s first lockdown came to an end and M&A deals started
picking up, WTW saw an increase in willingness by M&A insurers to treat
each deal on its merits rather than insist on a blanket exclusion. M&A
insurers sensibly attempted to address this through their underwriting
questionnaire process.
This was not really an extra burden on deal teams; the underwriting process
focused on what any prudent buy side deal team would be doing to understand
the impacts of COVID-19 and/or the lockdowns on a target business. The
process included detailed questioning regarding the likely direct and
indirect impacts the target business may face as a result of COVID-19 (or
related government mandated lockdowns), for example:
a. Potential financial impact of COVID-19 on the business itself as well as
the industry in which it operates
b. effect on key contracts with customers, suppliers and employees
c. mitigation steps already taken by the target business in relation to
COVID-19
d. whether an expert review of the target’s insurances has been undertaken
to assess which of those will respond to issues raised by COVID-19 e.g.
business interruption insurance
e. supply chain issues, including both underlying raw materials,
manufacturing and logistics
f. ability to replace existing suppliers and likely cost/ time impact
g. ability of employees to work from home
h. availability and use (or abuse) of government subsidies like JobKeeper
and the NZ wage subsidy.
Buy side financial, legal and tax due diligence teams recognised the
M&A insurers’ requirements were aligned with the buy side teams
investigations and, on a majority of deals, the M&A insurers’ concerns
were covered off through diligence.COVID-19 and the lockdowns have had an
impact on the availability of new breach cover in the market and initially
all M&A insurers balked from offering this feature. The current
position is that it can still be offered for a price but with a COVID-19
specific exclusion to apply to any new government-imposed lockdown or other
restrictions that impact the target after signing but pre-closing. The WTW
team has managed to get this exclusion removed by using bring down
diligence calls tied to the COVID-19 situation just before completion. It
should be noted that this exclusion will generally apply to W&I
policies that do not have new breach cover as well.
As of February 2021, COVID-19 is just another factor to be included as part
of the buy side due diligence process. The risk of new lockdowns has not
gone away so M&A insurers will no doubt still look to carve out that
aspect on deals where there is a gap between signing and closing.
M&A insurers will still focus on risks around COVID-19 and lockdowns
but if the buy side team’s diligence processes show an understanding of the
financial and legal impacts of this on the target business then it will be
less of an issue.
Offshore buyers
For the WTW team the first half of 2020 was dominated by domestic PE funds.
Later in the year we began to see offshore PE and corporates featuring
again in deal processes. Obviously, the reluctance or inability to travel
for diligence, site visits or management meetings was a big factor,
although platforms such as Zoom, Teams and Webex were certainly used
frequently.
Interestingly it appears that North American, British or European buyers
have come back into the Australian and NZ markets faster than Asian
corporates or PE. The WTW team has been involved in a number of competitive
auction processes with offshore bidders happy to do their deal making and
diligence remotely. Certainly, a number of offshore bidders had previously
been active in Australia and NZ with pre-existing relationships with
quality advisors on the ground which no doubt made it an easier proposition
to transact in this part of the world.
No doubt some of the recent decision making by FIRB (or the Treasurer) may
have created some reluctance and uncertainty amongst potential buyers from
certain Asian jurisdictions. It is certainly hard to predict what this
means for 2021 but it might be difficult right now for an Australian seller
to sell any asset to a Chinese buyer.
Given the relatively benign COVID-19 experiences here, we do expect
Australia and NZ to continue to be attractive jurisdictions for offshore
capital.
Other themes for 2020
In 2020 we saw the continued evolution of public M&A using W&I as a
deal tool. Certainly, a number of WTW’s PE fund clients are very savvy at
using W&I insurance as a deal tool in public to private transactions. A
number of notable such transactions utilised M&A insurance.
Far from the doom and gloom of March 2020, the back half of last year saw
investment bankers smiling again. There was a significant number of
competitive sale processes in the back half of 2020 and several of these
have spilled over into 2021. No doubt many of these processes were delayed
or stalled by the first lockdown, but clearly the way Australia and NZ
dealt with the COVID-19 situation gave dealmakers the confidence to push
forward, with sales processes for the right business in the right industry
sector. The WTW team had a significant number of sell buy flip processes
baked into these competitive sales processes in the second half of the year
which kept the M&A insurers very busy.
The December quarter was one of the WTW team’s biggest ever and we
understand from some of our insurance partners that they experienced
similar “budget busting” quarters – probably just as well given how poor
the June quarter was.
W&I insurance market key issues/themes
Apart from COVID-19 impacts, there have been several evolving issues for
M&A insurers:
-
Employment diligence:
Not surprisingly given the media and political focus on wage theft and
underpayments in Australia, M&A insurers now tread very carefully
with employment due diligence. It is no longer enough for the buyer’s
legal team to have analysed key employment contracts, template
contracts or enterprise agreements. M&A insurer expectations on
every deal is that a level of sampling is done by the buy side team
into a number of matters such as classification of the workforce
(particularly if casuals or contractors are used), correct application
of modern awards and other industrial instruments, employment tax
diligence etc. The actual sampling exercise would include:
a.
at least 5% of the target groups (i.e. the sample should be a
representative cross-section of employees and independent contractors)
b.
a fair representation of employees classified by different industrial
instruments
c.
Separate pay periods: two to three pay periods as a minimum but
preferably five for each sampled employee.
Sample testing:
d.
Review payroll records, payslips to confirm that wages and
superannuation actually paid over the sample pay periods is correct
e.
Confirm classification of casuals and independent contractors are
correct based on patterns of work.
This increased focus has been driven by increased claims activity in this
area and the WTW team has prepared a guidance note for due diligence
scoping for employment diligence and sampling.
-
Insurance DD:
The WTW team is now seeing insurance due diligence being undertaken on
a large number of M&A transactions. This is proving a useful tool
for the buy side team to ensure they get coverage for the insurance
warranties under a W&I policy but also to understand the target
group’s current baseline insurance coverages and spend, as well as
claims history. It becomes critical for certain classes of insurance
which are typically not picked up under a W&I policy e.g product
liability/recall, E&O or professional indemnity, cyber insurance or
environmental liability. Understanding what a target currently insures
for and where there might be gaps in the future is a very important
deal tool.
-
Cyber/privacy and IT security:
The requirement to obtain and hold cyber insurance has now become
critical for most businesses. There have been a number of high-profile
cyber security events reported in media in the last year. In the past
M&A insurers would routinely elect to include coverage for cyber
risks. This is now more difficult especially where the target is seen
to be holding significant amounts of “personally identifiable
information” or confidential information”. M&A insurers are now
requiring focused diligence around IT systems and IT security and IP
diligence regarding the use of proprietary, licensed or open source
software – including requests for Penetration Testing and/or Black Duck
audit reports.
-
Quality of diligence:
The rise of corporates using M&A insurance has continued in the
past year. Occasionally this has created some friction where corporates
have looked to bring parts of their due diligence efforts in-house
rather than use third party advisors. This can be workable as long as
the in-house diligence has been appropriately scoped and documented.
The M&A insurers can be ruthless in communicating whether in-house
diligence is not up to scratch and gaps in diligence, or inadequate
diligence, can lead to gaps in coverage. Early engagement with WTW is
critical where in-house diligence is used on the buy side.
-
Pricing trends:
The W&I insurance market stands out from all other financial lines
products which are experiencing what is known in the industry as a hard
market. Our colleagues have horror stories of reduced insurance
capacity and unprecedented price hikes for corporate buyers of D&O,
PI, management liability etc. With the break in deal flow due to the
first lockdown from March to May last year, M&A insurers’ budgets
suffered. When deal flow ticked back up again post-June, M&A
insurers piled back in and rates have remained very competitive across
Australia and New Zealand. Large W&I programs with multiple M&A
insurers were seeing historically low premium rates for the excess
positions.
-
Capacity/flight to quality:
During 2020 a number of articles came across our desks from reinsurers
and large corporate insurers warning of reductions in capacity for
M&A insurance. This is not something we have really seen in
Australia and New Zealand. The market here is competitive but only has
six or seven key M&A insurers. This contrasts with North American
and European markets which have 20 plus different insurers, many of
these being underwriting agencies.
We understand there have been a number of large losses in the North
American and European markets which have led reinsurers to closely
scrutinise who they are providing capacity to. We are fortunate in
Australia and NZ to have a very experienced bench of M&A insurers
for our clients.
-
Claims
: Claims activity has been relatively stable in 2020. Perhaps not
surprisingly we have experienced and are working on several claims in
the employment arena and the WTW team has managed to settle a number of
these. Some M&A insurers produce valuable claims studies on an
annual basis. The M&A insurers state they receive claim
notifications on roughly 20% of policies placed. Our own figures, built
up over many years, indicate this figure to be around 12–13% of
policies. A significant number of these claims relate to the accounts
warranties and this is pretty consistent with what our insurance
partners report.
-
Increase in use of standalone tax policies or contingent risk
policies:
A logical development for M&A insurance has been the increase in
interest for policies based on “known” risks. These include Tax
Liability and contingent risk policies. Indeed, in the last 12–18
months a number of underwriting agencies specialising in tax liability
policies have been established in London and Amsterdam. Having five or
six legitimate tax insurers to work with has meant more appetite for
tax risks and WTW has placed a number of standalone tax policies in the
last year. WTW has embraced this momentum and hired our own tax
specialist in Michelle Chua. Michelle joined the team from EY’s Sydney
tax team in October last year. A number of the local M&A insurers
have or are in the process of considering a tax resource as well.
Distressed sales/insolvency
Perhaps surprisingly the WTW team saw few significant insolvency sale
processes (the Virgin process aside) in 2020. Government stimulus measures
certainly assisted large sections of the economy. With the potential end of
stimulus measures in sight, 2021 may see a rise in distressed sales.
Apart from corporates rationalising and selling off business units,
distressed sales have not traditionally looked at using M&A insurance
as a risk mitigation tool. Most savvy insolvency practitioners know that
this may be a useful tool where a going concern sale can be achieved, but
it becomes more difficult in a true insolvency process.
The WTW team canvassed our M&A insurers for their views on distressed
sales in 2020. All M&A insurers operating within Australasia have
expressed interest in insuring Distressed Transactions. Typically,
processes run by insolvency practitioners, such as a receivership or
liquidation tend to be asset sales. A turnaround type transaction will
likely be couched as a share sale and the owners will usually be required
to give the warranties.
Distressed Transactions will be viewed as riskier which may have an impact
on pricing and terms. There will also be greater underwriting focus on the
ability to give a standard suite of financial/accounts warranties, the core
operational warranties and the accuracy of Title and Capacity Warranties.
Some M&A insurers have indicated they may require a higher than normal de minimis and retention – but this would be considered on a
deal-by-deal basis.
All M&A insurers operating in Australasia are willing to consider
utilising a structure for Distressed Transactions where the target is the
warrantor, provided that the parties acknowledge that there is likely to be
a carve out for fraud of the warrantor given the M&A insurer’s
inability to subrogate against the owners of the target or the insolvency
practitioner in these circumstances. As with any other transaction where
the target is the warrantor, M&A insurers will be acutely focused on
understanding:
- the level of disclosure and verification by the target/management and (if
applicable e.g. in a turnaround transaction) key sellers – comfort around
disclosure may prove challenging where an insolvency practitioner is
running the target business or where management no longer has any incentive
to assist in a disclosure process.
- the warranty negotiations and the input which management have had into
this process.
M&A insurers have a mixed appetite for synthetic warranties - some
indicated they would be willing to consider this structure on a
case-by-case basis while others considered the structure problematic.
Moreover, in our experience, synthetic warranty structures typically offer
more limited coverage than a tailored set of warranties and have broader
exclusions.
The challenge with synthetic warranties will be producing a set which a
potential buyer/insured sees enough value in terms of core operational
warranties to pay a premium. Further, the W&I insurer needs to be
comfortable that the buyer/insured’s due diligence is sufficiently
representative of the synthetic warranties required and that the necessary
disclosure exercise can be demonstrated.
The WTW team has an insolvency practice with deep links into Insolvency
practitioners making WTW well placed to handle distressed transactions.
Outlook for 2021
Australia and NZ will continue to be viewed as “safe harbours” and
attractive investment destinations for foreign and domestic capital. The
achievements through lockdowns and the promise of a robust vaccination
process to stay on top of COVID-19 and keep the economy moving should
assist the M&A market. No doubt active sectors such as technology,
healthcare, logistics, renewables, infrastructure will remain active.
The M&A insurers WTW works with are all positioning for further growth
and we anticipate the M&A Insurance market to continue to be extremely
busy.