Representations and warranties (R&W) insurance is a type of insurance policy purchased in connection with corporate transactions that can offer added protection and reassurance to both parties involved. Historically, R&W insurance was not widely used in transactions below approximately $50 million in enterprise value – referred to in this article as “small-cap” or “SME” deals. This was due to several factors, including cost-effectiveness, lack of awareness amongst buyers, and lack of capacity of underwriters to take on transactions of that size.
These barriers to entry have since been overcome. There are now more than 30 underwriters in the marketplace who have scaled to increase underwriting capacity, a sea of new insurance brokers who have been marketing the product’s benefits to small-cap buyers, and a general slowdown in transactions, which has resulted in a substantial decrease in premiums charged to buy the product. Collectively, the changes have resulted in the emergence of tailored and cost-effective R&W policies for transactions as small as $5 million in enterprise value. The increasing demand for products tailored to niche needs, such as small-cap clients, has resulted in the rise of underwriters focused specifically on this space.
R&W insurance for smaller companies provides the same benefits for buyers in SME deals as it does in the mid-to large-cap space, including:
- Providing a means to reduce or eliminate the need for escrows and to limit sellers’ indemnification obligations.
- Giving a buyer a sense of comfort that there is a reliable pool of funds to seek recovery from in the event of a claim.
- Providing a means for buyers to stand out and provide more attractive offers during the Letter of Intent (LOI) stage.
The two primary barriers to widespread adoption of the product in the SME space are: (1) cost and (2) additional diligence obligations required by buyers to satisfy underwriting needs. Greater adoption of the product shows that buyers increasingly see the cost/benefit analysis favoring the purchase of R&W insurance. Concerning diligence obligations, underwriters are answering the call by adapting their processes to address the reality that buyers of small-cap companies have different due diligence focus points than buyers of large-cap companies. Some underwriters have taken the need to offer a streamlined underwriting process to heart by offering more R&W insurance products that are limited in scope or are SaaS platform-driven to make the product acquisition process as painless as possible for potential buyers.
Ultimately, the growth of R&W insurance in the small-cap space is a welcome and valuable tool in the SME mergers and acquisitions landscape. Whether R&W insurance makes sense on a particular deal rests on various factors; however, the rapid growth and flexibility of underwriters in adapting to the needs of SME buyers demonstrates how immensely beneficial it can be for the transaction process and the outcome. Buyers in SME transactions should add R&W insurance to their repertoire of available tools that can help win deals, facilitate faster closings, and ultimately support higher returns on investment.
Taft Partner Dave J. Bartoletti contributed to this article.