W&I insurance (“W&I”) is now seen as a vital tool to transfer risk in an M&A deal. To ensure that the buyer has the proper protection, it is important to know how W&I policies work and how they can be used as part of the overall M&A strategy. One recent development in the insurance market has been W&I insurers looking to limit their exposure by taking greater interest in the valuation methods being used by the buyer.
Map
The valuation itself – is it an art or a science – or a bit of both? There are multiple different methods used to value a business but ultimately it is looking to establish an objective estimate on what a company is truly worth at the point of sale. But how does this affect your W&I policy?
Clarify
Historically an insurer will ask a handful of questions around the valuation method and the approach taken by the buyer and corporate finance team. This aims to clarify their understanding of any subjective approach applied to the objective estimate to ensure that a sensible approach was being taken.
Cover
But why does this matter? To understand the impact on the buyer you need to look at the definition of ‘Loss’ in the W&I policy. The buyer will want to ensure they have coverage under the policy to put them back into the same position had the claim not have materialised or had the issue been known prior to the deal completing. To be sure that this happens, the definition of ‘Loss’ should make clear that any multiple applied by the buyer is reflected in the calculation of ‘Loss’ under the policy, and that any multiple isn’t explicitly excluded. This ensure the ‘Loss’ isn’t limited to the single liability amount alone.
To ensure that the buyer has the proper protection, you need to know how W&I policies work and how they can be used as part of the overall M&A strategy.
Claim
It is easy to show this via way of example, applying the traditional approach taken by insurers.
- BidCo 1 Limited is looking to acquire TargetCo 1 Limited for a valuation of £100mn. They use XYZ Corporate Finance to value they business and they determine that the enterprise value is based on an EBITDA figure of £10mn and applied a 10x multiple to the business.
- BidCo 1 Limited fortunately acquired a W&I policy. After the deal completed the buyer uncovers a quantified liability of £1mn. Should BidCo 1 Limited have known about this liability prior to the valuation they would have calculated the EBITDA figure as £9mn instead.
As BidCo 1 Limited had protection under a W&I policy they sought to recover the Loss they have suffered. The Loss was calculated as £10mn – being the £1mn liability multiplied by the 10 x valuation multiple applied by BidCo 1 Limited.
The Alternative Cover & Claim Approach
In the post Covid boom deals attracted very high EBITDA multiples and in the case of technology deals very high revenue multiples. Given the high valuations and potential exposure in the event of claim insurers have taken further interest in the valuation methods applied.
In some limited cases with particularly high multiples insurers have looked to limit or even exclude the valuation multiple applied for the purposes of the policy. For example:
A buyer may have used a pricing multiple of say 18 times EBITDA at the time of acquiring the target business. An insurer may look at this and say that they effectively view that as too high a multiple and in the event of a claim they would interpret the multiple used for the purposes of the claim as say 12x EBITDA. The insurers would take a similar approach to revenue multiples being applied.
Conclusion
With the instances of claims increasing and the wave of high valuations, insurers are likely to maintain a keen focus on the valuations. We are here to push insurers to make sure they follow the valuation applied on a transaction but where this is not possible and there is limited insurer appetite for the deal then allowing an insurer to use a lower multiple for the purposes of the policy can be a way to get a deal with a high valuation insured.
