Merger and acquisition (M&A) activity has spiked in the past year, with much of the attention has been on financial buyers like private equity, special purpose acquisition companies (SPACs) and others. But from March 2020 through February 2021, more than 54% of M&A activity has been from strategic acquirers. This accentuates the important role risk professionals play in acquiring companies, as they bring expertise and insight to the deal process and help to enhance overall outcomes.
Financial buyers make acquisitions to realize an investment return following a hold period through a sale or public offering. Strategic buyers focus on acquisitions that add something to an existing operation—a complementary product, geographic reach, a new capability, or technology that enhances efficiency or competitiveness.
Strategic buyers typically have a risk management function. For small and mid-sized companies, the CFO or a member of the legal team may handle risk management, but larger companies have professionals dedicated to managing risk. When strategic acquirers deploy their risk management capabilities in the context of a deal, it creates advantages for assessing and managing the complex transactional and operational risks that come with M&A activity.
Timing is Critical
The confidentiality of a potential deal often prevents a deal team (CFO, general counsel and corporate development leader) from including the company’s risk manager. However, in an environment where transactional risks increasingly affect deal structure and even valuation, the earlier the risk manager is involved the better. When deal teams are able to identify and quantify risks early, they have more time to implement cost and liability allocation into the deal structure and terms.
Understand the Differences
While a strategic buyer may have some familiarity with an acquisition target company, it is critical to gain a deep understanding of the target’s risk profile. Every business, no matter how similar, has different risks and exposures. And it takes a thorough analysis of the business to understand the differences, how they impact the transaction and the role they play in the acquiring company’s risk profile going forward.
A risk manager must bring a technical understanding of how to mitigate these exposures. From basic property and casualty items to more specific contingent business interruption exposures—supply chain, intangibles assets, intellectual property, product recall, wrongful acts and misrepresentations by company directors and officers, as well as data security and cyber risks—insurance and alternative risk transfer play a crucial role. Therefore, the risk manager can be key to the deal team’s understanding of whether the target company has adequately and appropriately addressed risks that would otherwise lead to future (possibly very material) impacts to valuation.
Use Capabilities to Your Advantage
Risk managers have the ability to think about how a target company’s risk exposures fold into the acquirer’s overall risk management. Do the target company’s financial statements appropriately account for target’s total cost of risk (TCOR)? Are there opportunities to reduce costs, enhance coverage terms, improve wording or explore new risk transfer strategies post-closing? Getting a handle on earnings before interest, taxes, depreciation and amortization (EBITDA) impacts of target’s actual TCOR can help inform deal valuation, and upgraded coverage post-close can help preserve that value.
Integration is Critical
For basic property and casualty (P&C) coverages, an acquiring company can elect to keep existing coverage in place or add the coverage to a master program. Directors and officers from the acquired company can be added to the acquirer’s existing D&O policy (and the other policy can go into runoff). Product liability and workers compensation typically require a closer look at the type of business and associated risk before folding it into existing coverages.
Structure is key to how the two programs can come together, making integration critical. Again, the involvement of the risk manager will support the development of an integration plan that takes into consideration coverage needs, carriers and service providers.
Insurance policies are rarely included assets in acquisitions in carve out deals—when one company acquires a part of another company, currently about 25% of all M&A transactions. When coverage stays with the selling company, there may be coverage gaps for the acquirer as a result of the piece of the business they have purchased. Successor liability must also be accounted for because acquirers cannot assume they are not liable for a claim involving an event that happened prior to the acquisition. Risk managers must take a deep dive into the acquired company’s liability exposures to understand how the occurrence or claims made triggers on their existing liability insurance programs will cover them for any incurred but not reported future claims. Tail or runoff coverage may be required.
Enhancing Competitiveness with Transaction Insurance
Transaction insurance has transformed the way deals are structured and is a proven tool for optimizing risk allocation between buyers and sellers. A well-structured and negotiated representations and warranties (R&W) insurance program can remove (or very significantly reduce) the need for seller holdbacks and indemnities, increase contract certainty and allow sellers to receive more consideration at closing without requiring the buyer to forgo a source of recovery for breaches or misrepresentations.
R&W insurance is now used in more than 70% of M&A deals. Historically, the coverage was most frequently used by private equity buyers, but there has been increased uptake of the product on strategic acquisitions over the last several years. The main driver is competitiveness. In an auction process, R&W insurance levels the playing field relative to other buyers with respect to deal indemnification. This makes it critical for a risk manager to understand how it works, what it costs and when to access the market to maximize competitive advantages and gain the broadest possible coverage terms.
The key takeaway is that when there are complex risks, more expertise—from a risk manager or expert advisors who understand the M&A insurance landscape—creates better outcomes.