Is a hotly competitive M&A market driving up insurance claims?

Pressure to close deals amid a highly competitive mergers and acquisitions (M&A) environment could have led to a higher number of representations and warranties (R&W) insurance claims this year, despite dealmaking slowing over the past year.

That’s the assessment of experts at Liberty Global Transaction Solutions (Liberty GTS), the M&A insurance arm of Liberty Mutual Insurance.

Liberty GTS’ latest annual claims briefing showed a “predicted uptick” in R&W claims based on the heightened M&A activity of 2021 and early 2022.

“We have seen, particularly during that pandemic period, that we were in a very frothy M&A environment, which was very much a seller’s market,” said Rowan Bamford (pictured right), president of Liberty GTS.

“Our claims experience now suggests what we all probably knew, [and that’s] deals are being done more quickly and diligence has been done perhaps less rigorously.

“This is not necessarily intentional, but I think that the nature of the experience of timelines and pressure in a competitive M&A environment meant that people perhaps weren’t spending quite as long with due diligence as they might otherwise have done.”

R&W insurance, also known as warranty and indemnity (W&I) insurance, offers coverage for all representations and warranties of a target company or seller in an M&A purchase agreement. It is designed to protect parties from financial loss arising from breaches during the sale.

R&W claims trends – accounting, financial issues driving large payouts

Liberty GTS has facilitated over 1,500 M&A deals a year on average and operates in 14 jurisdictions across the Americas, Asia Pacific (APAC), and Europe, the Middle East, and Africa (EMEA).

In its 2023 claims briefing, it pinpointed several R&W insurance trends, drawing insights from nearly 500 notifications it has received since 2019.

The data shows that accounting and financial issues have been responsible for over a quarter (28%) of claims of over $1 million in the last 18 months.

Simon Radcliffe (pictured left), head of claims at Liberty GTS, said there was a broad range of claims related to financial and accounting issues.

“In terms of common themes, issues with management accounts are something we’re seeing a lot of and is driving some of our larger claims,” said Radcliffe.

“Inventory-related issues are also a common source of claims. Revenue recognition issues also seem fairly common, often resulting in large claims because revenue is a key driver for EBIDTA, which is a key driver for valuation.”

Liberty GTS has also seen several claims relating to the accuracy of (unaudited) carve-out accounts and, specifically, issues with how expenses have been allocated between the business being sold and the company being retained.

Claims involving intellectual property issues are becoming increasingly common and costly.

The notifications involve trade secret theft and IP infringement claims, making up 9% of the notifications that Liberty GTS received in 2022 (up from 6% in 2021). These types of claims are most common in the IT, pharma, and consumer products sectors, according to the claims report.

Buyers’ remorse, inflation influencing R&W insurance claims?

According to Bamford, deals are more likely to have claims on them when the market is most buoyant because valuations are at their highest, and thus, buyers are most likely to have remorse on their purchases and file for R&W claims to get some value back.

“When you’re in a down cycle, which perhaps we are now, as valuations dropped significantly, not only do buyers have a more realistic idea of what they’re buying, they’re paying less for it. So, the claims we get should be for a lower value than the comparable deal written three years ago,” Bamford said.

“You would also hope that because there isn’t the pressure on timings, any buyer will have had a lot more time to lift the hood and check the tires of the business, so they should have a more accurate and realistic view of the business than they perhaps would do in a very frothy, overheated market.”

Additionally, rising operational costs due to inflation have had a significant downstream impact on R&W claims.

“When people or businesses are under pressure, it goes without saying that they try and cut costs where they can,” Bamford said.

“That might be around the maintenance of assets. You might spend less during the annual service, or your health and safety department may shrink because it’s not critical for the business.

“All those cost-cutting measures, in turn, lead to problems down the line because machines fail or somebody hasn’t spotted that something’s leaking into the water system, which leads to reps and warranties claims surrounding the adequacy of assets.”

Insurance ‘not a substitute’ for M&A due diligence

On the other hand, Radcliffe said the slowdown in M&A activity due to higher interest rates and other economic factors has also been reflected in the claims notifications for 2023.  

“We are seeing a bit of a slowdown in terms of notifications that we’re receiving, and that’s a byproduct of the fact that the last 18 months have been relatively quiet from a dealmaking perspective, certainly compared to 2020 and 2021,” said Radcliffe.

“But we still have a lot of active claims on our book, and those are translating into some significant payments.”

With global M&A forecast to pick back up in 2024, Bamford stressed the importance of insureds conducting thorough due diligence.

“We would argue that M&A insurance is always intended not to be a substitute for due diligence but to sit on top of it,” said Bamford.

“[During M&A], you are meant to act as an insured like you would if you aren’t insured.”

What are your thoughts on the R&W insurance claims trends highlighted by Liberty GTS? Please share them in the comments.