Against the backdrop of innovation, growth and opportunity, it is little surprise that investors are attracted to the market.
An annual review of deal terms and trends in the M&A and private equity markets (40-page / 4.56MB PDF) carried out by Pinsent Masons, in partnership with Howden M&A and Arrowpoint Advisory, looked at the terms of more than 500 PE transactions in the UK in 2021, with a total value of over £100 billion. In terms of the PE transactions and M&A deals analysed in the review, 28% were in the life sciences and healthcare and ‘digital’ retail and consumer sectors, and those sectors accounted for 41% of the total value of transactions across all sectors.
Implications for buyers where target companies are PE-backed
When negotiating the terms of a Sale and Purchase Agreement, buyers focus on the warranties and indemnities (W&I) given by the seller as a key tool to protect against undisclosed problems in the target company. Buyers will, for instance, want protection against losses arising from any IP infringements, supply chain disputes or product defects that the seller has failed to disclose, or, indeed, any other claims that could be raised against those sellers.
PE-backers do not, as a matter of policy, offer warranties and indemnities to a buyer because it potentially limits the funds available to distribute to their investors, particularly when taken across a large portfolio of such investments. This tends to mean that the burden of supporting claims for breaches of warranties on the sale of a PE backed business falls on the management sellers, who may only have a minority interest in the business. As a consequence, this increases the potential ‘gap’ between the sale price and the amount recoverable for a warranty claim by a buyer.
Allied to this, it is not attractive for buyers to obtain warranties and indemnities from founders and other senior personnel who, generally speaking, are the innovators and driving force at the target company who will often be retained to continue to grow the business after the sale. One of the main reasons consumer health businesses will acquire an entrepreneurial business is to bring the founders and other senior people from the target company, who are the brains behind successful products or who have the customer contacts, within their own business. Buyers do not want those individuals distracted or demotivated by the prospect of having a warranty claim brought against them further down the line – buyers want to incentivise these individuals. If they are in the crosshairs of potential claims post-completion then this can inhibit the way they think and operate, and stifle ideas and actions that were the very reason the buyer found the business attractive in the first place.
Buyers therefore have a dilemma. They are unable to obtain the warranties and indemnities they would like from the PE backers but reluctant to obtain the comfort they want from the very people they wish to incentivise, not stifle with the weight of risk and liability. A common solution to this problem is available in the form of W&I insurance.
How W&I can support acquisitions by consumer health businesses
With W&I insurance, the bulk of the risk in any claims post-closing of the deal is transferred to insurers. Founders and other senior shareholders at the target company will notionally be liable for risk arising under the warranties and indemnities covered by the policy, but their liability is typically capped at very low levels or even just nominal recourse. The insurer insures against the potential breach of warranties – anything from £1 up to the full purchase price – enabling buyers to make a claim against losses they suffer in the event of a breach.
An increase in M&A volumes has, historically, translated into an uptick in the use of W&I insurance on transactions. This trend continued in 2021, with W&I insurance taken out in 69% of all transactions we analysed – up from a previous high of 66% of transactions in 2020.
The W&I market is evolving, however, and consumer health businesses exploring acquisitions will want to monitor for changes in pricing and exceptions insurers are imposing on cover. Our analysis of the W&I market in 2021 found that insurers have been happy to increase their risk profile. However, as the popularity of W&I insurance has increased, so have insurer prices. Towards the end of 2021, insurers faced capacity issues in dealing with requests for W&I insurance and buyers sometimes struggled to obtain multiple quotes for cover. In addition, carve outs for matters such as product liability, cyber risks and others began to become increasingly commonplace.
Despite this, many consumer health companies are likely to view W&I products as an attractive option for de-risking acquisitions whilst freeing up entrepreneurial founders to concentrate on what they do best.