R&W Insurance: A Useful Tool For Private Equity & Venture Capital Transactions

A major challenge in M&A deals is to negotiate collection devices and guarantees, such as escrow accounts and security interests. There is a natural tension between the purchaser's desire to obtain maximum protection, and the seller's aspiration to receive the price and cease to have responsibility for liabilities involving the company that is being sold. Such tension is exacerbated when the seller is a private equity or venture capital (PEVC) fund, given the frequent need to wind up the fund within a tight timeframe.

Largely used in the American and European markets, an interesting alternative to overcome deadlocks over collection devices and guarantees has recently been made available in Brazil by insurance companies: the representations and warranties (R&W) insurance. Such insurance covers losses, including litigation costs, suffered by either the seller or the purchaser as a result of misrepresentations in M&A deals (provided, of course, that the insured party was not aware of the misrepresentation at the time of execution of the relevant agreements or closing).

Contingent liabilities known by the parties, even if the likelihood of a loss is low, are generally not covered. The insurer may impose additional exclusions in view of the particularities of each case. And there is often great flexibility for the insured party to negotiate other exclusions it might be comfortable with, which usually leads to reductions in the insurance premium (for example, if the seller does not have many employees and the purchaser is confident that all representations made with regard to compliance with labor laws are true, it may feel no need to insure against the risk of misrepresentations in this field).

Although there is room for negotiation, it is trade usage to have an indemnification cap between 10% to 30% of the value of the deal and to limit the period of coverage to no longer than 3 to 5 years. In most cases the premium for R&W insurance corresponds to 3% to 7% of the amount involved in the transaction, though a minimum fee is almost always charged regardless of the size deal, which may make it economically unfeasible for smaller cases. Preliminary quotations can be obtained by furnishing insurance companies with drafts of the relevant agreements.

To mitigate the risk of fraud and moral hazard, insurance companies hardly ever provide a firm quotation without reviewing the purchaser's due diligence report (and in extraordinary occasions, insurance...