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| Jonah Goldberg |
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| Troy Ungerman |
It is not surprising that the increased reliance on RWI as an effective tool to mitigate risk allocation and to facilitate deal-making correlates closely to the historic levels of Canadian M&A experienced in 2021. While Canadian M&A deal activity has started off slightly choppier this year than last, there is no shortage of deals in the making or dry-powder required to complete the deals. In our view, as in 2021, RWI will continue to be utilized by parties to streamline negotiations and as a deal sweetener to get transactions over the finish line.
A refresher on RWI
First, a bit of a primer for those unfamiliar with RWI. RWI is a form of insurance policy that is purchased in connection with an M&A transaction that protects the insured party (almost always the buyer) against financial loss arising from the unanticipated or unknown breach of certain representations and warranties in the purchase agreement. Depending on the deal structure, RWI either sits on top of negotiated indemnification coverage in the purchase agreement or, in no seller indemnity constructs, RWI serves as the sole recourse for the buyer. Coverage is available for both fundamental and non-fundamental representations and warranties and is customizable to match the needs of the insured and the transaction.
Similar to other types of insurance policies, RWI has a “retention” which is akin to a deductible and reflects the quantum of loss that the insured is responsible for before RWI kicks in. Once the retention (which is typically 0.75 to one per cent of the purchase price depending on the size of the transaction) has been exceeded, RWI will cover the loss that exceeds the retention up to the policy limits.
RWI has proven to be a strategic and cost-effective tool that significantly simplifies risk allocation and the indemnification negotiation process in M&A transactions; however, we caution that RWI should not be viewed as an end-run around a meaningful diligence exercise and careful negotiation. If RWI carriers sense that the parties have turned to RWI as a means of short-circuiting meaningful diligence and negotiation, coverage may be limited or potentially denied.
Trends in Canadian RWI market: 2021 year in review
Reflecting on the blockbuster M&A activity of 2021 and corresponding meteoric rise in the use of RWI in Canada, we noticed the following trends in 2021:
Increase in premiums
Since the rebound of the Canadian M&A market in Q3 2020, which followed a prior period of skittishness due to the onset of the COVID-19 pandemic, RWI has been in high demand. The torrid pace of M&A activity created limited bandwidth for RWI carriers, which naturally resulted in an increase in RWI premiums in the Canadian market in 2021. While Canadian RWI premiums are still notably lower than RWI premiums in the U.S., this increase in premiums caused some to reconsider the scope of coverage being sought and led to, in some instances, higher retention amounts. However, the use of RWI merely morphed, and it did not abate as 2021 RWI pricing continued to allow for a viable product with benefits that significantly outweighed its cost.
Increased number of strategic buyers using RWI
In 2021, we witnessed a significant increase in the use of RWI by strategic buyers. By utilizing RWI, strategic buyers were able to gain a competitive advantage, particularly in the auction bid context, while eliminating the “PE advantage” previously enjoyed by private equity buyers. In addition, strategic buyers came to appreciate RWI as an elegant solution which would enable them to still seek recourse in the event of breaches of representations and warranties without negatively impacting their relationship with sellers and/or management who remained with the target business post-closing.
More deals in industries impacted by COVID-19
While RWI policies during Q2 2020 contained broad exclusions for the direct and indirect impacts of COVID-19, this trend changed in 2021, with COVID-19 exclusions becoming more circumscribed and tailored to the target business’ risk profile. With the easing of broad COVID-19 exclusions, we witnessed more RWI-backed deals in industries that were more adversely impacted by COVID-19 (but still viewed as favourable targets), such as in the retail and hospitality industries.
Increased use of no seller indemnity
Although commonly associated with “public-style deal” transactions, no seller indemnity (NSI) transactions became increasingly more popular in private Canadian M&A transactions in RWI-backed deals in 2021. Broadly, NSI transactions are those in which the seller provides no indemnities (other than for specifically negotiated indemnifiable matters, if applicable), thereby affording the seller with a cleaner exit and less post-closing contingencies. Absent negotiated indemnity protections, a buyer would otherwise bear the entire risk in an NSI structured transaction absent RWI. However, where RWI is used in an NSI structured transaction, the buyer avoids bearing the full brunt of risk because the RWI policy provides protection in the event of a breach of representation or warranty. Accordingly, RWI provides an elegant solution in an NSI structured transaction as both sellers and buyers alike are able to minimize their risk exposure while achieving their respective transaction objectives.
As a practical matter, in NSI deals, the purchase agreement tends to contain seller-favourable definitions of damages and the definition of fraud will more closely approximate what is customarily seen in public-style deals. Further, the RWI policy will likely contain synthetic double materiality scrapes (because the purchase agreement is typically silent as to materiality scrapes) and market standard synthetic pre-closing tax indemnities in the case of share purchase transactions.
Claims are increasing with consistent commonality
Another current trend we observed in the Canadian RWI market in 2021 was an increase in the number of claims being made under RWI policies in Canada. We believe this trend is attributable to the institutionalization of the claims process and, obviously, the increased use of RWI. It is important to note that, though the number of claims rose, the claim quantum did not and many claims were precautionary in nature. The most common claims under RWI policies related to alleged breaches of employment, accounting and financial, tax, material contract, compliance with laws and litigation representations.
As 2022 kicks off, we predict the following for the RWI market in Canada:
Increased penetration into Canadian M&A market
We believe that strong reliance on RWI will continue through 2022 and will continue to grow as more buyers (both strategic and PE) and sellers become comfortable with the product. Particularly, we expect that the use of RWI in private deals will continue to grow in line with the Canadian M&A deal volume (both domestic, cross-border and international M&A) expected in 2022. Further, with interest rates set to rise and inflationary woes impacting businesses, we have to wonder whether the wave of bankruptcies and distressed M&A that was predicted in 2020 and 2021, will come to fruition in 2022, and the potential for RWI to play a key role in negotiating and completing distressed M&A transactions.
Industry sector focus and impact on RWI
In 2021, we noticed an increased use of RWI in deals in sectors where RWI was less commonly used than other sectors. Particularly, we noticed an increase use of RWI in deals involving the consumer discretionary, consumer staples, industrials and agriculture sectors, which clearly correlates to industry darlings of the pandemic era. However, as we (hopefully) round the corner of the pandemic and see shifts in M&A industry focus that correlates with economic activity tied to inflation, interest rates and supply-chain challenges, the sectors in which M&A targets operate will also change, which will lead to the use of RWI in deals in such evolving sectors.
Increased focus on cybersecurity/data privacy matters
As more businesses continue to ramp up their online presence and reliance on technology, we anticipate cybersecurity and data privacy matters will continue to receive heightened attention from RWI carriers in 2022. RWI carriers will likely expand their critical review and assessment of cybersecurity and data privacy matters (including reviewing the sufficiency of existing cyber coverage) while providing more narrowed coverage for such matters — customarily “excess no broader than” based cyber coverage.
RWI premium pricing will stabilize
Although we expect that the Canada M&A market will have another robust year, we anticipate that RWI pricing will stabilize in 2022. This is because RWI carriers have adapted to the demands of managing risk virtually, which will increase bandwidth in 2022 to match the Canadian M&A market. Further, the levelling off of premiums will restore RWI’s reputation for those naysayers who doubt the value proposition of obtaining RWI coverage.
Deals of all sizes will utilize RWI
For all the reasons noted above, we anticipate that small and mid-market deal participants will continue to jump on the bandwagon and insist that their deals be RWI-backed. No longer will RWI be seen as limited to, and the coveted mainstay of, larger transactions ($200 million EV and more). We further anticipate a further uptick in the use of RWI in cross-board/international transactions to complement the use of RWI in purely domestic transactions.
As we sit with our crystal ball in hand and stare intently into it with great excitement at the year ahead, we remain cautiously optimistic that M&A activity in Canada will continue to surge and that RWI will continue to play an integral role in helping parties to successfully close their deals.
Jonah Goldberg is head of Canada, Liberty Global Transaction Solutions, one of the largest and most experienced M&A insurance teams in the market, with a team of more than 80 specialists operating in 11 jurisdictions across the Americas, Asia Pacific (APAC), and Europe, Middle East and Africa (EMEA). Troy Ungerman is a partner and co-chair M&A, and RWI Practice lead with Norton Rose Fulbright Canada LLP, one of the leading legal firms offering M&A advice in Canada and internationally. For any inquiries about RWI in Canada, please contact Jonah Goldberg at (647) 981-9560 or at jonah.goldberg@libertygts.com, or Troy Ungerman, at (416) 216-1862 or troy.ungerman@nortonrosefulbright.com. The authors would like to thank Adamo Fucile, associate at Norton Rose Fulbright Canada LLP, for his significant contribution to this article.
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