Carveouts in take-private deals and the implications for RWI

As representations and warranties insurance (RWI) becomes increasingly mainstream in the M&A market, the use cases for the product have rapidly grown beyond traditional, sponsor-backed buyout transactions. Innovative RWI solutions for a broad array of transaction structures now exist, including for minority investments, joint ventures, distressed deals, secondaries transactions, and increasingly, take-private transactions.

The basic fact pattern for the use of RWI in a take-private involves a buyer purchasing the equity interests of a publicly traded company. Before signing, the buyer engages a broker to place an RWI policy to cover losses arising from breaches of the representations and warranties given about the Target company in the merger agreement.

The challenges in take-private RWI structures

The RWI process for take-privates has always required buyers, brokers and underwriters to collaborate on a subset of issues unique to take-privates, including:

1. The elevated number of representations and warranties qualified by a “Material Adverse Effect” (MAE) standard (as compared to a private deal) and the implications of such MAE standards on the disclosure schedules and the RWI policy coverage
2. The approach to subrogation rights for seller fraud, especially where there is a broadly distributed, public shareholder base (i.e., no controlling shareholder)
3. Whether an exclusion for shareholder litigation arising from the transaction is appropriate

An emerging trend with key considerations to remember

In the last 12 months, WTW has noted an uptick in take-private transactions that also involved the carveout of a subset of the public company’s assets or businesses. These transactions often involve a strategic or corporate buyer seeking to purchase only a portion of the public company’s assets or businesses (which in some instances may be dictated by antitrust concerns) and one or more financial sponsors who purchase the remaining assets or businesses of the public company that are not acquired by the strategic buyer. The parties typically execute two transaction agreements: one to effectuate the take-private, and another to effectuate the carveout.

In these deals, the RWI policy for the broader take-private transaction is usually very similar to that which would be placed for a traditional take-private, except for the need for an exclusion relating to the business that is being carved out. However, the carve-out transaction taking place in connection with the take-private can give rise to complicated issues from an RWI perspective, specifically concerning 1) which party is in a position to make the ‘sell-side’ or Target-level representations and warranties, both as of the signing and as of the closing, and 2) whether the representations and warranties in the separation/carveout agreement, and the corresponding disclosure schedules, are specifically tailored to cover the carved-out business. In these circumstances, RWI insurers would typically require that the Target itself or some member of the shareholder base make the representations and warranties in the separation/carveout agreement at both signing and closing and would also expect such representations and warranties and the corresponding disclosures, to be specifically tailored to the carved-out business. In WTW’s experience, however, this ‘best case scenario’ for the RWI insurers is often impractical due to the complicated dynamics among the Target (which, being public, may have additional pressures placed on it that do not apply to a private seller), the strategic buyer and the financial sponsor(s).

Practical approaches to examine

Fortunately, there are various tools that RWI practitioners can use to try and address these concerns.

For instance, in a situation where the ‘seller’ under the separation/carveout agreement is the strategic entity that is first taking private the combined public company, the RWI insurers may be comfortable without the strategic entity (which typically owns the carved-out business for only a moment in time) giving Target-level representations, so long as members of Target’s management are directly involved in the negotiation of the separation/carveout agreement and the preparation of the disclosure schedules. In this situation, the representations regarding the carved-out business would most often be given by the legal entity housing that business.

For another example, in transactions where certain representations and warranties in the separation/carveout agreement speak to the combined public company, and not specifically to the carved-out business, RWI insurers may consider using deemed disclosures and/or targeted materiality or de-minimis thresholds as a solution to bridge the gap between the buy-side due diligence, the scope of the representations and warranties in the agreement and the coverage afforded under the RWI policy. Importantly, in all these fact patterns, the RWI insurers will expect the purchaser to conduct thorough buy-side diligence with respect to the carved-out business.

Given the complexity of these issues, WTW recommends that buyers in these transactions work closely with their legal advisors and insurance brokers to ensure that the coverage afforded under the RWI policy is as broad as possible.