How insurance can protect SMEs during a business sale or acquisition

After a tough two years for the UK’s SMEs, there are signs that market conditions are improving. According to a recent survey, SMEs are cautiously optimistic about the outlook for 2022, with many seeking routes to renewed growth.¹

Interestingly, around 30% of SMEs reported that they were considering a merger or acquisition over the next 12 months¹, but they are not alone. In parallel, private equity interest in acquiring UK SMEs is significant, driven by relatively low valuations compared to EU and US firms.² In fact, the number of deals completed during the first half of 2021 rose by 60%, and shows no sign of slowing down.

Together, these two trends point to a busy 2022 for SME mergers and acquisitions (M&A) – and with deal values currently running at around 5.5 times gross profit, owners of high-growth SMEs in particular could find themselves dealing with the complexities of an M&A transaction for the first time.²

Risks in SME mergers and acquisitions

Rising interest in UK SMEs might bring opportunity, but buying or selling a business is rarely straightforward. Indeed they are among the most complex and riskiest business transactions, so taking steps to manage risk before, during and after a deal is vital to success.³

A big part of that risk management takes places during due diligence, which is a process of assessing the risk associated with a sale or acquisition and usually takes place once the outline terms of a deal have been agreed.⁴

Due diligence is a detailed process, usually guided by independent expert advice and will look at areas such as a target firm’s financial position, as well as risks that might arise in areas such as taxation, legal, operations, the supply chain, HR, the customer base, technology and cyber, insurance and the environment.⁵

Crucially, the due diligence process should give the buying business the insight it needs to assess the merits of completing an M&A deal, and to ensure suitable warranties and indemnities are included in any final deal agreement.⁵

Warranties and indemnities are essentially a way to allocate the risks associated with a deal between the buyer and the seller. If there is a breach of a warranty, the buyer can seek damages for the losses that it incurs as a result of the breach.

These days, however, buyers and sellers are increasingly seeking to reduce the risks arising from warranties and indemnities by transferring them to the insurance market – in the form of warranty and indemnity insurance (W&I insurance).

How warranty and indemnity insurance can protect SME M&A deals

In simple terms, W&I insurance covers financial losses arising from a breach of a warranty given by the seller to the buyer in a sale agreement – specifically in relation to issues that were not disclosed or known about at the point of concluding the transaction. Either the buyer or seller can take out W&I insurance, albeit almost all of the placements that the Marsh Private Equity and M&A team advise on are buy-side policies.

For a seller, W&I insurance can eliminate their financial exposure for a breach of warranty because the buyer instead has recourse under the insurance policy i.e. the insurer ‘steps into the shoes’ of the seller.

Meanwhile, for the buyer, if the seller is not willing to offer contractual recourse for a breach of warranty or is seeking a limited warranty period, W&I insurance provides recourse from an insurer with a strong credit rating and can help facilitate the transaction. Other key motivations to use W&I insurance include:

• Maintaining management relations by avoiding the need to claim against warrantor management teams where they are retained post completion
• Enhancing bidder status, enabling bidders to offer a low liability cap to the seller with a view to positioning their bid competitively.
• Alleviating concerns on recoverability, either due to the financial strength of the seller or a disparate selling shareholder base.

The W&I market is ever evolving. As well as the traditional W&I product – which is there to support deals with an enterprise value anywhere from circa five million to several billion pounds – there are new products entering the market to cater for small and micro deals in the UK with an enterprise value of £250,000-£10 million across the manufacturing, education, franchise, retail, leisure, hospitality and real estate sectors. Such products are the first of their kind and are targeting the SME market, offering lower costs, lower complexity and lower time commitments compared to traditional W&I insurance. The biggest difference with this product compared to the traditional W&I product is that these are offered as sell-side policies only, meaning the seller is the insured party. We expect such products to continue to develop (and span across all sectors in the UK) and manifest in a mature SME W&I market.

Mitigating SME merger and acquisition risks

W&I insurance can play a vital role in helping to bridge the gap between a buyer and a seller during negotiation of deal risk allocation⁵ – but there is a lot more that can be done to mitigate M&A risk.

Working closely with Marsh UK, we have access to a dedicated Private Equity and M&A team, which supports the investment and M&A community to de-risk transactions and create value through:

• Risk and insurance transaction advisory services.
• Advising on and placing M&A insurance solutions for identified, specific risks to facilitate transactions and transfer transactional liabilities to the insurance market.

The world of mergers and acquisitions is highly complex. We appreciate that this is quite a technical topic to understand. If you have any questions, or if you are thinking about selling or buying a business, get in touch with your Marsh Commercial advisor or contact your local office.

Keen to learn more? Check out the following articles:

• Manufacturing mergers and acquisitions risk trends and solutions.
• Technology M&A risks trends and insurance solutions.
  
  

<sup>Sources
1. https://www.uktech.news/growth-strategy/uk-smes-2022-growth-pandemic-20211201
2. https://www.cityam.com/acquisitions-of-uk-and-irish-smes-climb-nearly-60-per-cent/
3. https://www.marsh.com/uk/services/private-equity-mergers-acquisitions.html
4. https://www.evokemanagement.co.uk/insights/planning-profitable-sme-growth-successful-ma-process
5. https://www.marshcommercial.co.uk/articles/manufacturing-mergers-and-acquisitions/</sup>