Should W&I lead on determining the scope of your due diligence exercise? The short answer is No.
The primary function of due diligence is to identify risks in a target and accurately price them into the transaction. However, when purchasing warranty and indemnity (“W&I”) insurance, the scope and quality of DD is almost always the most important factor in obtaining a best in class W&I policy with broad policy coverage and a more limited list of exclusions.
Why insurers are doing their due diligence
HWF are increasingly seeing due diligence scopes come under tighter scrutiny from W&I insurers. This shift is largely due to:
Wider use of transactional risk insurance
- An increase in claims
- Growth in insurer numbers
- A shift in underwriting approach
At the same time, the pursuit of greater returns is leading to parties seeking to reduce transaction costs. This can lead to a smaller budget for the DD process – making the scope of what is looked at even more relevant in order to bridge the gap.
Understanding what W&I covers
It’s a common misconception that W&I insurance only covers fully diligenced areas. This is not the case. W&I exists to provide cover for unknown liabilities, so there would be little benefit purchasing a W&I policy which only covered fully diligenced areas.
The purpose of an insurer’s underwriting is to gain comfort that material operations and risks have been subject to adequate diligence which allows a buyer to understand the target business.
At HWF we more and more frequently feed into processes at an early stage in order to refine scopes and pre-empt issues that may arise. This is particularly pertinent in the case of internal due diligence. The due diligence process can also highlight any specific risk areas on a deal which can often be insured under a separate product called Contingent risk insurance (which will be the topic of the next HWF article for Crafty Counsel!).
What Due Diligence is required?
As a general rule, the minimum reporting requirements for insurers are legal, financial and tax due diligence.
However, additional workstreams relevant to the operations of the target business can also reduce the number and/or breadth of excluded matters under the insurance policy. In short, it is important for a balance to be found as to the appropriate and proportionate levels of DD that are conducted in light of the size, operations and jurisdictional footprint of a target.
Additional focus areas might include:
- Insurance
- IT (e.g. open source software or Black Duck searches)
- Technical and regulatory reports
- Re-organisational reports (including a steps paper – vital for carve-out coverage)
- Commercial, property and assets
Vendor due diligence (VDD) is not required for a buy side W&I policy (which make up over 95% of policy placed by HWF). However, high-quality VDD can reduce the burden on the buyer’s DD and improve coverage. It should be noted that poor quality VDD may have the opposite effect.
Internal DD: What do insurers expect and some practical considerations?
A common question arising multiple times at the Craft Counsel M&A day related to whether or not insurers will accept internal due diligence when underwriting a W&I policy. The short answer is yes, provided the internal review is:
– Of equal quality to an external exercise
– Appropriate to the size and nature of the transaction.
Recently, insurers have moved to become more accommodating of internal DD processes, given the increase in the number of both large corporations (who have significant M&A capabilities and track records and highly qualified internal teams) and specialist dedicated sector investors (such as renewable and infrastructure funds) using W&I insurance.
Your broker proactively reviews scopes before report preparation and identifies gaps that, from our experience, insurers expect due diligence to cover. In the case of internal DD, brokers might look to share DD scopes, team bios, indexes of the documents reviewed and Q&A with insurers to allow them to get comfortable with the exercise and flag any concerns or highlight any gaps, as well as assessing the opportunity for integration of smaller or more focused internal workstreams for example around plant & machinery, stock, IT, IP and insurance.
The broker identifies flagged risks and recommends specialist products – such as tax or contingent risk insurance – to address them as part of the strategic review process.
Key principles insurers focus on for internal DD:
- Who conducted the review – Who has carried out the work and are they qualified / have relevant experience (in-house or externally) to do that work?
- Scope – Does the scope include everything a third-party provider would examine during the exercise?
- Materials – whether documents and Q&A have been thoroughly reviewed.
- Reporting – including analysis of materiality and clarity of risk profile
- Presentation – while content is most important, mirroring external formats can be helpful
Key Takeaway
Internal DD is not a barrier to obtaining W&I insurance.
HWF frequently advises clients, helping them rely on internal reporting and secure cover equivalent to what they would achieve through external due diligence.
Approach to DD on all transactions remains a balancing act between desired spend and visibility on the target and early engagement with HWF will be important so we can advise on the scope and form of reporting, manage the underwriters appropriately and ensure cover reflects a buyer’s expectations.
This article was written by Eleanor Swinburne, Associate Director at HWF Partners. You can find more insights from the HWF team at hwfpartners.com/insight.
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