Property transactions – achieving a clean exit

As anyone who has been involved in a property transaction or the winding up of a fund or investment vehicle knows all too well, the ramifications of a deal can go on for years after the ink has dried on the sale and purchase agreement.

In the case of a property deal, the warranties provided by the seller can cover all manner of issues, from tax to planning. The result is that a substantial proportion of the sale value can be locked in an escrow account to fund potential future contractual liabilities for a lengthy period, preventing the seller from releasing cash to shareholders or recycling it into fresh ventures.

But there is another way - one which has been well known, and liked, by private equity houses for many years: Warranty & Indemnity insurance (W&I).

The product provides comfort to the buyer, as the costs of any potential contractual liabilities of the seller will be picked up by their insurer. For the seller, it means they can do what they like with their money immediately.

The specifics on how W&I works were covered in a previous article in Property Week, but in summary:

• W&I allows contractual liabilities to be transferred under a contract of insurance for a known fixed cost;
• there are significant potential financial benefits to both buyers and sellers;
• the most common driver for the purchase of W&I is to achieve a clean exit;
• there are a number of programme structures which can be used; and
• from a real estate perspective, general market competition is driving real improvements in policy coverage and pricing which is very good news for buyers.

W&I: Key trends in a rapidly developing market

Matthew Bates (MB), head of risk advisory, major risks practice, and George Minoprio (GM), executive director, mergers & acquisitions practice, major risks practice, at Arthur J. Gallagher answer key questions on how W&I is evolving to meet client demand in the property industry.

What trends are you seeing at the moment? Is the upcoming vote on Brexit having an impact?

GM: While actual deal volume might be down due to the uncertainty, there’s no doubt about the increase in the underlying demand we are seeing in the W&I market. Sellers are seeking to limit their liability to as little as possible and are often using a W&I policy to achieve a clean exit and make sure the deal gets done. So there are fewer actual deals, but a higher percentage are using W&I.

In addition to Brexit, recent budget announcements - combined with the Panama leak - will focus attention on offshore structures. There could be a shift of holding companies back onshore, and a subsequent demand to insure potential liabilities of the past.

Also, buyers of the offshore companies who own such real estate may reorganise to remove the offshore corporate entity and may wish to insure the seller’s actions from the past and from the reorganisation itself.

So is insurance market capacity increasing to meet that demand?

GM: The short answer is ‘yes’. There have been new insurer entrants into the market and in addition to this, the majority of existing insurers have increased their capacity. Combine this with lower volume and you have the perfect environment for competitive pricing and wider cover. So you’ve got significantly more capacity than you had 12 months ago.

MB: There are other significant upsides, too. The competitive insurer landscape has pushed insured retentions - or excess levels - right down, to NIL in some circumstances. We expect this to become more widespread. Underwriters are increasingly looking to differentiate themselves through innovation and service levels too. Some of the things that might have been dismissed as too difficult in a more restricted market are now being embraced.

So insurers are willing to consider different sorts of risk?

GM: Now that W&I is becoming the norm, insurers are focusing on the contingent risks of a transaction too. For instance, it could be a tax risk where the buyers’ advisors are concerned that the seller might have historically paid the wrong amount of tax and the buy-side team worries that this contingent liability could come to a head in the future. We handled a situation recently where there was a planning issue that may or may not crystallise in the future.The buyer was worried and they wanted to insure against the risk. If you can solve a contingent liability, it’s often a real deal maker. If you can deliver a workable solution to a contingency liability that’s preventing a deal from happening, then you’re adding real value to the process.

Do you find there are many claims?

MB: It’s a question I am often asked. Most claims happen within the first two audit periods and the majority of them relate to financial statements, contracts or tax. Historically, there may have been relatively few claims, but claim frequency is definitely going up. We’ve recently published a webinar on the subject of W&I claims with a leading insurer in this area; it’s available on our website and is worth listening to. The numbers can be quite scary.

Where are you seeing most interest?

MB: European property funds are increasingly interested in W&I. As the product is maturing, it’s becoming more relevant to multi-asset transactions across different jurisdictions. It’s become more sensitive to the specific needs of the property industry and, despite the inherent complexity in such deals, the underwriting process is getting quicker all the time. It’s about innovation, but not all insurers have the capacity to fully support multi-jurisdiction transactions or funds; we are seeing increasing elements of specialisation as insurers seek to establish areas in which they can compete from a position of strength. It’s classic market dynamics.

What sort of interest are you getting from property lawyers?

MB: We’re seeing tremendous interest from the legal community. Lawyers recognise early in a transaction that W&I can deliver real benefit and call us for advice; W&I can be a tool which allows a deal to be done. Lawyers play an important role in educating their clients, but with the market changing on a day-to-day basis, they require the in-depth market understanding of a specialist broker such as ourselves. It’s why initiatives such as our webinars are so useful at keeping the real estate community up-to-date with what’s happening in the market. We are often asked to provide in-house briefing and training sessions and are happy to do so.

But aren’t the rates for more complex transactions prohibitive?

GM: No. The rates and retentions for a big European fund are as low now as they are for a standalone UK deal. Rates for a big European deal are now down to around 1% of policy limit.

What advice would you have for a fund on how to use W&I to best advantage?

MB: Think strategically. When you’re thinking about your strategy for disposal or acquisition you need to consider W&I. If you’ve got 15 assets that may be sold in different structures, you need to think about it. Where are they located? What’s the likely transaction value? What issues are you likely to face during the transaction? At least then they will start the process from an informed perspective.

Is W&I something that can be used retrospectively?

GM: Yes, it’s not just something that should be thought about in terms of future deals. Transactional covers can be used retrospectively.They can be utilised to tie up loose ends and enable funds or escrow to be released. In theory, they should be priced even cheaper. If you’re already a year down the track post completion, then the risk has reduced from the insurer’s perspective, if you remember that most claims are notified within the first two years.