Private equity firms are increasingly keen to avoid major risks related to deal closing and transactional cost challenges.
Currently, two effective solutions have become increasingly popular, though they exist at different ends of the purchase life-cycle.
Ahead of a purchase, warranty and indemnity insurance can help protect buyers from potential problems, while freeing sellers from having to escrow vast cash sums in case of a claim. Once terms are settled, sophisticated hedging strategies help mitigate drawdown risk during the execution.
Warranty and indemnity insurance
As the world continues to digest the implications of the U.K. referendum result, it becomes particularly pertinent to stress that by no means is private equity an exception to the intensely risk-averse attitudes that pervade the financial markets.
Indeed, during a time when individual investors and regulators seek to limit risk, buyers are increasingly searching for greater protection from the threat of unexpected issues following a purchase.
Those on the sell-side are also acutely aware of the difficulties involved in packaging a safe sale for those buyers, and are looking to avoid the costs of providing warranties and to limit their own claim exposure.
The effects of warranty and indemnity insurance are reverberating throughout this market. While purchases still require proper due diligence, these forms of insurance are sold directly to buyers, and work through genuine claims being paid by insurers instead of sellers.
Effectively, buyers are much more assured of their purchase, with “full protection from an A-rated insurer,” explains Richard French, Director of M&A Insurance at Howden Insurance Brokers. “While a decade ago some companies might have seen insurance as another process to get through in a deal, today many simply will not buy without the protection of warranties and therefore W&I insurance.”
Such a strategy can help make conducting a deal a much safer process. “If you transact and subsequently find out that there’s a problem, such as the purchased company facing litigation or an environmental issue, you might have previously sued the seller, but now you can turn straight to the insurer,” French explains.
“Claiming from an A-rated insurer is far preferable to claiming from an individual manager who might have very limited assets, and who is also running your business.”
Insurance is also supporting PE transactions in real estate. Given the massive financial liabilities buyers may face when trading across continents, insurers can help them to ring-fence these issues when exiting, making for a much more effective investment.
Mitigating drawdown risk and cash drag
Beyond insurance, buyers need to execute transactions with a view towards what will ultimately be best for the balance sheet in the long term—which can present its own set of challenges.
Complex private equity deals can take weeks or even months to draw to a close. During this lengthy period, especially when a transaction happens across currencies, participants risk a major negative shift in the financial exchange.
Often, companies will pull down the cash for a transaction, but the eventual cost of that purchase may change after currency swings. Such drawdown is “the most unknown of the risks,” according to Ashley Hall, EMEA Head of Institutional Sales at AFEX, who urges firms to improve their understanding in this area.
“For a transaction worth $30 million, for example, funds could lose tens or hundreds of thousands of dollars on a cable swing quite easily over a four-week period,” he says. “They have an obligation to do something to proactively mitigate this risk for their underlying investors.”
Currency markets have been unsettled for some time. This means that the potential cost fluctuation is immense for businesses conducting cross-national purchases. Serious questions around monetary policies, the Chinese economy, Britain’s relationship with the European Union, and commodity price fluctuations mean that forex rates may shift quickly.
This has led to businesses looking more closely at ways to protect themselves, making sophisticated hedging strategies involving FX forwards or options that cover a deal’s expected completion timeframe even more attractive.
Hall says expert counsel is vital here, particularly for newer PE funds. “With very young funds, often they are well-versed in their asset classes, but less so in FX strategy and that can be a real problem. It is extremely important to have a specialist who has seen the volatility and understands the repercussions alongside them.”
In spite of the cost involved in hedging this way, mitigating this volatility offers far greater gains while also satisfying investors—and regulators—about the risks involved.
“New investors are holding back from young funds unless they have a really robust policy on risk management. It’s not enough for those funds to still say that an asset level increase alone will be the hedge.”
Sophisticated protection measures
There is no doubt that awareness of deal and currency risk has increased among private equity businesses and their clients.
Buyers are increasingly interested in—and able to afford—the means necessary to protect themselves ahead of purchases by turning to well-structured warranty and indemnity insurance. And during transactions, drawdown risk and cash drag can be effectively tackled with clever forex hedging.
Serious operational and financial issues are at stake here, and private equity businesses will increasingly look to protect themselves in these smart ways when transacting.