Every year at this time, Liberty GTS publish an analysis of the claims that have arisen on M&A deals that we have insured. The results give us real insight into how the nature of R&W claims is changing over time, and how they are likely to change in the future.
This year particularly, the macroeconomic and geopolitical environment poses numerous challenges for businesses, and insight to help manage this turbulence is particularly useful for all those involved in making and insuring M&A deals.
The significant headwinds facing the global economy are likely to weigh on the M&A industry in the coming months and increase the possibility of more instances of ’buyer’s remorse’, especially where the buyer believes it bought at the top of the market or that the business it has acquired may not deliver the expected returns. However, if our experience from COVID-19 is anything to go by, we do not anticipate that this will lead to a sudden flood of R&W claims.
We anticipate that the current environment will, instead, lend itself to an increase in certain types of risks and we have identified a number of potential areas of concern.
Undisclosed price increases
The inflationary pressures that have built-up due to the supply chain issues created by COVID-19 and the disruption caused by the on-going war in Ukraine could mean that we see more claims relating to undisclosed price changes going forward. The risk is particularly acute if the price change is imposed on the target late in the day, just before signing, particularly in a big business. This increases the importance of a buyer taking active steps to understand the target’s pricing arrangements with its suppliers and the contracting parties’ ability to amend the terms of an agreement or to terminate it. We take additional comfort if we know that the buyer has been allowed to speak with key suppliers, as this will usually flush out any issues not picked up as part of the desk-top due diligence.
Undisclosed customer incentives
We have seen a number of claims already this year relating to undisclosed customer incentives, with the allegation being that these were either not properly reflected in the accounts or were given outside of the usual course of business. This is probably a by-product of the fact that customer incentives (which can range from rebates to discounts on future orders) were used as a means of retaining customers through the pandemic – a trend that is likely to continue given the current economic climate. As such, we expect this to become an area of increased focus for buyers and their advisors during the due diligence process.
The supply chain issues that resulted from the pandemic are still not fully resolved and continue to impact businesses and their customers. This is a particularly critical issue for businesses whose operations are heavily reliant on large amounts of diverse inventory, such as the automobile industry. Furthermore, any bottlenecks that impact the speed with which inventory is able to ‘move’ gives rise to potential issues around stock deterioration and obsolescence. Therefore, understanding supply chain risks remains a crucial part of the due diligence process and a heightened area of concern.
We anticipate that we could see more claims in the coming months relating to accounts receivable issues, such as the setting of inadequate bad debt reserves and errors in terms of quantifying a company’s total accounts receivables. Indeed, one of our largest paid claims to date resulted from an allegation that the target’s management had knowingly under-estimated the accounts receivable reserve, which caused more revenue to be recognised in the financial statements than management knew could be realistically collected. We are paying much closer attention as part of our underwriting to the size of the accounts receivable figure, relative to the size of the balance sheet and asking more questions around this issue.
There is a risk that the challenges presented by the current economic environment may provide target management with a greater incentive to cross the line in order to boost revenue and avoid breaching financial covenants or avoid future cash flow difficulties. Indeed, we have already received several significant claims this year involving allegations of fraud. The types of issues we see differ in terms of the range of sophistication: from an allegation of a local manager passing off a set of forged accounts as the audited accounts, to an allegation of a long-running and elaborate fraud around revenue recognition issues. Rigorous forensic scrutiny applied across the entire due diligence process is the best way to avoid later complications here.
The invasion of Ukraine and the resulting isolation of Russia has moved cyber even further up the risk agenda as concerns grow about the possibility of state-sponsored attacks against Western businesses. These concerns are compounded by fears that many businesses do not have adequate cyber insurance cover in place. Indeed, we received a notification within the last 12 months where the estimated loss suffered by the target is significantly higher than the limit provided by its cyber insurance cover. We, and many other M&A insurers, are increasingly focused, therefore, on managing cyber risk, in many cases by excluding cover for cyber-related issues altogether and, in other cases, limiting it by only covering specific cyber-related warranties that we are satisfied have been properly diligenced.
We have seen a significant increase in third-party claims in the last 12 months, especially in the Americas region. We do not expect to see any let-up in this trend in the near-term, particularly given that, during times of economic uncertainly, litigation is seen almost as a means of raising revenue. This is likely to necessitate an increased emphasis on the identification of potential future disputes (as opposed to ongoing and/or threatened disputes) during the due diligence process.
We expect to see more claims arising from ESG related issues, reflecting the increased importance of this area and the reality that buyers are increasingly expecting sellers to give specific warranties on these issues. The raft of associated legislation that has been or is due to be implemented will create more pitfalls for businesses and require costly new ways of working. A business that does not keep up with these changes or fails to live up to its own ESG credentials (or ensure that its suppliers live up to theirs) will be susceptible to enforcement action or litigation, including from increasingly active action groups.