Thomas Taylor, Charlotte Tullis and Richard French examine how W&I insurance is helping to marry buyer expectations with what the seller is willing to provide in corporate real estate transactions
Real estate funds are increasingly turning to warranty and indemnity insurance (“W&I insurance”) to obtain a clean exit, release capital and maximise returns for investors. This article explores why W&I insurance has become more prevalent and the reasons for considering it in a corporate real estate transaction.
Warranties: an imperfect proposition
Real estate funds tend to structure an exit by way of a share sale, in preference to the transfer of the target asset. This structure is attractive to both buyers and sellers. The buyer benefits from certain tax breaks (for example, stamp duty is 0.5% of the value of the consideration, as opposed to up to 4% SDLT in commercial asset purchases; share purchases are VAT exempt; and there is no capital goods scheme adjustment). For the seller, this structure allows it to transfer all of the assets and liabilities of the target special purpose vehicle (“SPV”) to the incoming buyer.
With the lack of common law or statutory protection afforded to the buyer, the buyer will expect the seller to provide extensive contractual protections in the form of warranties relating to the activities of the SPV. These warranties will address a wide range of risks, such as title, tax liabilities, employment, litigation and environmental matters.
However, reliance on the warranties alone does not provide complete protection:
λ From the buyer’s perspective, the warranties are only as good as the seller’s covenant. The buyer may have concerns about the seller’s financial standing following completion (ie, if the seller is an SPV with no assets, or is distressed).
λ From the seller’s perspective, although the assets and liabilities of the SPV have been transferred, there is no clean break – there is a contingent liability as the seller may need to account to the buyer for a breach of warranty at some point in the future.
Additional comfort for buyers has traditionally been provided by seller parent company guarantees and/or holding back a portion of the sales proceeds in escrow. For a real estate fund, this posed real issues: any money which was tied up in this way limited returns to investors and damaged the fund’s internal rate of return. As such, real estate funds typically sought to limit warranties on exit. This approach poses an issue in today’s market. Buyers are more risk-averse than they were prior to 2008; in order for a transaction to be signed off, investment committees like to see extensive contractual protection capped at the appropriate level.
There is, therefore, a gap between what the buyer expects from the seller and what the seller is willing to provide. W&I insurance is designed to fill that gap by allowing the seller to give warranties while limiting its risk to, in some cases, a nominal amount (although this may not always be possible and is dependent on the specific facts of the transaction).
W&I insurance: the perfect solution?
As the name suggests, W&I insurance is intended to cover the damages that result from breaches of warranties and indemnities given by the seller. Although it is often the seller that introduces insurance to a deal, the insured party is normally the buyer.
Buy-side insurance developed as a result of sellers either being unable or unwilling to provide the level of warranty cover required by the buyer. Insurers will still require the parties to undertake an arm’s length negotiation of the underlying contract, including customary buyer due diligence. However, the seller’s liability cap is reduced in the underlying contract, with the buyer obtaining its contractual protection above and beyond the cap specified in the contract directly from the policy. The policy tracks the warranties in the underlying agreement. In the event of a breach of warranty, the buyer claims directly against the A-rated insurer (and not the seller), allowing the seller to achieve a “clean exit” (subject to the liability cap). The buyer should ensure that the sale contract and policy coverage afford complete protection, as it will have limited recourse against the seller.
The insurance process runs in tandem with the underlying transaction, with insurers provided with updated documents and diligence reports as they become available. A good benchmark is to allow two to three weeks to complete the insurance process, but specialist brokers and insurers recognise the need to meet the deal timetable and this timeframe can be significantly reduced.
W&I insurance in action
On a recent transaction, Howden advised a close-ended fund when selling a Jersey company that owned a prime central London real estate asset. The transaction was valued at £170m and Howden arranged an insurance policy of £25m for the benefit of the buyer. The seller used insurance to cap its risk in the underlying contract to £1, but provided extensive warranties to the buyer. As a result, the seller avoided placing £25m into escrow, allowing it to distribute all sale proceeds to investors.
A permanent fixture
The rising number of share deals, combined with risk-averse buyers, has created a gap between what the buyer expects from the seller and what the seller is willing to provide. Real estate funds are turning to W&I insurance to fill this gap. Increasing awareness of the product suggests W&I insurance will be an ever present feature of the deal landscape.
Thomas Taylor is a senior associate and Charlotte Tullis is an associate at Norton Rose Fulbright LLP and Richard French is an associate director at Howden Insurance Brokers Ltd
