Accessing the credit insurance and surety markets can support creative deal-making and help create value by enhancing operational efficiencies post-closing.
How are credit and surety solutions relevant to structuring M&A deals? More than you might think, according to Aon’s C-Suite Series report – Driving growth through uncertain times – which challenges deal-makers to see through the conventional perception that credit insurance and surety simply protect against bad debt or default in payment or performance. The report describes how, beyond these core objectives, “credit solutions can [also] be a growth enabler, unlocking vital working capital, maximising balance-sheet efficiency, supporting new business wins, and assisting in M&A.” As businesses hunt for growth, particularly in an environment where preserving or optimising liquidity is a key priority, capitalising on solutions available in the credit and surety markets can help support corporate strategy by introducing flexibility and efficiency - both in structuring the M&A deal and in the operational phase post-acquisition - to create value.
Or, to put it another way, by arbitraging the relatively lower cost of capital these solutions can help investors ‘secure’ the deal in the first place - optimising the basis on which an acquiror transacts with the seller with, for instance, better insights on the quality of a target’s cash flows – as well as ‘enhance’ the returns going forward, thanks to improved capital efficiency and capturing of synergies from day one. In short, any demand for security or collateral in the context of either the transaction itself, or in the operations of the target, could benefit from a solution in the credit insurance or surety markets that, compared with alternatives, is both off-balance sheet and attracts a lower cost of capital.
This capital efficiency play is analogous to recent developments in the M&A insurance market, where warranty and indemnity insurance has rapidly become a core part of the M&A playbook as deal-makers take advantage of the trade between (a) the cost of insuring against the breach of warranties provided by a seller in a sale and purchase agreement, and (b) the benefit to the seller of being able to distribute or monetise all sale proceeds at completion (a portion of which, absent that insurance, would have been held back by the buyer as security for any claims resulting from a breach of those warranties).
Insights on quality of cash flows
Understanding the credit risk inherent in the value chain of a target represents one key aspect of valuation that enables an acquiror to bid with confidence and on an informed basis. For instance, the credit risk associated with a target’s trade receivables can be identified and assessed with Aon’s access to data and analytics, helping an acquiror to understand the target’s supply side and customer base and quantify the probability of default, as well as the expected future credit losses to support bad debt provisions. This analysis can also guide an acquiror on the credit insurance market’s view of, and appetite for, the target, and - significantly - help develop the buyer case for accessing that capacity to support improvements to the target’s cash conversion cycle post-completion.
Capital optimisation
Structuring deferred consideration and alternative security arrangements with credit insurance or surety solutions are good examples of how the capital arbitrage referred to above can be used effectively and more efficiently, especially when compared with traditional arrangements like a cash escrow or a letter of credit, both of which typically involve a higher cost of capital and can therefore have a corresponding downside impact on the balance sheet.
Indeed, the benefits can accrue to buyer and seller alike, as illustrated in a recent deal where Aon advised a leading information services provider on the disposal of its stake in a conference business where the buyer sought, for commercial reasons, to defer paying half the consideration to the seller for 12 months. To provide the seller with the comfort required to accept this proposal, Aon arranged a credit insurance solution to protect the seller from the buyer’s non-payment of the deferred consideration. This solution bridged the gap between the parties by providing the requisite commercial flexibility for the buyer and legal recourse, in the event of the buyer’s non-payment, to an A-rated insurer for the seller, thereby facilitating completion of the deal.
An example of structuring a surety solution in M&A is illustrated by Warburg Pincus’ acquisition of Leumi Card for NIS2.5 billion, where the deal structure included payment of consideration in three instalments: at completion, and on the first and second anniversary of completion. Among other requirements for obtaining regulatory approval, a guarantee was necessary to provide sufficient comfort that Warburg Pincus’ deferred consideration obligations would be performed.
While a bank guarantee could have achieved this, the nature of such an instrument would have tied up credit lines and been more expensive than the surety solution that was ultimately structured by Aon - a deferred consideration bond of USD$600 million issued by a panel of surety providers that back-stopped Warburg Pincus’ legal obligation to pay the deferred consideration. As well as the obvious commercial advantage for the buyer, there was an indirect benefit for the seller, Bank Leumi, because the amount of regulatory capital that it had to hold against the risk of Warburg Pincus defaulting on that obligation was significantly lower, thanks to the high credit rating of the surety providers.
Efficiencies at the equity level of the capital structure can also be improved, as illustrated by the solution arranged by Aon for a European mid-market private equity (PE) fund’s portfolio company, which was subject to the Capital Requirements Regulations (CRR)[1]. The portfolio company was experiencing rising credit exposures and, as a result, the PE shareholder was anticipating the need to capitalise it further with expensive equity. Aon was able to structure a credit insurance solution for the business, however, which satisfied the applicable CRR criteria and enabled the portfolio company to reduce significantly the amount of risk-weighted assets held against those credit exposures, given the AA-rating ‘wrap’ presented by the insurance arrangement. Avoiding the need for an injection of equity helped optimise the business’ capital structure and, thereby, enhance the PE shareholder’s returns.
Innovative support for UK takeover rules
An example of further innovation in M&A with surety is the cash confirmation bond that can be used in the context of a UK cash takeover to support the statement - required to be provided under UK takeover rules (usually by the takeover bidder’s corporate finance adviser- that the bidder has sufficient cash resources to satisfy its obligation to pay all target company accepting shareholders, in full (the ‘cash confirmation’). Analogous to the development of M&A insurance as mentioned above, a surety instrument can provide - for the appropriate credit quality - a more capital-efficient solution than the escrow option typically used to support cash confirmation statements for cash-funded deals. Equally as important, though, the cash confirmation bond can also enhance liquidity for the bidder as well as help improve deal execution efficiency.
Aon developed and placed the first cash confirmation bond, a GB£75 million surety instrument backstopping the obligation of Fiserv, Inc., a US investment grade bidder, to pay the cash proceeds due to accepting shareholders in its takeover of Monitise plc. The solution gave Fiserv flexibility by allowing it to draw-down funds under its existing revolving credit facility shortly prior to completion, rather than having to do so at the start of the formal takeover process and then escrow that cash for a number of months, pending deal completion. The surety solution also gave comfort to Fiserv’s financial adviser, J.P. Morgan, and was a key factor which enabled it to give the cash confirmation statement, helping to simplify that part of the deal process.
Achieving deal synergies
Surety and credit insurance solutions can also be applied to help achieve post-deal synergies from day one, including the optimisation of credit insurance arrangements – from a straightforward trade credit policy, to a supply chain finance facility or an accounts receivable facility – by restructuring, remarketing or integrating a target’s arrangements into an acquiror’s pre-existing programme. An example of this can be seen with the optimisation of the legacy surety arrangements for a media business that an Aon client acquired in Latin America. Upon the change of control in the M&A deal, several surety bonds supporting the target’s tax obligations to the local government would have triggered an obligation for cash or other security to be provided to cover these legacy contingent liabilities of the target; Aon successfully restructured these arrangements, however, to bring them within the acquiror’s existing surety facility, thereby adding greater flexibility to the target’s working capital and creating operational efficiency.
Challenging the conventional
Moving beyond more conventional uses of surety and credit insurance (such as, for instance, bonding in the construction industry or insuring open account, commercial export and trade in the retail sector), and building on Aon’s prior innovation structuring surety bonds to back-stop sponsor commitments for defined benefit pension scheme deficits, the examples above aptly demonstrate how credit insurance and surety solutions can be applied in novel situations to support both M&A deal-making and the generation of operational efficiencies to help create value.
[1] The CRR applies to credit institutions and investment firms and contains provisions relating to, among other things, own funds and capital requirements, large exposures, securitisations, liquidity, leverage and supervisory reporting.