A key theme in Aon’s new M&A report ‘Leaving nothing on the table: Unlocking off-radar transaction value’, is the growing role insurance can play for dealmakers looking to hedge transaction risk.
The perception of credit insurance within the M&A space has often centred around pure risk mitigation or bad debt protection for organisations selling goods and services, with a small overlap with the Surety market issuing various commercially related performance bonds. However, the industry has undergone a sustained period of evolution in recent years, consequently transforming the art of the possible; the application of Credit, Political Risk Insurance (CPRI) and Surety solutions in an M&A environment.
Solutions for buyers
1. Transactional solutions to hedge deal risk – Deferred Consideration Bonds
One of our clients approached us to discuss potential solutions for a strategic acquisition they were close to signing. They were to acquire a business with an Enterprise Value of £100m, structured by an initial cash payment of £60m, with a deferred consideration of £40m payable in four years.
While the UK PLC purchaser represented a strong credit risk, the seller wanted to secure their returns in the deal. Usually our client (the buyer) would have approached their bank to request the issuance of a security, in the form of a Letter of Credit (LoC) Bank Guarantee. In this case the LoC would have effectively lowered the amount of working capital the buyer could source from the issuing bank (-£40m). However the business was in a growth phase and wanted to minimise the amount of working capital tied up in this deal.
Our solution was to replace the LoC with a Surety Bond equivalent, enabling the buyer to complete the transaction using deferred payments. The surety bond, a third party guarantee issued by an AA- rated insurance company, [SS1] effectively secured the payment from the buyer to the seller. The surety bond was issued on an on-demand basis, allowing the seller to call on the bond in the event of buyer default on the deferred consideration payment .
The seller was happy because their credit risk was mitigated – they would get their money, regardless of the solvency of the buyer– whilst in turn our client (the buyer) was happy because the guarantee was issued on an unsecured basis, removing the need for capital to be tied up.
More recently we have used Credit Insurance to support clients in the divestment process, where sellers look for security against payment default by the acquiring entity. In these cases credit insurance not only mitigates risk, but also acts as a pricing gap bridge; enabling bidders to offer more competitive prices (closer to a sellers target), because they can offer an insurance protected staggered payment structure. The available capacity for such transactions runs into the hundreds of millions (USD).
2. Enhance the risk Due Diligence process with the use of Credit DD
Providing a tangible solution in the due diligence phase is another theme in our M&A report. Having taken note of the growing focus and pressure to get pre-transaction due diligence right, and then examining how the insurance industry can harness and utilise its rich source of data to give buyers a deeper insight and understanding of their target acquisition(s) from a credit and financial risk standpoint.
Having identified that as much as 40% of an enterprises assets sit in the current assets of the balance sheet, namely trade receivables, Aon coordinated the development of a Credit & Working Capital Assessment to help clients understand their exposure to credit risk. Aon partnered with a global credit insurer to develop a unique tool which provides in depth analysis of a target(s) Trade Receivables ledger, outlining individual counterparty credit risk, as well as sector and country analytics.
This process allows the acquirer to accurately map the portfolio so as to determine the distribution of debt and calculate the risk weighted Probability of Default (PoD) and Estimated Credit Loss (ECL) across that asset.
Our recommendation? Get involved early
It is critically important to involve Aon and potential insurers at an early stage. If a company is looking to complete an acquisition, the credit insurance market must be engaged as soon as is practicable. This allows insurers to get a clear pre-close understanding of the purchaser’s investment strategy and funding plan for the target. If this process doesn’t occur early enough, insurers may treat the acquirer as a greater credit risk and stop supporting future exposures due to a perceived level of uncertainty and lack of financial visibility. This may detrimentally impact the buyers contracted payment terms and the result could be a negative working capital shift, with liquidity put under undue pressure creating a demand for cash.
Securing Investments, Enhancing Returns
Everything we do centres around the creation of a tangible financial benefit for our clients. We aim to achieve this through the innovative use of CPRI, Surety Bonds and Guarantees. These solutions have successfully unlocked substantial levels of working capital for private equity firms, reduced the level of capital tied up supporting acquisitions and secured financial returns for organisations completing divestitures. During the M&A process this approach can make a big difference to both buyer and seller, and we expect to see the application of insurance products continue to evolve to help all parties mitigate and hedge those low frequency, high severity risks, that can threaten to derail transactions.
For more details on due diligence and risk mitigation in the M&A process, see Aon’s ‘Leaving nothing on the table: Unlocking off-radar transaction value’– the latest report in our C-suite Series.