The insurance market is proving to be a rich source of innovation for private equity firms looking to squeeze more value from their portfolio
Despite the impact of COVID-19 on the global economy, there are reasons to be cheerful from an M&A perspective. Yes, the deal flow declined through the first half of 2020, but when we look back at the whole year, the story will tell that private equity-fuelled M&A activity remained at reasonable levels with some pick up after the summer and into the second half of the year. That said, when it’s all about creating value in times of uncertainty, the M&A community continues to overlook additional tools such as alternative sources of capital that can extract deal value both during the transaction itself and well after a business becomes part of a private equity firm’s portfolio.
Greater competition demands greater innovation
One of the big challenges for private equity firms is that asset valuations remain high – despite the muted deal flow – and competition is strong. That means funds are having to look for alternative ways to differentiate their bid in an auction process, while ensuring that they’re not overpaying for an asset, as well as communicating effectively where value can be created during the ownership of a business.
Sale process timelines have also accelerated in the past couple of months, resulting in only a few weeks to get critical due diligence done. So again, it’s about looking at alternative areas – particularly around specialty due diligence – to see where firms can create value post-closing and find tools and financial instruments to try and differentiate a bid.
That’s where insurance capital comes in. For a long time, it has been an overlooked source of capital by the M&A community, which has preferred to stick to what it knows best – using traditional financial instruments from the banks to help facilitate deals, ring fence specific risks, and deal with traditional transaction requirements like deferred consideration. Critically though – and watch an investor’s ears prick up – the insurance marketplace has a lower cost of capital than these traditional forms of financing and banking instruments. Even pre-COVID-19, the banking sector was going through a period of shift and a tightening of regulations which meant that the speed of execution, the appropriateness of use and the cost of using those traditional financial instruments to get deals done was just getting tougher and tougher.
Leveraging the lower cost of capital
What the insurance marketplace had done – and done it spectacularly well – is to allow itself to harness that lower cost of capital to create products that help get deals done for clients in quicker timelines and, often, at a lower cost. Not only that, but the capital is more flexible, and usually with broader underwriting criteria than would be the case for traditional banks. The use of warranty and indemnity (W&I) insurance, for example, has been a great pathfinder for the insurance industry in M&A and has led to the continued growth of contingent risk insurance to protect against known risks such as tax and litigation; risks that would have been dealt with via a traditional banking instrument.
Beyond getting the transaction over the line however, there is much more that can be done long after the champagne corks have been swept away to extract value from the portfolio company. One thing we have learnt in recent months is there has been a greater focus on portfolio company efficiency. So, when deal flow is reduced, it’s common for private equity firms to hunker down in their portfolio and look to create value. That means there has been a focus on operational procurement type efficiencies, but unfortunately the use of alternative value generators has been overlooked.
Turn on the liquidity taps
One of the big opportunities is how the insurance market can help create liquidity and free up working capital and cashflows within the business using more innovative instruments like surety bonds, structured credit, and credit insurance. These all follow a similar process to a banking underwrite but they’re off balance sheet which allows companies to free up cash flow. Don’t wait until the deal has been signed though; careful thinking about the role that these instruments can play in the post-closing phase should be a part of the transaction process. This allows businesses to understand that from a day one perspective, there are opportunities to free up working capital by deploying solutions identified through due diligence.
For private equity firms, it’s about asking a series of questions in relation to their portfolio companies. Are we being proactive with our assets in looking to create additional financial value that doesn’t just come from traditional methods such as refinancing? What else could we do to free up capital? How are we engaging with advisors and specialist due diligence providers to identify post-closing working capital solutions?
Rise of the intangible
Another growing risk and opportunity often overlooked is a company’s intangible assets. Aon’s latest C-Suite Series report on M&A – Leaving nothing on the table: Unlocking off-radar transaction value – reports the top five companies in the S&P 500 had more than US$21trillion worth of intangible assets in 2018 as compared to US$4trillion of tangible assets.
A key element of those intangible assets is intellectual property (IP) such as patents, trademarks, and copyrights. The challenge for private equity firms is whether they have taken steps to understand and value the levels of IP within their portfolio companies. Are appropriate risk management and risk transfer solutions in place to protect a firm’s IP from threats such as stolen or litigated trade secrets? And what is being done to harness that IP value? Is there an opportunity for example, to create licenced partnerships and generate new revenue streams from the IP stack within the business? Again, the insurance market can come up with solutions to harness the value of IP such as using it as collateral to unlock other funding with support from insurance capital.
If not now…
Given the many options to use insurance capital in creative and innovative ways across the deal cycle, the challenge continues to be raising awareness of what these products can bring. The M&A community is far from being alone in not exploiting the full potential that sources of insurance-based capital can bring – Aon has estimated that as few as two in 10 CFOs are making full use of credit insurance solutions – but the opportunities are there to extract the value in M&A deals that often gets lost. With the hunt on to maximise enhanced returns, has there ever been a better time to look at what the insurance marketplace can bring to the deal?
To understand how M&A can maximise more deal value, download the full Aon report Leaving nothing on the table: Unlocking off-radar transaction value.