United Kingdom

Skeletons in the closet threatening Real Estate deals

Can tax liability insurance can unlock the deal?

The spectre of skeletons in the closet will be a familiar risk to real estate investors. Aon’s tax liability and warranty and indemnity specialists Anka Taylor and David McCann to reveal how insurance is helping M&A deals cross the line.

“No one in real estate acquisitions wants to face their investment committee or their financial backers and admit that they haven’t bought something they thought they were buying,” declares Anka Taylor, Director of Transaction Liability at Aon UK.

A stark assessment indeed, but Anka says the insurance market is increasingly stepping in to smooth out the risks created by potential human error at every step of the M&A process.

“In today’s market, sellers will often reject bids that do not include warranty and indemnity insurance because long term liabilities for either side are unpalatable. Historically the seller may have left money in escrow, but this is becoming less and less appealing when an off balance sheet option is available.”

Typically, real estate investors will buy a ‘working layer’ with general warranty cover that protects against possible problems with the target company such as mis-stated accounts or an unknown litigation pending. Then this will be supplemented by specialist layers for risks such as title.

A potential worst-case scenario recently stole the headlines when problems encountered by the US real-estate empire of Nicholas Schorsh, saw a US $700m deal collapse owing to accounting irregularities.

Meanwhile, tax liabilities in the corporate vehicle being acquired can be of equal concern, says David McCann, Tax Liability Director at Aon UK. “Her Majesty’s Revenue and Customs carefully scrutinise offshore property holding structures.

The sellers of the assets you are acquiring may say that the entity is resident outside the UK, but the position is not always clear-cut. The directors of the target may have originally planned to fly out to board meetings every three months, but due diligence may find that in fact a meeting or two has been held in London. Do you accept the risk that the company is actually resident in the UK and has a potentially large tax liability or do you seek out options to mitigate?”

$700m Deal Call Out

Discount, Cancel or Indemnify?

David points out how investors are using tax liability insurance alongside warranty and indemnity insurance to achieve their objectives. “Where a tax risk is identified in due diligence and there is a disagreement between the buyer and seller on the materiality of that tax risk, the parties can reach an impasse. The seller is not willing to reduce the price or grant an indemnity, while the buyer is not comfortable signing the deal without some protection. Here, a third party insurance policy can unlock the deal.

“Sellers, especially private equity or real estate funds, have targets on their returns and tying up cash in escrow works against this. If you can use insurance as a substitute for a conventional indemnity and escrow, capital isn’t trapped.

Insurers are typically charging a one off premium of between 2-5% of the sum insured, covering the lifetime of the issue.”

In both cases, W&I and Tax Liability markets are served by competitive markets willing to underwrite suitable risks. In the latter case, David adds that insurers have been upping their capability. “There’s been a clear effort from many insurers to bring in underwriters who have a tax specialism. This should benefit clients, because it speeds up the insurer’s analysis of the risk and reassures that the initial view of a risk will be an informed one; this in turn reduces the odds of obstacles arising during the underwriting process.”