With PE portfolio exits stalled last year, sponsors increasingly put their money to work acquiring founder-owned businesses. Many of these assets lacked sophisticated financial and record-keeping systems, prompting PE buyers to demand and win indemnification clauses to cover post-closing issues. That may change in 2024.
Weil Gotshal & Manges Partner Christopher Machera says indemnity clauses were one of the more hotly contested provisions in founder-owner transactions last year. Buyers seek these clauses to cover potential issues such as financial misstatements, employee or customer disputes, cleanup costs, lawsuits and other issues that arise after a deal’s close.
These clauses are especially popular in lower-middle market deals of about $50 million or less that don’t include representations and warranties insurance, or RWI. And even with RWI, PE shops often still seek indemnity clauses.
“We generally get reps and warranties insurance for mid to larger deals,” says AUA Private Equity partner David Benyaminy. “We get indemnity for things that are not covered by the policies.”
AUA acquired the family-owned Weaver Popcorn maker in January.
“These things ebb and flow,” Benyaminy says.
PE buyers’ fear of the unknown in acquiring family businesses and founder-owned assets was the biggest driver, but acquirers also demanded them as a way to bridge valuation gaps.
But Machera and Weil colleague Douglas Warner forecast in a report published in January a return of PE portfolio assets to the market in 2024, which they say will lead to fewer clauses being included in deals. Pitchbook reports that PE shops are holding more than 10,000 companies, an all-time high, and the median hold time last year was 6.4 years.
“This trend is not tenable,” they report. “The number of companies that sponsors are trying to sell, are thinking about selling, or have failed to sell is at some point going to cause a deluge of exits, and we think that it will begin this year.”
Expect more auctions and quicker closes, they write.
“PE sellers are going to return to the market to sell their portfolios companies,” Machera says. “PE sellers are very allergic to any post-closing liability.”
The falling cost of reps and warranties insurance, too, should contribute to the decline of indemnities clauses, Machera says.
Reps and warranties insurance, or RWI, cost more than six percent of the coverage when they first came into vogue about 15 years ago. Now, they can be had for less than four percent and the price continues to fall as the product matures and more insurance carriers enter the RWI market.
“Reps and warranties are almost universally adopted by PE sponsors,” Machera says.
Advisory firm SRS Acquiom reported that 65 percent of private equity buyers it worked with in 2022 obtained RWI.
And RWI claims, too, are evolving.
RWI typically only covers unforeseen post-close issues and explicitly excludes known risks, leading to an emerging market for insurance coverage that does cover known liabilities.
“RWI brokers have identified this gap in the market,” Machera says. “They are now increasingly offering bespoke products.”
All of which will set the stage for pushback on the clauses because of increased seller resistance. Machera says the demands for the clauses will remain, but sellers are going to successfully resist these provisions going forward.
“The demand will certainly be there this year,” Machera says. “But as a buyer’s market becomes a seller’s market, buyers will have to take no for an answer.”