Buyer expectations and seller limitations can be bridged using Warranty and Indemnity insurance
Real estate funds are increasingly turning to Warranty and Indemnity insurance (W&I Insurance) to help obtain a clean exit, release capital and maximise returns for investors. We explore why W&I Insurance has become more prevalent and the reasons for considering it in a corporate real estate transaction.
Warranties – an imperfect proposition
Real estate funds tend to structure an exit by way of a share sale, selling the shares of the special purpose vehicle (SPV) in which title to the property is vested, rather than selling the underlying asset itself.
With the lack of common law or statutory protection afforded to the buyer, the buyer will expect the seller to provide extensive contractual protections in the form of warranties relating to the activities of the SPV. These warranties will address a wide range of risks including title, tax liabilities, employment, litigation and environmental matters.
But reliance on the warranties alone does not provide complete protection:
- From the buyer’s perspective, the warranties are only as good as the seller’s covenant. The buyer may have concerns about the seller’s financial standing following completion (i.e. if the seller is an SPV with no assets, or is distressed).
- From the seller’s perspective, although the assets and liabilities of the SPV have been transferred, there is no clean break – there is a contingent liability the seller may need to account to the buyer for a breach of warranty/indemnity at some point in the future.
Additional comfort for buyers has traditionally been provided by seller parent company guarantees and/or holding back a portion of the sales proceeds in escrow. For a real estate fund, this posed real issues – any money which was tied up this way limited returns to investors and damaged the fund’s internal rate of return. As such, real estate funds typically sought to limit warranties on exit.
This approach poses an issue in today’s market. Buyers are more risk adverse than they were prior to 2008. In order for a transaction to be signed off, investment committees like to see extensive contractual protection capped at the appropriate level.
There is, therefore, a gap between what the buyer expects from the seller and what the seller is willing to provide. W&I Insurance is designed to fill that gap by allowing the seller to give warranties while limiting its risk to, in many cases, a nominal £1.
W&I Insurance – a perfect solution?
As the name suggests, W&I Insurance is intended to cover the damages that result from breaches of warranties and indemnities given by the seller. Although it is often the seller that introduces insurance to a deal, the insured party is normally the buyer.
Buy-side insurance developed as a result of sellers being either unable or unwilling to provide the level of warranty cover required by the buyer. Insurers will still require the parties to undertake an arm’s length negotiation of the underlying contract, including customary buyer due diligence.
However, the seller’s liability cap is reduced to a nominal amount in the underlying contract, with the buyer obtaining its contractual protection above and beyond the cap specified in the contract directly from the policy. The policy tracks the warranties in the underlying agreement. In the event of a breach of warranty, the buyer claims directly against the A-rated insurer and not the seller, allowing the seller to achieve a ‘clean exit’.
The insurance process runs in tandem with the underlying transaction, with insurers provided with updated documents and diligence reports as they become available. A good benchmark is to allow two to three weeks to complete the insurance process, but specialist brokers and insurers recognise the need to meet the deal timetable, and this timeframe can be significantly reduced.
W&I Insurance in action
During a recent transaction, Howden advised a close-ended fund when selling a Jersey company that owned a prime central London real estate asset. The transaction was valued at £170m, and Howden arranged an insurance policy of £25 million for the benefit of the buyer. The seller used insurance to cap its risk in the underlying contract to £1, but provided extensive warranties to the buyer. As a result, the seller avoided placing £25m into escrow, allowing it to distribute all sale proceeds to investors.
Conclusion
The rising number of share deals combined with risk adverse buyers has created a gap between what the buyer expects from the seller and what the seller is willing to provide. Real estate funds are turning to W&I Insurance to fill this gap. Increasing awareness of the product suggests W&I Insurance will be an ever present feature of the deal landscape.
This article was submitted to be published by Howden UK Group Limited as part of their advertising agreement with Today’s Conveyancer. The views expressed in this article are those of the submitter and not those of Today’s Conveyancer.
