Litigation and Contingent Risks: Unlocking the Value in Mergers and Acquisitions

After a record-breaking global spike in merger and acquisition (M&A) activity in 2021 to USD 5.9 trillion[1], current global economic volatility has reduced the volume of deals in 2023 significantly, with first quarter volume of only USD 559 billion[2]. Climbing interest rates, geopolitical conflict, supply chain volatility and evolving regulation are all shaping the short-term economic outlook and directly impacting M&A deals. Amid these challenges, dealmakers also have to deal with the financial burden of litigation.

The threat of litigation can affect the valuation of a company, making an otherwise attractive deal stall, be renegotiated or fail completely. How buyers and sellers deal with that risk can go a long way toward the success of a deal. But beyond just simple preservation of deal flow, managing litigation risk properly can have other benefits.

Here we discuss the strategy behind the use of litigation insurance and how it can enhance M&A deal opportunities for your firm.

Mitigating Litigation Risk on M&A Deals

Just the threat of litigation or arbitration claims can impact asset valuations and limit market appetite. Buyers may seek escrows, indemnities or price chips, or even back away from a deal entirely if a company has risk of material judgments against it. Similarly, if a target has a favourable judgment or arbitral award that is not final, buyers may be reluctant to pay full value for that award. In such an environment, litigation is problematic for both buyers and sellers. Add to this tighter and more expensive financing, and the importance of mitigating litigation risk becomes even clearer. The two main types of insurance that are available on the risk transfer market are:

• Adverse judgment insurance — companies facing or involved in a potential lawsuit can purchase this defence-side coverage to cover a damages award if ordered to pay one.
• Judgment preservation insurance — coverage that allows businesses that have won judgements to lock in those favourable results by paying out if the verdicts are reversed on appeal.

Companies can use these to mitigate risk, unlock capital and help ensure that deals happen on the best possible terms.

The Benefits of Adverse Judgement Insurance

In situations where the target company is facing litigation that could result in a sizable judgment against it, adverse judgment insurance can help ensure that both buyers and sellers may proceed with a transaction with relative security. Essentially, a company purchasing adverse judgment insurance is buying a measure of financial security against shocks to its balance sheet from an adverse judgement.

Without insurance, sellers are often forced by buyers to retain part of the purchase price in escrow. They might also have to provide indemnities to cover losses from the litigation — or to reduce the price. Adverse judgment insurance allows a clean exit for the price of the premium, which provides sellers with immediate free use of the full deal proceeds. It also affords buyers a level of comfort when it comes to litigation risks — with which they are less familiar compared to the current owners.

Instead of waiting for litigation and arbitration matters to reach a conclusion, sellers can exit at the right time for them to free up capital for new investments and maximise investment internal rate of return.

The Benefits of Judgment Protection Insurance

When a company secures favourable court judgments or arbitral awards, it could take years to become final given the length of time appeals and annulment processes usually take. Therefore, until the awards are final, a buyer will refuse to pay a purchase price that assumes that the favourable outcome remains intact. Judgment preservation insurance provides certainty of outcome so the seller can receive full value and the buyer is protected from unexpected (and unbudgeted) losses.

3 Tips to Consider When Implementing Litigation and Contingent Risk Insurance

Buyers and sellers can benefit from litigation and contingent insurance by following these three steps:

1. Analyse the litigation risks, both current and future. Consider the impact on the company’s balance sheet. How would a judgment in a current case affect the company’s valuation? How could the reversal of a previous judgment affect the company’s valuation?
2. Recognise that a judgment won may need protection from reduction or reversal, while the risk of damage from an adverse judgment can be mitigated.
3. Understand that these are complex issues that may require complex solutions with the help of an advisor. Litigation and contingent risk insurance can help smooth the path for a transaction.

When used strategically, litigation and contingent risk insurance can provide a safety net for companies involved in a transaction. But beyond that, it can be a powerful tool to unlock flexibility during the deal and long-term value after it’s complete. Making better decisions starts with the security and peace of mind that litigation and contingent risk insurance can provide.

[1] Dealmakers ring out 2021 as the year of M&A | Refinitiv Perspectives

[2] ANALYSIS: There Was No Sign of an M&A Market Rebound in Q1 2023 (bloomberglaw.com)