What are Synthetic Warranties?
In short, synthetic warranties are warranties agreed with a Warranty and Indemnity (W&I) insurer, rather than given by a seller as is typical. The warranties are set out in a schedule to the W&I insurance policy rather than incorporated into the relevant sale agreement. In order for an insurer to be comfortable insuring synthetic warranties, thorough buyer-side due diligence needs to have been carried out and sufficient time allowed for the insurer to conduct its own review and analysis of the diligence, as well as corroborative checking against the data room.
Synthetic warranties may attract a higher premium than traditional W&I insurance policies, reflecting the added uncertainty the insurer assumes because the seller is not “providing” the warranties, i.e. the parties are not going through a rigorous process of negotiating the warranties and the seller and/or management are not available to prepare a fulsome or traditional disclosure schedule.
These limitations can be tempered somewhat to the extent that the seller/target can assist in answering RFIs or generally be co-operative with the buyer during the diligence process. However, these fundamental limitations in the negotiation and disclosure process will remain, and accordingly the breadth of warranties that can be covered in a synthetic context will depend on the insurer’s ability to negotiate the warranties with the buyer and underwrite to these risks where the seller or management are not involved in the process.
As the market for synthetic warranties has developed, we have seen it deployed more for asset or real estate dominated transactions. This is because an asset sale transaction will not generally require the same variety and depth of warranties that one may expect on a traditional share sale of an operating business, and the warranties that are given can generally be validated through disclosure.
In a traditional M&A context the seller is usually comfortable providing warranties. However, where an administrator has been appointed there is an obvious reluctance for that administrator to stand behind the warranties that are proposed to be given. There may also be reasons why it is undesirable for the target to provide warranties. Synthetic warranties can provide a solution in this context. Provided there is a well-populated data room and there has been sufficient buyer-side diligence conducted, a synthetic warranty package could be offered with the right deal dynamics. The main practical difference for the insurer from a procedural perspective is that it will not have any subrogation rights (even in the case of fraud) against the seller, the target, or the administrator.
Application in the Australasian Market
The insurance of synthetic warranties in the Australasian M&A market is still relatively nascent. Due to the increased risks to the insurer and the corresponding premium they would be willing to offer, we have not seen meaningful take-up of the product in Australasia. Furthermore, we are finding that often the work-around of having the target business provide warranties has proven a worthy and effective substitute to the seller or the administrator providing warranties in distressed transactions (absent anxiety from the buyer about the insurer’s ultimate subrogation rights for fraud). That said, given the increasing international use of synthetic warranties, we do predict an increase in the use of these products in the future.
At Aon we are in active discussions with our key insurer partners around developing synthetic warranty solutions. We see the offering of synthetic warranties as gradually becoming simply another variable alongside traditional W&I insurance that we can arrange for our clients.