Mergers & Acquisitions: 5 Risks That Threaten Transactions

Jump to Section:

This content originally appeared as an Aon-sponsored article for Wall Street Journal Custom Content.

OVERVIEW

Even as global growth remains sluggish, merger and acquisition (M&A) transactions have continued to hold their own. Over the two years since record-setting 2017, an annual average of almost 50,000 M&A transactions, worth a total of more than $3.6 trillion a year, have been announced.

In a competitive M&A market, in which buyers look to maximize their investments, everything from revenue to reputation is at risk. Now more than ever before, the risks presented by cyber crime, a constantly changing regulatory environment and the chance of a mega deal turning into a mega lawsuit must be considered and mitigated. For all parties involved, it’s increasingly important to look at deals carefully – to protect the downside and create value.

“Take an ecosystem with thousands and thousands of moving parts and then blend it into another ecosystem with similar complexity of parts, and there are literally a million things that can go wrong. You have to look at all of them,” says Alexandra Reed Lajoux, a member of the Board of M&A Standards, a nonprofit that recommends training and best practices for M&A practitioners.

IN DEPTH

To address growing complexity, new strategies can mitigate both traditional and emerging M&A risks.

Cyber Risk

Cyber risk is one of the newer M&A threats. In a recent survey, 53 percent of business executives said a critical cybersecurity issue had put an M&A transaction at risk. What’s more, 65 percent of those surveyed said they had experienced buyers’ remorse because of cyber security concerns after closing a deal.

“Too often in the past, cyber assessment during due diligence was light and didn’t occur until after the transaction was completed,” says Jason Hogg, chief executive officer of Aon’s Cyber Solutions Group.

Hogg says companies are now approaching cyber security risk in two ways. First, companies perform forensic analysis of the cyber risk accompanying a deal using new big-data tools. Second, they lean on insurance policies to help safeguard against issues that could come up during a deal.

A company with a solid cyber security strategy risks both its business and reputation if it acquires a company with a lower level of security. “People are less likely to remember the smaller company that was acquired,” Hogg says. “Instead, everyone is going to go after the parent company with the big brand and the deeper pockets.”

Intellectual Property Risk

The number of new U.S. patents grew 300 percent from 1985 to 2015, to almost 300,000. Today, intangible assets now represent nearly 85 percent of the value of the S&P 500. Given that dynamic, understanding the value of a firm’s intellectual property (IP) is paramount to valuing an acquisition. However, quantifying the value of a firm’s trademarks, copyrights, patents and trade secrets can be difficult. Therefore, IP valuation represents a growing risk in any deal.

One of the biggest mistakes a company can make is considering IP a legal instrument that lives in the legal department rather than a core asset to the business, according to Lewis Lee, chief executive officer of Aon Intellectual Property Solutions. “Afford these types of assets incredible focus,” he advises. “Understand that intellectual property is a strategic element of your value creation proposition — valuations rest upon it.”

At the same time, that value can make a firm a target. “Not infrequently, IP litigations come out of the woodwork once an acquisition gets announced because plaintiffs sense they might have leverage at that point,” says Elliot Konopko, senior managing director and co-head of Aon Litigation Risk Group.

Litigation Risk

When a business is exposed to risk of significant loss from a pending or possible litigation, the potentially catastrophic damages can be difficult to anticipate and measure. Faced with the threat of litigation, sellers may find it difficult to attract a buyer that is unwilling to assume an open-ended exposure to loss.

“Obviously, that dynamic prevents a lot of deals from happening,” Konopko says. “Many buyers are not willing to take on this type of potentially catastrophic risk and sellers are looking to walk away cleanly.” As a result, he says, “In the past two years, we’ve identified a substantial market for what we call judgments-only catastrophic insurance.” This coverage caps exposure in connection with existing or threatened litigation.

Breach Of Representations And Warranties Risk

Every M&A deal has a degree of risk between buyer and seller around unknown liabilities, from hidden pre-close tax issues to errors in financial statements. These risks are typically addressed through negotiation of the seller’s representations and warranties about the target asset. Matt Heinz, senior managing director and co-practice leader of Aon’s M&A and Transaction Solutions, notes that lawyers now address this risk through representations and warranties insurance (RWI) rather than a robust seller indemnity in respect to breaches or an escrow.
Historically, sellers would leave behind as much as 10 to 20 percent of a deal’s purchase price in the form of an indemnity to address breach risk. Now, rather than spending the time, money and goodwill required to negotiate such an indemnity, deal parties are buying RWI to cover the same risk – often with slightly better terms and with a longer duration of recovery as compared with a standard indemnity.

This process inserts an objective third-party insurer to recover losses rather than from the sellers. Such an arrangement allows the sellers to exit with more of their cash at closing, and further, by utilizing RWI, potential buyers can be more aggressive with their bids when attempting to acquire a business. Aon estimates that more than 45 percent of North American M&A transactions now include RWI, up from 34 percent in 2017. “This increase indicates that sellers are utilizing insurance to achieve cleaner exits and buyers are realizing they can be more competitive (yet still protected) by purchasing insurance in lieu of the traditional indemnity/escrow structure,” Heinz says.

Tax Risk

The insurance market has also evolved to address more known or heightened risks in M&A, particularly tax. While RWI covers the unknowns, tax insurance can address liability associated with an uncertain tax position. When giving a tax opinion, a lawyer or accountant may advise a 70 to 80 percent chance of the relevant taxing authority agreeing with a company’s position, which means there’s a 20 to 30 percent chance it won’t. If material, those sorts of tax issues can present “a small but deep hole if you fall into it,” Heinz says, “and this is the sort of risk that tax insurance is meant to address.”

Heinz notes that recent upticks in insurance coverage in various M&A scenarios indicate the transformative role insurance is playing. “There will always be unknowns in transactions that can lead a company to kill a deal or that can result in hundreds of millions of dollars of unexpected exposure. The insurance markets can help analyze those risks and bring capital options to the table to address them, helping push a deal through at a maximum value.”

Read the original article on Wall Street Journal Custom Content.