Deferred Consideration Insurance – The Product

Definition

Deferred Finance is created where the Purchaser agrees with the Vendor to pay some of the purchase price at a future date, as opposed to paying the full purchase price in cash on day one.

The future payments are secured by major global Underwriters. The Vendor payments are those to be made by the Purchaser to the Vendor. These payments are made to the Vendor by the insurers should the Purchaser fail to pay the deferred amounts or become insolvent.

Payment Methods

The Vendor will accept a deferred payment structure in the sale of the business as they will receive a permanent and irrevocable undertaking from major global Underwriters to promptly pay all the deferred payments should the Purchaser default or become insolvent depending on what Deferred Consideration Insurance method is used.

Transaction Sizes

We can write these policies in any currency and the range of £100,000 and £25,000,000 in insured deferreds has the equivalent value in Euros, Australian Dollars, USD or any other chosen currency.

Typically, Deferred Consideration Insurance is provided for deferred debt of between £500,000 and £10,000,000 on each transaction and we insure periods from 1 year to 5 years.

How is Deferred Consideration Insurance Used?

Deferred Consideration Insurance works especially well for:

- Management Buy Outs (MBO)
- Management Buy In (MBI)
- Buy In Management Buy Outs (BIMBO)
- Secondary Buy Outs (SBO)
- Public to Private Transactions (PPT)
- Share Buy-Backs (SBB)

We are either insuring, or Credit Enhancing the Loan Note or the contracted deferred debt as specified in the SPA

The Deferred Consideration Insurance can also protect the Vendor against interest payments as well as the principle deferred debt and can secure Earn Outs – see ‘How it Works’ for more data on the Earn-Out insurance

Why is deferred consideration insurance required?

On-going merger and acquisition activity occurs in a negotiating context in which a price is agreed between the Vendor and Purchaser. Resistance toward or from the debt, mezzanine or equity markets may lead to deadlock whereby a large gap exists between the agreed headline price and the normal debt leveragability of the target business, even though both Vendor and Purchaser would like to conclude.

Deferred finance addresses this situation and is created by negotiating with the Vendor a high proportion of headline purchase consideration on deferred terms. The Vendor’s deferred consideration on behalf of the Purchaser is secured and guaranteed with a third-party insurance-backed instrument. This is similar to a cash-backed bank guarantee but is provided by the insurance market.

The use of deferred consideration can be a deal-enabler allowing the Vendor to obtain the price that he or she requires. It also enables the Purchaser to proceed with the acquisition by deferring that portion of the price that is beyond his or her means or desires to pay at acquisition date. This sum is then paid out of future earnings from the acquisition within a determined post-acquisition period.

A deferral approach to acquisitions helps the Purchaser acquire the target company out of cash generated by operations rather than debt or equity. In effect, the acquisition could be financed out of future profits whilst improving day-one liquidity of the Newco.

The problem is how does the Vendor secure this deferred debt? The solution is through Deferred Consideration Insurance.

Why Do Advisers Need Deferred Consideration Insurance?

1. In the UK, the first driver for the deferred consideration instrument was in the late nineties. It enabled Vendors to take advantage of a 75 per cent reduction in Capital Gains Taper Relief (CGTR) by disposing of the company asset, subject to ‘time held’ formula and still, by using deferred consideration, could achieve a 10 per cent tax liability.

2. This was combined with a major funding gap appearing over the past eight to ten years caused by Private equity firms withdrawing from the SMB/OMB equity market. This still exists in 2005 and thus, an ‘equity gap’ has been created as they concentrate investments on larger transactions. The gap in available funding for the low cap market has been filled by deferred consideration insurance.

3. Banks are competitive on levels of funding, especially with the cash-flow-driven EBIT multiple formulas they offer. In some instances these formulas are sufficient to achieve the headline consideration and headroom required to acquire. However, all major lenders have built into their credit expectancies a compulsory level of deferred consideration to be employed ranging between 25–40 per cent of the total price. Sometimes the EBIT multiples fall short of the total funds required.

4. Banks and asset-based lenders can employ ‘loan to value’ lending criteria. With this method based on say, 80–90 per cent of eligible receivables, 50–60 per cent on inventory, 50–70 per cent on plant and 80–90 per cent on freehold, it would be even less likely that the entire target funding could be achieved. Once again a funding gap needs to be addressed.

5. Advisers are increasingly concerned about the greater structuring complexity of acquisitions and the timescales involved. This is especially apparent with the numerous ‘layers’ of different types of funding that they are being driven to find, where often three, four or even five different layers of funding, such as debt, mezzanine, private equity, conditional deferrals and ‘buy-in’ type angel funds, are not uncommon.

6. The classic bank guarantees no longer realistically exist unless the Purchaser can ‘cash back’ or ‘asset collateralise’ the guarantee on a pound-for-pound basis. This is pointless because if the Purchaser had the cash then full consideration would normally be paid to the vendor. There would also be an opportunity cost deficit for the purchasers if cash were to be tied up in an account. Deferred consideration insurance provides the solution.

7. As private equity increasingly focuses on larger deals, high growth companies and key sectors, Vendor-assisted transactions — where the Vendors have cash in the business to fund the deal — are, in the current economic climate, almost the only way it is possible to sell a mature market sector business.

There are two situations where private equity might be an unfavourable option:

(a) Where the deal is not right for private equity due to IRRs or the size of the investment,

(b) Where it is a private equity deal but the Advisers are looking to avoid major equity dilution for the Purchasers.

Sometimes there is no option but to have private equity invested. But if private equity was just being raised to reach the purchase price then it would be far more cost efficient for the purchasers to attempt to defer the equity proportion and offer security. This means that they would not have to dilute equity and be under pressure to meet exit time scales.

8. Deferred consideration insurance was also required as an alternative to mezzanine funding as not only is it not widely available to the small and medium-sized market but, where it is, the cost of mezzanine finance is high.