DEALING WITH A SAFETY NET

As Premier Parks Inc. was preparing for its $1.85 billion acquisition of the Six Flags chain in 1998, a potential deal killer confronted it. Six Flags was insured against the cost of injuries suffered at its 13 U.S.- based theme parks, but retained the first $2 million of loss per injury -- self-insurance that would create unknown latent costs for the conservative Premier. The challenge for the potential acquirer: assess the exposure and, if warranted, transfer it to a third party. "We wouldn't have touched the deal without full knowledge of the hidden liabilities we were taking on," says James Dannhauser, Premier's CFO since 1995.

Premier, a New York­based theme-park operator with 1998 revenues of $813 million, turned to its insurance broker, Aon Corp. After analyzing how much self-insurance might be drawn down in existing claims against Six Flags, Premier completed the purchase from Time Warner Co. and Boston Ventures on April 1, 1998, creating the world's second-largest theme-park company. Premier and Aon then decided to transfer the risk to American International Group Inc. (AIG). "The hidden liabilities were exposed and removed," Dannhauser says.

Relatively few acquiring companies face the possibility of a ferris-wheel or roller- coaster accident. Nonetheless, the popularity of insurance to mitigate the risks of unknown liabilities in a merger target seems to be growing sharply.

Many buyers are shy about discussing such coverage, of course, knowing that even having insurance may send signals that there are doubts about their targets. But AIG, the leading carrier in the field, acknowledges that it has racked up hundreds of millions of dollars in premium income so far this year from these lines, approaching 5 percent of its total premium income, and up from nothing two years ago. "We're finding vibrant acceptance by clients for these products," says Gregory Flood, president of AIG's mergers-and- acquisitions division. And Aon estimates a third of its 159 private equity company clients employ the coverage in their acquisition strategies.

Five years ago, the merger-risk market was in its infancy, with few companies willing to tack on the additional cost of an insurance premium to the millions in shareholder dollars they were spending on acquisitions. Today, though, "people are paying ridiculous multiples for companies, at a time when their internal rate of return is dropping," notes Neil Krauter, chairman and global practice leader of the M&A group at Aon, a Chicago- based insurance broker and risk-management consultant. So acquirers are having "to look with a microscopic eye at potential hidden liabilities," he says. "We don't get calls saying, 'I'm concerned about paying the target's $8 million insurance premiums. Can you lower that?' We hear, instead, they're freaking out about financing issues. Financing sources will charge more for the debt--or pass- -when they feel they're on the hook for hidden liabilities. Insurance resolves the financing issues that disable the deal."

Marriage Brokers
Besides AIG, major insurance markets for M&A risks are ACE Insurance, Chubb, Kemper Insurance, and Travelers Property Casualty. Deals typically are brokered by such firms as Aon, New York­based Marsh & McLennan Cos., and London-based Willis, each of which has a separate consulting unit focused on the business. While not every company covers every risk, M&A insurance is available somewhere for a multitude of exposures, including environmental liabilities, securities class- action suits, seller representations and warranties, accrued balance-sheet liabilities, product recalls, and even a deal's failure to qualify for an expected tax treatment.

"This is insurance as a business tool," says Bryan Carey, CFO of Aearo Corp., an Indianapolis-based manufacturer of personal- protection equipment, such as respirators, goggles, and hard hats. Carey bought M&A risk insurance for Aearo's 1995 management buyout from its former owner, Cabot Corp. "We make the type of equipment that is long-lived and, therefore, relatively uncertain as far as future liabilities," he says. "Anyone who has used our respirators over the years and who later develops a respiratory illness might seek legal redress against us. This was a huge unknown."

Most of the concerns were in the funding arena. "The management buyout was structured as an LBO [leveraged buyout], so we needed certainty in terms of cash flows" to obtain private equity funding, Carey notes. "We had to figure out what our future liability risks were and, once assessed, determine whether or not to transfer pieces of [the risks] to a third party. For us, this was the deal breaker."

Aon, Aearo's broker, "quantified our product risks using intense data collection and modeling to measure the economics of the various product liabilities," says Carey. "What they discovered figured into the contractual negotiations between the buyer and the seller. Some product risks were deemed best for transfer, while others were handled contractually," to be absorbed by the seller or the buyer, or shared.

"Bryan was deathly afraid that when 10 private equity firms descended upon him for due diligence, he wouldn't be able to quantify the purchase price, because of the liabilities," according to Aon's Krauter. The LBO candidate hadn't kept accurate records to allow a full review to take place, he says, so Aon performed a 20-year forensic study of Aearo's claims. "We reconstructed how these would have run through a P&L if done properly, and then projected forward for the next five years how these would play out."

• 1
• 2
• 3
• next »