We have all seen the numbers by now. Almost 250 special purpose acquisition companies completed an initial public offering in 2020 and 160 more already filed for IPOs in 2021. The pace is not slowing and the enthusiasm is contagious with more and more investors piling into the SPAC scene and bankers, lawyers, auditors, and other service providers working 24/7 to keep up with demand.
What worries most now is the real possibility of the SPAC exuberance coming to an abrupt halt from overheating. What also worries me is that many SPAC teams fail to take into account the ever-rising costs of directors and officers (D&O) insurance until it is too late.
For some teams, not factoring those costs into their plan early on could slow down their progress towards an IPO or a de-SPAC. For others, it could completely derail their entire enterprise.
SPAC Insurance Market Remains Difficult
I’ve written previously about the quadrupling of directors’ and officers’ liability insurance pricing for SPACs between the summer and winter of 2020. The situation in the insurance market has, unfortunately, not improved, and shows no signs of improving in 2021.
Competition among SPACs for D&O insurance coverage is the highest it has ever been considering the sheer number of SPACs in the market, but insurers have been very cautious and slow to add capacity and some have even pulled out of the market afraid of ever-increasing risk.
To exacerbate matters, SPAC teams pursuing an IPO often leave insurance until the last moment, assuming that its costs are manageable and the process of obtaining coverage is simple (akin to filling out a form). That could not be further from the truth. Typical costs of D&O coverage could now take up 50% or more of the SPAC’s at-risk capital and placing and negotiating a policy could take multiple weeks.
I hear myself repeating this advice to the SPAC teams that come to me with insurance questions: Get current pricing from an insurance broker that specializes in SPAC D&O insurance, factor the pricing into your IPO and de-SPAC costs ahead of time, and approach the insurance market as early as possible.
Five Points of Contact for Insurance
Insurance is a key feature throughout the life cycle of a SPAC, but there are five main points of contact:
First is the need to get D&O coverage ahead of IPO pricing so that insurance coverage commences at the IPO. A typical policy will cover the SPAC between the time of the IPO and the merger for between $5 million and $20 million in liability, with most mid-sized SPACs now opting for $10 million or less in cover.
The costs of the premium for these policies can run between $500,000 and $2 million depending on the features of the SPAC and its team and the structure of the coverage. A typical policy also has a hefty deductible of between $3.5 million and $5 million.
Second in the timeline of a SPAC is the optional representations and warranties insurance (RWI) policy. A SPAC can use a RWI policy to smooth the merger negotiations and to protect the SPAC and the de-SPAC entity from breaches of representations in the merger agreement and from fraud. Good news here is that pricing for RWI policies has been holding fairly steady and is currently running between about 3% and 4% of the limit of coverage obtained.
The third insurance cost to consider is the tail for the original IPO D&O policy. The tail is negotiated at the time of the original D&O policy but will cover the SPAC team for six years after the IPO policy terminates. The premium for the tail policy is payable at the time of the merger and typically runs between 200% and 400% of the premium of the original IPO D&O policy.
The fourth slice of insurance for a SPAC is the D&O policy for the post-merger going forward entity. This looks and feels a lot like a traditional IPO D&O policy for an operating company. The deductibles for this policy are now frequently running north of $15 million and premiums are in the millions of dollars per year because these policies are renewed on an annual basis.
Many SPAC teams heading into a de-SPAC, especially those with roots in the private company world, do not realize and properly budget for the costs associated with public company D&O insurance.
The fifth and final element of a SPAC’s insurance needs revolves around the coverage of the target company’s directors and officers. There are several ways to approach this coverage at the time of the merger, including through obtaining tail coverage on the target’s private company D&O policy. Depending on how the target’s coverage is structured, additional costs are associated with this piece of the insurance puzzle as well.
With the skyrocketing price of D&O insurance, a knowledgeable SPAC insurance broker can provide critical advice on how to structure coverage and budget for the SPAC’s various insurance needs. Engaging an insurance expert early in the SPAC process can save hundreds of thousands of dollars and weeks of aggravation for a SPAC, and avoid the situation where the insurance tail ends up wagging the SPAC.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Yelena Dunaevsky is a corporate finance and securities attorney. As a transactional insurance broker at Woodruff Sawyer, she specializes in SPACs and advises clients on M&A and IPO-related insurance solutions, including representations and warranties insurance and D&O insurance. She is a frequent speaker and author and serves as the M&A managing editor of the American Bar Association’s Business Law Today.