Management warranties in investment agreements: Why they matter and what they cover

From a management team's perspective, a distinction however, needs to be made between the two types of warranties that would be given in a PE transaction, these being: (i) the "sell-side" company/operational style warranties which would be given by a seller(s) in favour of the PE investor in any sale transaction (or by the investee company in a non-sale private equity investment) and (ii) the "management warranties" being given by the management team in favour of the PE investor in an investment agreement.

In a sale transaction, the reality is that the PE investor will seek to take the fullest possible company/operational warranties from the seller(s) in the main transaction SPA (on the basis that it is the seller(s) who will be receiving the lion's share of the sale proceeds (although it should be noted that management may also be sellers in such a scenario), and accordingly, the SPA warranties will be the only warranties under which the PE investor could hope to recover material damages in the event of a claim. However, the PE investor will also expect certain warranties to be given by management in the accompanying investment agreement, although these should not extend to the "operational" style warranties that you would expect to see in the SPA.

Management warranties vs company/operational warranties

It is important to distinguish between company/operational warranties and management warranties.

While, in a sale transaction, company/operational warranties would typically be given by the seller(s), it may be the case that with a private equity investment into a business that falls outside of a full sale process, that company/operational warranties may be given by the investee company in an investment agreement. These company/operational warranties will typically relate to the business, its assets, contracts, employees, intellectual property, regulatory and data compliance, litigation history and financial position and will be similar to the same warranties you might otherwise expect to see in a SPA. In practice, however, while the company/operational warranties may be substantially the same whether given by a seller(s) in a SPA or by a company in an investment/subscription agreement, a claim against the company in the latter scenario can only be of limited value to a PE investor because any recovery ultimately reduces the value of the business in which the PE investor has just acquired an interest.

Management warranties, however, are different from company/operational warranties and serve a different purpose. They are given by the management team collectively and as individuals and provide the PE investor with a direct contractual remedy against the management team where certain information provided during the investment process proves to be inaccurate.

What do management warranties cover?

The scope of management warranties varies from deal to deal, but in the investment agreement, management will normally only be required to give warranties in relation to their own personal status, integrity and solvency and that the investee company business plan prepared by management has been carefully and diligently prepared. However, the level of warranty protection a PE investor may want from management in the investment agreement in relation to the investment is a matter for negotiation, but any company/operational style warranties (if accepted at all) should be very limited in scope (e.g. that the PE investor's commissioned due diligence reports do not contain any material inaccuracies). In turn, management will want to limit their liability to the PE investor in relation to any such warranties, by introducing awareness/knowledge caveats and/or materiality thresholds, where appropriate, and by limiting their financial liability with the limit being typically capped at a multiple of salary.

PE investors are generally less interested in creating a broad avenue for claims against a management team and are more interested in ensuring that by the management warranties, management are prepared to stand behind elements of the information on which the investment decision has been based.

Is disclosure relevant with management warranties?

In respect of the management warranties in an investment agreement, the nature of those warranties means that there should only be limited cause to make disclosure, if any at all.

For example, if management identified an error in a commissioned due diligence report, rather than addressing this by way of a disclosure, this would likely be addressed by further engagement with the diligence provider (and an amendment to the requisite report).

However, management, given their knowledge of the target business, can still expect to be involved with the disclosure process on the company/operational warranties. A good disclosure process allows warrantors to identify exceptions to the warranties being given by them and qualify potential areas of risk. Matters that have been fairly disclosed cannot usually form the basis of a warranty claim. For warrantors, careful disclosure is often the most effective tool for limiting future liability. For the PE investor/buyer, the disclosure exercise serves as an additional information gathering exercise and provides valuable insight into areas requiring further diligence or risk assessment.

Management warranties and W&I insurance

Where warranty and indemnity (W&I) insurance is used to cover the company/operational warranties in a PE transaction, the risk dynamic of course, changes but management will still be expected to be part of a full disclosure process in respect of the company/operational warranties. In terms of management's own warranties however, the nature of those warranties is such that they would not be the subject of W&I underwriting.

Conclusion

Whilst much attention is often given to investor protections and governance rights, management warranties play an equally important role in allocating risk between the key stakeholders in a PE transaction and providing PE investors with confidence in the business they are backing. Understanding what management are being asked to warrant, and the limits that should apply to those warranties, is therefore an important part of any investment process. Although limited in scope, management warranties in an investment agreement are a key feature of PE transactions as a fundamental aspect of a PE transaction is that the PE investor is backing a management team to deliver the business plan upon which an investment decision is being made. The management warranties in conjunction with the company/operational warranties provide investors with reassurance that the information underpinning the investment is reliable, while negotiated protections such as liability caps, knowledge qualifiers and time limits help ensure that management's exposure remains proportionate. When combined with a robust disclosure process and, where appropriate, W&I insurance in respect of the company/operational warranties, management warranties can provide an effective balance between investor protection and management alignment.