By Amol Dhargalkar, managing director and leader of the global corporate sector at Chatham Financial
As memories of the 2008 global financial crisis continue to fade, strategic and financial buyers have pressed on with cross-border mergers and acquisitions at a rapid pace. These transactions bring new types of risks to those unfamiliar with them, including funding, legal and regulatory risks.
Funding risk can be particularly significant, given how quickly currencies fluctuate. Signing-to-closing timelines can easily take months or quarters. Buyers and sellers use many different strategies to reduce this risk, including vanilla FX derivatives such as forwards and options.
Unfortunately, these standard tools do not always adequately address the sign-to-close risk. Many dealmakers have instead chosen to use deal-contingent hedging for cross-border M&A transactions.
Enter deal-contingent hedging
Deal-contingent hedges have many benefits and reduce the gaps found on standard hedges — though many other factors need to be considered when determining their suitability for any particular M&A transaction.
At the simplest level, deal-contingent derivatives are similar to their vanilla counterparts, with one significant twist. For example, a vanilla FX forward requires the two parties to sell euros for dollars to one another, as an obligation to be settled on a pre-specified date in the future.
Under a deal-contingent forward, the obligation is only triggered if the underlying M&A transaction is completed. So deal-contingent transactions do not suffer from hedge breakage costs, should the underlying M&A transaction not close.
The incremental cost for a deal-contingent forward tends to be much cheaper than buying an option and is only incurred should the M&A transaction itself close. Finally, deal-contingent forwards are very simple to explain to senior decision makers — it’s akin to having signed the M&A transaction in your desired currency in the first place.
But the link to underlying M&A transactions make deal-contingent hedges much more complicated in several ways. It’s possible that buyers and sellers may not be able to execute the hedge as desired.
Deal-contingent hedges transfer the risk of the underlying M&A transaction closing to the counterparty banks rather than to the buyers or sellers. Consequently, the banks need to underwrite the risk of the deal closing and having to mitigate a loss on the derivative itself.
This underwriting process requires banks to evaluate the risks of the deal not closing, which typically include regulatory risks such as competition objections.
Typically, financial buyers face fewer such risks than strategic buyers, which may have overlapping businesses of interest to regulators. Consequently, a strategic buyer may need to work harder to put together a stable of banks willing to provide a deal-contingent FX hedge.
Furthermore, even with multiple banks interested in providing the transactions, deal-contingent hedge users find that pricing is not transparent. Deal-contingent derivatives are not exchange-traded, partly as a result of their extensive customisation for each individual user.
As a result, infrequent users of deal-contingent transactions have no way of knowing the difference between retail and wholesale pricing. To further compound the challenge, the banks backing the underlying M&A transaction may not be the most aggressive on pricing.
Second or third tier relationship banks may provide much better service and pricing (to the tune of millions of dollars saved) than a company’s primary banking relationships.
Finally, pricing is driven by structure, including the tenor and settlement mechanics, should users of the deal-contingent forward need to settle earlier than anticipated.
Clash on terms
Legal terms can impact upon not only pricing but also the usefulness of deal-contingent hedges.
Given the link between the derivative and the underlying M&A transaction, all deal-contingent documentation cross-references the documents that govern the M&A transaction, such as the sale and purchase agreement (SPA). The principle of any deal-contingent hedge is that it only exists and creates obligations on the parties if the underlying M&A transaction closes.
Still, bank providers of deal-contingent products will have an incentive to define the completion in as broad a way as possible, while users will want as narrow a definition as possible. Navigating this can have a large impact, particularly if something causes the underlying M&A transaction to go awry.
Additionally, “phoenix” clauses may force the parties to a deal-contingent transaction to cash-settle the termination value of the transaction, should an underlying M&A transaction get called off, only to be completed later, within the phoenix period.
Derivatives regulatory regimes also impact upon whether a firm uses deal-contingent hedging. Specifically, some banks may view deal-contingent forwards as marginable products, depending upon the hedge users’ classification (financial end user or not) and jurisdiction.
If this occurs, the user will need to post daily cash collateral against the mark-to-market value of the deal-contingent hedge, impacting the user’s liquidity position. Hence, it becomes critical to review the appropriate derivatives regulation before any hedge execution.
Some companies struggle with the accounting for deal-contingent hedges, too. Public strategic buyers using a deal-contingent forward are often required to mark the hedge to market through their income statements on a quarterly basis. This can cause undesirable volatility as currencies move from quarter to quarter, though investors tend to understand the short term impact if it is described as a hedge of the impending acquisition.
Difficulties of planning
A final consideration for deal-contingent hedging involves taking a step back and looking at the broader exposure of the target company and the ideal capital structure and FX hedging programme for the combined business.
For example, if a US company is buying a primarily euro-based business with dollar debt capital, the acquirer may want to utilise a cross-currency swap to synthetically convert its dollar debt to euro debt. Doing this simultaneously with any deal-contingent hedging of the acquisition price itself can lead to a substantially lower cost of hedging.
Unfortunately, many companies may not have the capacity or desire to make such determinations in advance of closing, thus leading to multiple separate transactions that may cost more than necessary.
Deal-contingent hedging transactions can be powerful tools for hedging M&A transactions. The details, though, have the potential to render some of the benefits less valuable and to increase costs substantially. First time users of deal-contingent hedges in particular should consider supplementing their staff with independent expertise to ensure the ability to structure and execute efficient deal-contingent hedges.