Nomura

Deal-contingent hedging: a flexible way to mitigate risk

  • You can use deal-contingent hedging in M&A situations to cost effectively manage FX and interest rate risks.
  • A deal-contingent hedge combines the best aspects of a standard FX forward and an FX option: it requires no payment upfront, locks in a forward rate, and disappears if the M&A fails.
  • Deal-contingent interest rate hedging is also popular given the growing prospect of US rate rises and increasing bond yields.

Recent geopolitical volatility has had dramatic repercussions in the financial markets. The Brexit negotiations between the UK and EU have caused sterling to plummet to lows not seen in years, and protectionist rhetoric from the US has sent shockwaves through global FX markets and lifted interest rates to 5-year-highs.

This instability occurred against a backdrop of buoyant M&A conditions, driven by large cash reserves and tough trading conditions for companies. Volatile IPO market conditions have also prompted increased sales of assets to other private equity players or corporates.

Many CFOs or treasurers might assume that risks relating to M&A transactions from unpredictable events such as Brexit are difficult to mitigate. But you can lock in the cost of an acquisition in the purchase currency, or ensure that re-financing costs of the transaction do not increase – without incurring costs if the deal doesn’t complete.

A solution for today’s markets

A lot can change during the three to 12 months an M&A takes to complete. If the acquirer is European and the target a US asset, a transaction is usually priced in US dollars. If the dollar appreciates against the euro, the deal becomes more expensive, and its internal rate of return (IRR) is lower.

To hedge that risk, you could use an FX forward to lock in costs. But if the M&A fails – because it’s rejected by anti-trust authorities, shareholders or lenders with a change of control clause over the target, for example – the hedge must be unwound.

If the FX market has moved against the hedge, you could incur costs. For private equity firms, which typically don’t have standing funds but rely on their limited partners to fund acquisitions, such costs may be prove problematic.

A deal-contingent FX hedge combines the best aspects of a standard FX forward and an FX option: there’s no payment upfront and you can lock in a forward rate. A small spread is added to pay for the hedge but this is only applied if the M&A is successful and the hedge is used. If it fails, the hedge disappears and there’s no fee.

Managing refinancing risk

Financing conditions can also change rapidly during the period it takes an M&A to close. Bridge loans are usually used for initial financing before being refinanced in the bond markets. If rates rise during this period, the cost of finance is increased and the IRR of the M&A falls.

A forward-starting swap locks in current rates for an asset or liability on a deal-contingent basis and costs nothing if the M&A fails. These swaps are especially useful for infrastructure transactions, which use long-dated debt that is more susceptible to interest rate changes.

Choosing the right partner

The purpose of a hedge is to transfer risk from the corporate or private equity firm to a bank. So it’s in your best interest that the bank’s capabilities are robust and it can ensure the effectiveness and security of the hedge.

A bank needs the following capabilities to structure a successful deal-contingent hedge:

• Risk appetite and balance sheet. There’s no traded market in deal-contingent hedges, so the bank can’t lay off this risk.

• Comprehensive M&A knowledge to analyze the purchase agreement and conditions precedent. Some banks – such as Nomura – have specialist M&A expertise and hedging capabilities and can offer competitive hedge pricing even when they have no role in the underlying M&A.

• Deep industry knowledge and coverage to understand the dynamics of the sector, the motivations and objectives of the buyer and seller, and the prospect of an interloper emerging during the closing process.

• The ability to competitively and consistently price hedges, execute them effectively and quantify and manage the risk associated with them (which requires awareness of likely drivers of FX movements and interest rates). You should seek a bank with an established transaction history in order to achieve a competitive price.

• The ability to coordinate these multiple units across the bank (as well as their legal division) in order to optimize speed. Nomura takes a holistic approach and offers a user-friendly service with effective products and processes, and streamlined documentation.

To gain further insights into deal-contingent hedging, please contact Selim Toker.

Contributor

  • Selim Toker

    Head of Strategic Risk Solutions, EMEA

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