A Dynamic Way to Manage Cross-Border M&A FX Risk
Corporations often face multiple logistical and regulatory challenges when acquiring or disposing of a subsidiary or other asset. But when that asset is outside their home country, they may also have to contend with FX risk.
The challenge of managing cross-border transaction risk
Managing the FX risk associated with a typical cross-border acquisition or disposal entails complications not normally encountered when hedging BAU risks. A transaction may have been agreed in a sale and purchase agreement (SPA). But it is by no means certain that it will ultimately complete; regulatory approval might be withheld, for example. If the deal fails, the hedger could face a sizeable liability.
Typically, corporates manage such risks using deal-contingent forwards. However, they are most cost effective when the probability of deal closure is very high (i.e. when an SPA has been signed). Option-based solutions (including zero-cost collars) may be more appropriate when there is less certainty of deal closure, but don’t offer protection against FX volatility.
This article explains why it is important to understand the FX risk posed by cross-border M&A transactions and introduces CitiFX’s analytical framework. We explain how the framework can be used to compare the relative merits of various risk management strategies. We also analyze the impact of hedging with optionbased strategies when there is lower certainty regarding a deal. In particular, we focus on a strategy where an option is purchased at an early stage and then sold again (as an asset with value) when there is a better understanding of whether a deal will complete.
Understanding the risk
For a corporate to make decisions about how to manage risk (if at all), it must first understand those risks. It is also essential to understand the impact of any risk management. Even with BAU hedging, the results of any action can be counterintuitive, but adding the possibility that a deal might fail adds further complexity. Senior personnel are frequently involved in decisions about M&A transactions and any associated hedging. For analysis to be useful, it must therefore be easily explainable in a board meeting while successfully capturing all the risks and benefits of any risk management.
CitiFX uses a combination of scenario analysis and an adaptation of Citi’s value-at-risk (VaR) framework to measure risk and compare the relative merits of different hedging strategies (which can produce surprising results). The VaR framework is consistent with our portfolio VaR, forecast uncertainty and the bid-to-award analyses that many of our clients are familiar with. To illustrate how our analysis can be used to determine the most appropriate strategy, let’s imagine a USD-based seller disposing of a GBP100-million asset.
Figure 1 shows how VaR changes depending on the probability of the transaction going ahead. As might be expected, VaR increases as probability increases. But as the likelihood of a deal decreases, VaR does not decrease at the same rate. In fact, as the probability of success falls to 50%, VaR falls to GBP11.5 million (from GBP14.2 million) — a decrease of only 19%. This seems counterintuitive but has important implications for risk management — it may not be optimal to scale the hedge ratio according to the probability of the deal being a success.
Figure 2 shows how a variety of hedging strategies impacts VaR as the probability of success changes. When the chance of deal success is very low, being unhedged is the strategy with the lowest VaR. However, for a broad range of probabilities (between 15% and 85%), an at-the-money forward (ATMF) option on the complete notional outperforms based on this metric. For this wide spectrum of probabilities, specific forward strategies also consistently have less risk than remaining unhedged. This is the case when the forward notional is probability weighted, to match the chance of deal success.
This raises an obvious concern regarding probability of success and how it is estimated. At best, this may be an educated guess — and a subjective one at that. Fortunately, for a broad range of probabilities (15%-85%), an ATMF put option or a forward on a probability weighted notional will reduce risk compared to remaining unhedged.
What risk, whose risk?
Corporates need to consider different risks depending on whether they are acquiring or disposing of an asset. For an acquisition, its characteristics, timing, and funding structure affect this analysis. The purchaser may also consider hedging the value of the asset and/or its cashflow or even its leverage on an ongoing basis. When the transaction is complete, the characteristics of the business and its FX risk profile may have changed; this could be more important if the acquirer is a private equity firm rather than a typical corporate. Private equity frequently has different performance benchmarks, shareholder considerations, and access to funding compared to corporates.
If the hedger is selling an asset, then its intended use of proceeds are important — will it distribute the proceeds to equity investors or use them to repay debt? And in what currency or currencies? The answer to these questions will impact any risk analysis (tenors, currencies, etc.) and any potential solutions that are considered (product mix, currencies, timing, etc.). Table 1 highlights some of the considerations that are associated with various risk management objectives.
The choice of strategy, product and timing
Having clearly established the risk the potential transaction creates, hedging alternatives can be objectively compared to determine the most appropriate. Some corporates will choose to take no action, and this can be the right strategy for them. But it is always important to make any decision (even if it is to be unhedged) based on a full assessment of the facts. This ensures that the strategy appropriately addresses the relevant concerns (costs, risks, etc.) and that the potential consequences are understood by key stakeholders in advance (see table 2).
Deal contingent hedging
The use of deal-contingent products, such as deal-contingent forwards (DCFs) and deal-contingent options, has become increasingly popular. A DCF is a forward contract that expires if the relevant deal falls through. It is signed at the same time as, and typically references, the SPA. The disadvantage of a DCF is that it offers a worse rate (from the perspective of the hedger) compared with a vanilla forward. However, in contrast to an option, this cost is only payable if the transaction closes. The difference between the DCF strike and the vanilla forward strike is often expressed with reference to, and as a percentage of, the premium payable for the corresponding ATMF (call or put) option. This highlights the fact that the DCFs are cheaper than the relevant AMTF option premium.
When things are uncertain — use options
The attractions of DCFs are clear, but they cannot be used in every circumstance. Perhaps most importantly, a DCF will not be executed unless it is clear that the probability of the transaction closing is very high (95% or higher). At the least, this will require an executed SPA, though other factors, such as a clear understanding of the conditions precedent, are vital.
There are many situations that do not meet this strict criterion, but still leave the corporate exposed to significant FX risk. For example, a company may have a high degree of certainty that a transaction will take place, but not be in a position to sign an SPA for several months. Alternatively, a company may be part of a managed or competitive bidding process with only one competitor (potentially creating a 50% probability of success). As figure 1 shows, even where the probability of deal success falls to 50%, the VaR only falls by 19%.
In such circumstances, options may be the optimal hedging strategy. The simplest approach is for the hedger to retain the option as the primary hedge until expiry; if the deal goes ahead, the option provides the correct economic hedge. If the deal fails, then the option either provides a positive payoff or none at all. Most importantly, unlike a vanilla forward, the option does not create any further liability for the hedger (once the premium is paid).
An option is an asset with value that can be recouped
Some corporates are reluctant to use options because of concerns about premium costs and/or budget limitations. Our analysis shows, however, that options can be used in a way that significantly reduces the total spend on premium.
Instead of purchasing and then holding an option to expiry, the corporate can hold the option only as long as it is unsure about the probability of deal success. Once it has a clearer understanding (e.g. when an SPA has been signed), it can sell the option and recoup the remaining value. This can then be used to improve the strike on a DCF (if an SPA has been signed) or simply retained if the deal has failed. Either way, this reduces the overall cost of owning the hedge compared to the original premium paid.
This strategy is illustrated by Strategy B in figure 3. The corporate purchases an option that expires on the expected closing date. The option is then held until there is greater certainty regarding the closure of the deal — for example, when an SPA is signed. At this point, the corporate recoups the value from option and can use any benefit to improve the strike rate of a DCF (if the SPA is signed) or simply keep it if the deal has failed.
Our analysis shows the impact of implementing this strategy. We assume a USD-functional corporate enters into a 12-month hedge to coincide with the expected disposal of a BRL asset (the hedger is selling BRL and buying USD). The results in table 3 and figure 4 show that, on average since 2001, it costs 0.07% of the original premium paid to own an ATMF call option for six months. In comparison, the average loss due to FX movements over six months, if left unhedged, is 0.40% of notional. This indicates that the cost of owning the option is, on average, far outweighed by any losses as a result of being unhedged. More importantly, remaining unhedged entails significantly greater uncertainty of outcome and higher standard deviation figures. This is consistent with the earlier message that it is best to start hedging with optionality early in the process rather than waiting to put the derivative on only when the exposure is more certain.
Managing transaction FX risk is just the beginning
Hedging cross-border M&A transactions is more complex than BAU hedging for corporates because there is the possibility that the deal may fail. As with any other area of risk management, it is essential to have a proper understanding of the risks and the relative merits of different strategies before making a decision.
The probability of deal success is a significant driver of optimal hedging strategy but can be difficult to estimate. Fortunately, options can be the optimal strategy across a broad range of probabilities, meaning that having a precise estimate may not be essential.
Deal-contingent forwards and options have enjoyed increasing popularity over recent years because, unlike vanilla forwards, they do not disadvantage the hedger if the deal fails and the cost is only payable if the deal succeeds.
However, contingent hedges can only really be executed when there is a very high probability that a transaction will succeed (at the least meaning that an SPA must be signed). Where the corporate’s visibility is less clear, it can buy options until better information becomes available and then recoup some value by selling them. CitiFX analysis shows that the cost of using options in this way may be less than the initial premium implies and significantly less than any potential losses associated with being unhedged.
By virtue of a transaction closing successfully, the nature of the resulting business and its FX risk profile may have changed. Depending on the objectives of the hedger, the corporate may wish to change its approach to risk management. For example, it may seek to risk manage the book value of an acquired asset. In addition to contemplating the risk created by the transaction itself, it is also important to understand its consequences for risk management in advance.
Citi has appropriate policies and procedures in place to advise clients on these types of transactions. In particular, it is of paramount importance that these transactions are kept confidential, and to that end there is a dedicated team that are well versed with managing strategic transactions that follow a strict operating framework to ensure quiet and effective execution.
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