With market volatility hitting the headlines and the geopolitical landscape seemingly changing every week, risk management is once more at the forefront of every CFO’s mind. One instrument that has become an established part of any financial risk management toolbox is the deal-contingent hedge. JCRA has released a whitepaper that explores what a deal-contingent hedge is, how and when to use this instrument and how to structure it for your company.
Deal-contingent hedging emerged in the early 2000s as an efficient way of mitigating the foreign exchange (FX) risk associated with the time between the signing and closing of a cross-border merger and acquisition (M&A) transaction. Over the past five years, deal-contingent hedges have evolved further, becoming a popular choice for hedging interest rates, inflation, and even commodities, in addition to FX risk.
What is deal-contingent hedging?
Deal-contingent hedging lets companies hedge the market risk associated with a planned acquisition in such a way that if the deal fails to complete, the hedge falls away at no cost without any payment by either party.
A typical situation might see a European company or EUR-denominated private equity fund buying a UK asset. The purchase price is likely to be denominated in GBP and will be agreed at the signing of the deal. If GBP appreciates significantly against EUR in the time before completion (typically between two and nine months), the investment is now more expensive for the buyer. This will not merely require additional EUR liquidity, but will also have a negative impact on the expected return of the transaction. This is no small risk - a lot can happen in the FX markets in few months.
How deal-contingent hedging works
Deal-contingent hedging works by linking the settlement of a vanilla hedging instrument to the success or failure of the underlying transaction, typically a merger or acquisition. If the transaction is completed, the hedge is settled as it would usually be on the completion date. However, if the transaction falls through, the hedge disappears at no cost and there is no obligation for either counterparty to settle it, thereby avoiding potential 'dead deal' costs.
While deal-contingent features can be added to any hedging product, the deal-contingent forward (DCF) is by far the most prevalent. Crucially, they allow the buyer to walk away from the hedge at zero cost if the acquisition fails to complete.
Unlike an FX option, a DCF involves no upfront premium payment (similarly to a vanilla FX forward). Instead, the premium for the deal-contingent feature (i.e. the cost the buyer pays for the ability to walk away from the hedge in the event that the transaction fail to complete) is ‘embedded’ into the DCF’s contract rate. The result is that the buyer locks in a slightly worse exchange rate than they would have done with the equivalent vanilla forward. Importantly though, the deal-contingent premium is only payable if the transaction completes and there is now an obligation to settle the hedge.
In this way, the DCF combines the best characteristics of a vanilla forward with those of an option. By design, the cost embedded into the contract rate is only a fraction of that of the equivalent option as the buyer is only permitted to walk away from the hedge if the acquisition fails to complete. This unique feature explains the popularity of deal-contingent solutions.
The JCRA whitepaper, written by Benoit Duhil de Bénazé, the group's head of Private Equity, also examines when and why to enter into a deal-contingent hedge, and details how to structure a this type of instrument.
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