Hedging Deal Contingent Cross-border Transactions
Updated: Dec 11, 2019
When an investment firm or other entity enters into a contract to purchase an asset; whether it be a warehouse, office, land, company, etc, there is always a due diligence period. Due diligence aims to confirm or correct the acquirer’s assessment of the value of the target asset by conducting a detailed examination and analysis of every aspect of the asset's operations – its financial metrics, assets and liabilities, etc. If the asset is real estate, this period may be as short as 45 days. If it is a company, with customers, human resources, etc, this may take as long as 180 days.
If the transaction is cross-border, then foreign exchange risk becomes extremely important. The acquirer and seller agree on a valuation at the time of an offer, each in their respective home currency, utilizing the current spot exchange rate. During the due diligence period, the spot rate between these currencies will change - often quite substantially. As a result, the valuation of one party with respect to the other will change unless this risk is managed.
Issues with common solutions
Forward contracts are the go-to solution for most transactions, allowing the holder to fix an exchange rate to be used in the future. However, forwards can be rarely used in this case, as the result of the due diligence may cause the deal to fall through - yet the forward contract must still be executed. This can put a financial burden on the holder of the contract, should the contract be out of the money, investors will be forced to take a loss (cancellation costs). Should the contract be in the money they will have to explain a taxable gain.
FX options are an alternative that works, as options give the right but not the obligation to exercise the transaction. However, FX options can be very costly, 2-3% for just a few month's tenor - even more, when EM currencies are involved.
Deal contingent swaps are available through some banks and have been used on a number of high profile mergers or acquisitions. Deal contingent products differ from standard swaps in that the right to execute the hedge is dependent on whether or not the deal is completed. According to a recent article in FX Week experts estimate that 30% of PE transactions are hedged this way and that they predict a notable increase in the price of premiums for these types of hedges.
The hedge owner
An interesting point of contention during these deals is to whom the responsibility for placing the hedge should fall.
The most popular argument is that it should fall to the buyer to take the risk as they are the ones that are ultimately responsible for putting the deal together and pulling the trigger. Issues arise here as placing a hedge often costs a large amount of collateral and cash calling investors for more capital is not always possible or welcomed. Some argue that the responsibility of the hedge should be on the seller, seeing that they are ultimately the ones benefiting from the sale. However, they may not have handled a transaction of this size before or they could be in a distressed situation and therefore placing the hedge with their bank may not be a simple option for them either.
In some instances, parties will specifically mention a specific currency risk tolerance which will call for a revaluation should the value of the currency pair fall outside these parameters. This is obviously not an ideal situation as the buffer has to be significant to avoid constant repricing and there can still be significant losses to one side of the deal.
There is an alternative, which can be enabled by both parties to agree upon using a basket of currencies to value the deal and potentially applying machine learning optimization techniques to FX risk management.
The beginnings of a solution
Assuming that both parties agree, exchanging the value of the acquirer's currency into a basket of currencies (such as the IMF's SDR), and at the closing of the transaction exchanging the basket into the seller's currency has the potential for reducing the volatility.
But while a basket such as the SDR can reduce volatility to some degree, it will not perform nearly as well as one chosen to manage volatility between two specific currencies. This is where machine learning comes into play.
A much-improved solution
By utilizing constrained optimization to analyze historical data across dozens of currencies, baskets can usually be identified that minimize the volatility of both a concluded transaction as well as a rejected one (ie the acquirer currency exchanged into the basket, and then back into the acquirer currency months later.)
Let's examine a specific example, a USD-based entity purchasing a UK company with cash valued at £100M. The due diligence period is 60 days. The GBPUSD spot rate at the time of writing is 1.2591, so this represents a $126M transaction.
The premium for a 60-day GBP call/USD put is 2.45%. On a $126M cross border acquisition, $3.08M is quite material, and longer tenors will be much more.
The GBPUSD spot rate changes from 1.2591 to 1.2161 (6/19 - 8/19), representing a 3.4% change. While in this case, the spot moved in favor of the purchaser, it can easily move against them. The optimum basket was identified as:
The result is 50% lower volatility than running un-hedged. If the transaction moved ahead, the basket converted to GBP is £101.7M, a gain of 1.70%. If the transaction had to be abandoned, the conversion of the basket back to USD results in a loss of 1.76%, 30% less than the option premium.
While there is some basis risk, it is spread among as many currencies as practical (here, 6 currencies) For 2-4 month periods, utilizing specifically-selected baskets to hold value represents an excellent alternative to expensive vanilla option premiums.
Specific deal analysis
No two deals are the same. For more on how your own cross-border transactions can be hedged using our "basket hedge optimization tool" and multi-currency accounts, please reach out to us HERE or book a free consultation using the button below.