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Deal or no deal: Protecting acquisitions amid manic market moves

Three to 12 months is a long time in global markets where so much can change in the blink of an eye.

And yet three to 12 months is the average time it takes to close a merger or acquisition – opening-up an acquirer to the risk markets may move against them.

In such unpredictable times as these this risk is increasingly real, potentially making any acquisition more expensive or, in extreme cases, unravel.

Take, for example, how markets reacted last year to the UK voting to leave the European Union and the election of Donald Trump as US president. Sterling lost almost 20% of its pre-referendum value in the weeks after, while Trumps election sent bond yields soaring in anticipation US interest rates would rise.

While such market moves only really occur when unexpected events hit, the regularity of these seismic events is undoubtedly worrying.

Indeed, over the next 6-12 months, high volatility in currencies, commodities and other capital markets is considered the greatest economic risk to the core business of companies, according to over 2,000 CEOs, CFOs and other senior executives who participated in the recent Capital Confidence Barometer survey that we conducted on behalf of EY.

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At the same time, a near-record number of the companies that participated in the survey said that they plan to acquire in the next 12 months, with most of them believing that the main theme in M&A this year to be an increase in cross-border dealmaking.

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So at a time when there is a resurgence in appetite for cross-border M&A and fear of higher currency and capital market volatility, what’s a deal-hungry CEO to do?

One option making something of a comeback is for companies to use derivatives to help mitigate the financial risk costs in an acquisition.

Foreign currency forwards – a derivative essentially enabling the buyer or acquiring company to purchase or sell a set amount of foreign currency at a specified price in the future, thereby protecting themselves against any wild market swings – is one such hedging solution. But it is so-called deal-contingent FX forwards, which offer buyers greater optionality, that are specifically re-emerging again.

Whereas a company must pay for a FX forward irrespective of whether or not the acquisition is completed. With a deal-contingent forward, the company can walk away – without paying to unwind the agreement – depending on how the acquisition actually progresses.

If that sounds too good to be true, the catch or downside is that deal-contingent forwards are expensive, costing between 2-5% of the notional value of the transaction – far more than a FX forward.

It’s a tough call to know whether it is worth it or not. But amid more volatile markets, what price does a company put on being protected?

Similarly, just as currencies can appreciate during the time it takes to close a deal, financing conditions can of course change rapidly too.

Most large-scale M&A transactions are financed initially using a bridge loan before being refinanced on the bond markets, but if interest rates rise during this time the cost of finance does too.

To manage this risk derivatives called forward-starting swaps offer something of a solution, essentially enabling the acquirer to lock-in current rates for an asset or liability and on a deal-contingent basis.

Similar to a deal-contingent FX forward, a company can walk away from the hedging agreement depending on how the deal progresses.

Such interest rate derivatives have been used for some time in infrastructure and project financing, where the long-dated nature of it means it is particularly susceptible to interest rate changes over time.

They haven’t, as yet, become as prevalent in the shorter-dated corporate bond markets. But interest is expected to grow. After all, interest rates can only go one way after being so low for so long.

Digital Currencies: Powerful Tools for Central Banks

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Today, we are launching a new project on digital currencies.

Over the next weeks and months we will investigate different types of cryptocurrencies and consider their benefits and potential downsides to financial institutions, central banks and the real economy.

We will discuss regulatory hurdles, explain digital payments systems, and look at distributed ledger technology.

We will also be speaking to central bankers and blockchain developers, commercial and investment bank experts, fintech visionaries and other stakeholders who will play a role in shaping the future of cryptocurrencies.

In the first part of this new project, which we are publishing in collaboration with law firm Baker McKenzie, we are examining why central banks are looking seriously at creating digital versions of fiat money. The article explains how the issuance of digital currencies will provide central banks with a new powerful tool that will give them unprecedented control over economies and markets.

Upcoming pieces in the series will include interviews, videos, animations, infographics and more.

In the meantime, please head over to our partner’s website to read our first article, “Digital Currencies: Life after Quantitative Easing”.

We hope you will find this new article series interesting. As ever, we would be delighted to hear your thoughts. You can get in touch using our contacts form. For social media, we recommend the hashtag #cryptocurrencies.

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UK Aviation after Brexit

Serving almost 76 million passengers in 2016, London Heathrow is Europe’s busiest airport. The decision by the UK government in October last year to support a third runway to be built by 2025 — after eight years of political squabbling — should pave the way for further growth.

But does it?

While a third runway might address the crucial capacity issue that is currently holding back the airport from serving more customers, the future of aviation in the country will also depend on, like almost all other aspects of the British economy and life, the terms of Brexit. And those are yet unknown.

International aviation is based on terms agreed between different countries in so-called air service agreements (ASAs).

In the early 2000s the European Court of Justice had ruled that any ASA between an EU member state and a third country needs to be open to airlines from all EU states. On that basis member states renegotiated around 340 bilateral ASAs in the past fifteen years to make sure they comply with the court ruling.

More and more often, the European Commission (EC) also took over as direct negotiator with countries outside the Union. Instead of leaving it to each member state to amend their respective bilateral ASAs, the EC negotiated new agreements with third countries that would cover all EU members. To date, the EC has negotiated new horizontal agreements with 41 countries, representing 670 bilateral agreements.

The implications for aviation in the UK in a Brexit-context are twofold: firstly, the country will need to come up with a plan to deal with those arrangements the EU has in place in the name of its member states. Most likely the UK will have to negotiate its own bilateral agreements with third countries currently covered under EU-wide horizontal agreements. And secondly, the UK will need to negotiate an ASA with the EU to address their future relationship in the skies.

Replacing the US-EU Open Skies agreement

One — crucial — example for an ASA negotiated by the EC in the name of EU member states is the Open Skies agreement with the United States. From the UK perspective this ASA, which came into effect in 2008, replaced the bilateral US-UK Bermuda II agreement, which had limited transatlantic competition from London Heathrow to just two US and two UK airlines.

It was the EU-US Open Skies agreement that opened up the market for competition as it exists today. Without Open Skies, disrupters like Virgin Atlantic would not challenge incumbents for routes to New York and other US destinations.

That’s why not replacing Open Skies, or doing so with an agreement inferior to the current arrangement, could have serious consequences for Heathrow as the dominating international airport in Europe.

Open skies

To find out how aviation experts expect this to play out Euromoney Institutional Investor Thought Leadership teamed up with Deloitte to survey more than 400 aviation experts globally.

Specifically, we wanted to know whether experts expect the UK to negotiate agreements that are, in essence, similar to the existing US-EU Open Skies agreement. We asked this question with regard to a future UK-US agreement, and to a UK-EU agreement.

The good news is: most of the respondents to our global survey think such agreements will come in the foreseeable future. Only 23% believe reaching agreement with the US will take longer than four years or not happen at all.

Less optimism about a deal with the EU

Interestingly, our survey panel — more than two thirds of which are C-level, VPs and senior directors — takes a somewhat more pessimistic view when it comes to a deal with the EU. 5% think the UK won’t be able to negotiate a deal with the Union at all (only 2% think so for the US), and 18% believe it will take longer than four years.

This expectation, that it will be harder to negotiate a deal with the EU than with the US, is confirmed even by those who generally think deals can be struck within the foreseeable future: Only 37% expect a deal with the EU to come within two years, versus 40% for a deal with the US. And, in line with this finding, 42% believe a deal with the EU will take between two and four years, but only 37% think so for the US. In short: Our panel thinks it will be easier and faster to get a deal with the US than with the EU.

If panellists are correct in their predictions, this could be bad news for Heathrow and the wider UK aviation industry. Europe is by far the most important destination for flights from the UK. According to the latest available data from the UK Civil Aviation Authority (for the rolling year ending Q1 2016), 61% of UK flights originate from or go to Europe. Only 9% of routes connect the island with North America.

In addition to the impact of Brexit, our report “Game Changer not Game Over” also looks at the challenges facing aviation and aviation finance in particular in light of upcoming international tax reform. The report can be downloaded for free from the Euromoney Thought Leadership website.

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Thought Leadership Consulting creates thought-provoking content for global business leaders.

With a team of independent journalists, experienced editors and professional marketers, we create reports, surveys, blogs, articles, videos and infographics. All of our content is unbiased, original, research-driven and audience-led.

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