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.
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.
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.