Swaps over choppy waters: deal contingent derivatives provide certainty in uncertain times

By Tim Stewart, Yu Zhang, Charles Ashton, Guy Alexander, Rod Aldus, Bree Rowswell
Dealmakers & Investors Mergers & Acquisitions Private Capital Private Equity

Risk mitigation and an opportunity to walk away 9 min read

In an uncertain and volatile global market, M&A deals continue to face completion risk, which can jeopardise their successful execution. To mitigate this risk, acquirers are increasingly turning to deal contingent derivatives, which allow them to lock in foreign exchange and interest rate pricing at the time of signing a transaction. These derivatives are particularly valuable in cross-border transactions with currency earnings or debt-funded deals, offering protection against pricing fluctuations and ensuring a more predictable investment return profile.

In this Insight, we examine deal contingent derivatives, including:

  • what they are;
  • how they operate; and
  • their limitations and enhanced risk-management capabilities,

with a particular focus on their benefits over other financial risk mitigation tools such as swaptions and forward starting swaps.

Deal contingent derivatives: a snapshot

Most M&A deals are exposed to some degree of completion risk—ie the risk that the transaction does not complete as planned or at all.

While completion risk is not a new concept, in the increasingly uncertain and volatile global markets, finding appropriate risk mitigation strategies is essential for deals where the acquirer is exposed to exchange rate risks or leveraged deals with interest rate exposure.

For these deals, a change in interest rates or foreign exchange pricing may radically alter the acquirer's expected return profile. As a result, acquirers are increasingly seeking to lock in foreign exchange and/or interest rate pricing through deal contingent derivative transactions that are executed at the time of signing a transaction, alleviating much of the increased pricing risk that may arise prior to closing.

We have seen deal contingent derivatives be particularly useful in two main scenarios:

  • in cross-border public M&A transactions where the bidder has foreign currency (eg USD, Euro) earnings, cash reserves or a fund acquirer has a fund denominated in another currency and is required to pay consideration in AUD; and
  • in other M&A transactions where acquirers are debt funding a significant portion of the transaction where they or the target business are likely to have long term debt arrangements and an investment return profile that is susceptible to movements in interest rates.

They could also be used to hedge any other underlying risk in a target business, including commodity price risk or any other exposure that a target may have and that is integral to valuation from an acquirer's perspective.

Deal contingent derivatives are a useful addition to, and alternative from, the other derivatives in an acquirer's financial risk mitigation toolkit, including (i) swaptions (an option to buy a swap) and (ii) forward starting swaps. Swaptions have not proven particularly popular, mainly due to their expense, whilst forward starting swaps are an attractive option when a completion date is known (their attraction diminishes where there is a level of completion uncertainty, since the acquirer will be left with a traded swap that must be closed out if completion does not occur). Deal contingent derivatives address some of these shortfalls in the other products.

What drives deal completion risk?

Completion risk exposure is a function of various factors that are usually outside the control of the acquirer or seller. For example, a transaction may be subject to a regulatory approval or third-party consent, there may be the potential for regulatory intervention or the emergence of an interloper with a superior offer, the target business may suffer a material adverse change, or the transaction may require shareholder or court approval.

Typically these issues are addressed through conditions precedent in the relevant transaction documents (ie the deal cannot complete until the conditions are satisfied or waived). Typically they must be satisfied by an end date (for example 6 to 12 months from the date of signing the agreement) and are particularly common in public M&A transactions.

In general, the greater the conditionality, the greater the risk that the completion of the deal is delayed or does not occur at all. Assessing that risk is critical for acquirers relying on significant acquisition debt or where the target business is exposed to foreign exchange volatility. For example, if interest rates rise during the period between signing and closing, the cost of the acquirer's financing will increase and, as a consequence, the internal rate of return on the investment will likely fall. Another example is where the foreign exchange rate moves so as to make what was previously a deal that made financial sense into one that is far less attractive to the acquirer. Failing to appropriately assess and manage that risk can have significant implications for the acquirer's return profile.

What is a deal contingent derivative?

A deal contingent derivative (usually a swap or forward) is a derivative contract entered into in connection with an M&A transaction, but which generally falls away if the M&A transaction does not complete. Unlike Lionel Hutz from the Simpsons, a deal contingent derivative only 'works on contingency, no money down'.

Like any derivative, the bank and the acquirer will agree to the interest rate or foreign exchange pricing at the time the transaction is launched, or potentially earlier in the case of financing. However, for a deal contingent derivative there are no obligations on either party unless and until the M&A transaction completes. These derivatives are typically documented as a long-form 'deal contingent' confirmation, with a deal contingency condition (ie closing of the M&A transaction) that provides that the derivative only takes effect if the contingency is satisfied.

The key benefit of this derivative is that the pricing is agreed upfront so the acquirer knows the cost of the transaction and has greater certainty on its likely rate of return at the time of signing the deal. In addition, there is no breakage cost if the M&A transaction does not proceed.

Of course, there is no such thing as a free lunch. There is an additional cost for the acquirer associated with these derivatives, compared to a vanilla swap or forward, as the acquirer is transferring risk onto the relevant bank. This may also involve a ratchet down to incentivise an early close—or, more likely, a ratchet up to push the transaction to early close—to reflect the greater uncertainty risk that the swap provider is taking on to give longer dated protection to the acquirer.

Given the increased level of risk for the bank, they will require a high degree of certainty that the transaction will proceed. This will usually involve the acquirer giving certain representations of support in relation to the transaction, as well as diligence on the underlying transaction—which of course can be limited if the relevant swap provider has another role in the transaction. The longer the period of the deal contingency, the more visibility the bank will require around conditions precedent, completion steps and other matters which may affect the transaction completing. It will also often require specific legal advice for the bank about that pathway to completion. It is also not unusual for the bank to have another role in the transaction, either on the M&A side or on the debt side, which may give them additional comfort around the path to, and likelihood of, completion.

How does a deal contingent swap operate at completion?

If the transaction completes as expected, then the deal contingency condition falls away and the relevant swap or forward is traded in accordance with its terms. Where the derivative is being used for a purchase price—or something else where the relevant product is required on closing—care should be taken to ensure the relevant delivery date aligns with the closing requirements. For ongoing transactions where the derivative is large, the relevant swap provider will often seek to sell down some of the exposure to other banks—eg an interest rate hedge for an acquisition bridge loan facility may be novated out to other syndicate lenders. For these purposes, the relevant deal contingent swap provider will re-write a 'vanilla' swap which will not have some of what might be considered commercially sensitive information in the long-form confirmation.

What happens if the deal does not complete?

If the transaction does not complete the parties are entitled to walk away from the derivative without making any payments. That is a key benefit of this product. However, it is common for the bank to require a 'phoenix clause' in these arrangements such that if the acquirer (or any of its affiliates) ultimately enters into a similar transaction to the one contemplated in the deal contingent derivative, then a payment obligation under the derivative will arise.  

A phoenix clause generally requires the parties to determine the mark-to-market value of terminating the derivative—as if the deal contingency hadn't existed—and one party will be required to pay that amount to the other. This operates as an anti-avoidance mechanic for the bank. It can also provide the acquirer with a necessary trade at market which it can use in relation to the alternative transaction. However, alignment of timing between the calculation of the mark-to-market on the phoenix and completion of the alternate transaction can mitigate this benefit. Banks will want the mark-to-market to be calculated on the relevant sunset date of the deal contingent swap (not necessarily the date of the alternative transaction).

Where to next?

Deal contingent derivatives have historically been used for M&A transactions, but that's not where the use case ends. There are many transactions with timing risks that could be mitigated by using deal contingent derivatives. For example, in project or development transactions where there is supply chain uncertainty, where equipment is priced in a currency other than AUD or where development approval timing is uncertain, there may be a role for a deal contingent derivative to mitigate interest rate or currency fluctuation in the period from investment decision to financial close. With energy transition being a key focus for the world in the future and much of the supply chain still to be completed, this may assist banks and developers to de-risk projects as it gives greater certainty of cost to complete. Whether the use of these products will take off in these transactions remains to be seen—so watch this space!