For sponsors and corporates buying and selling businesses cross-border, the deal contingent (“DC”) FX trade is a familiar instrument. Where there is a currency mismatch between consideration and funding, or the proceeds of sale are in a different currency from the denomination of the relevant fund, hedging the FX risk between signing and completion has become common practice. Where deals pass a threshold level of certainty, for major currencies banks will provide such a hedge on a “deal-contingent” basis, transferring the risk of non-completion of the M&A process to the bank. In summary, that means “no completion, no payments”. As M&A markets have boomed in recent years, these hedges have become easier and quicker to execute, with ever more standard documentation.
As markets absorb the impact of the Fed’s 0.75% hike in interest rates last Wednesday plus the impact in the UK of the Truss administration’s fiscal largesse, can similar DC technology be used to bridge the gap between the cost of debt funding M&A deals at signing and at closing? Where that period lasts several months, the increased cost of debt over that time could be punishing – remember that it was only in March this year that the Fed started to increase rates from 0.25%.
Over the summer months, DC interest rate swaps have become a new piece of kit in the acquisition toolbox. Shortly after signing the M&A deal, the purchaser will enter into an interest rate swap with a bank. That swap will lock in periodic fixed payment by the purchaser in return for floating payments matching the relevant interest rate in which it seeks to denominate the applicable debt. Of course that fixed payment is priced off today’s interest rate curve, not the curve which is influenced by whatever rate rises occur between trading the DC hedge and drawing the relevant funding. The swap is forward starting – the parties only start to exchange fixed/floating cashflows if the deal completes and the debt is drawn by an agreed long-stop date (which will usually match that under the applicable SPA or equivalent). The bank generally takes the risk of non-completion, as obligations under the hedge are of course contingent on completion occurring.
But users of DC products should be wary of that assumption. Allocation of non-completion risk is a delicate negotiation in these transactions. In deal contingent FX arrangements, usually there are very limited circumstances in which this risk is passed back to the sponsor. Where that risk is for the account of the sponsor/corporate, the parties will pay between themselves a mark-to-market based hedge termination sum in the event of non-completion of the M&A deal. For DC interest rate swaps, which are much longer dated than FX trades (and potentially more valuable transactions), there seems a greater focus on allocation of this risk. Users of the product need to analyse carefully (i) the obligations they agree to with respect to the attempts they make to close the underlying deal, and (ii) how broad the circumstances are where a failure to complete is laid at their door, and a termination sum on the swap becomes payable.
A second risk, potentially unfamiliar to the regular user of the DC FX hedge, is the basis risk between the swap and their financing. Financing terms may still require significant detailed work at the point the swap is traded. Where rates, notional amounts and payment periods are agreed in the swap, will those match the financing? Or is some degree of flexibility required in the swap terms at the point of trading the DC product?
By their very nature, DC FX hedges are not long-term instruments. Interest rate hedges of course need to match the term of the linked financing. It is common practice in finance linked hedging for one “hedge coordinator” bank to trade the swap and then immediately offload portions of it to other banks, usually those in the financing syndicate. This process carries little risk for the end-user as the identity of the relevant banks and documentation with each one is lined up prior to the swap being traded with the coordinating bank. With a DC hedge, where novation of parts of the swap only takes place at closing, end-users need to take care that they do not agree to one-sided terms, purporting to permit novation to a wide range of banks, possibly on inappropriate terms.
These are just a flavour of the distinctions between DC FX and DC interest rate hedges. Users of these instruments should focus on the differences rather than the more superficial similarities to avoid hedging headaches as rates rise.