Deal Contingent Hedging

2. Typical Contractual Aspects

Author: Federico Bellanti

February 11, 2024

Conditionality

In the previous article ("Deal Contingent Hedging: What It Is and What It Is For"), we explored the primary characteristics of Deal Contingent Hedging (DCH), whether related to foreign exchange (FX) or interest rates. In this post, we will delve into specific contractual clauses unique to DCH, essential for delineating the governing rules and mutual obligations between the parties. I believe it's crucial to be well-acquainted with these clauses, as they precisely outline the conditions under which the obligation to execute the underlying derivative—a currency exchange or a swap of a fixed for a floating rate—either ceases or continues.

The hallmark of DCH is its conditional nature: under certain circumstances, the derivative ceases to exist, releasing both parties from their commitments without any exchange of mark-to-market values. While clients find this feature highly attractive, it poses a significant risk for banks providing the derivative, as they must unwind any corresponding hedge established to manage market risk. Should these hedges be negatively valued, the bank faces potential losses, which could be substantial given the typical scale of these deals, without any recourse to recoup these losses.

Consequently, banks and financial institutions offering DCH products exercise great caution in specifying the conditions under which clients can terminate the agreement without cost.

Initially, a comprehensive Due Diligence of the entire transaction is conducted by the bank to identify potential deal-breakers, such as Antitrust approvals, Regulatory or Tax Authority approvals, or even the outcome of a Shareholders' Meeting vote.

The bank assesses these conditions to gauge the likelihood of fulfilling all prerequisites for a successful transaction. This analysis not only influences the bank's willingness to offer hedging—typically, a probability below 90% greatly reduces the likelihood of participation—but also affects the derivative's pricing; lower probabilities entail higher costs.

The Long Form Confirmation

But let's examine what might be found in a Long Form Confirmation (LFC), the typical document detailing a DCH trade. An LFC typically includes all standard clauses from a standard ISDA Master Agreement, or references to an ISDA previously negotiated between the parties, along with DCH-specific clauses.

One clause will define "Completion" or outline the circumstances that could prevent it. Banks generally avoid DCH agreements where Completion depends on the parties' actions or inactions, preferring those determined solely by external factors. Consider the hypothetical scenario where a client deliberately sabotages the underlying negotiations to avoid entering into a derivative contract that has now become heavily "out-of-the-money" —a situation banks must guard against.

The "Phoenix" or "Lookback" clause is common in DCHs, covering scenarios where Completion fails, possibly due to an unexpected negative outcome at a Shareholders' Meeting. Here, the DCH would end, and the bank would bear the mark-to-market losses of its hedge, if there are any. However, if negotiations later resume and successfully conclude, nearly as initially anticipated, the "Phoenix" clause enables the bank to seek compensation for any losses then incurred.

To ensure parties strive for Completion, banks often insert "Hell or High Water" clauses prescribing all necessary customer actions. The goal is clear: to prevent negotiation failures due to customer behavior. Failure to adhere to these commitments, resulting into a failed Completion, allows the bank to seek compensation from the customer, assuming the customer opts against proceeding with the derivative.

Documentation changes for the underlying transaction, such as those in Project Financing requiring significant revisions before finalizing the Financial Package, could affect the conditions and likelihood of achieving Completion within the anticipated timeframe. During the "window period" between DCH negotiation and the expected Completion date, it's generally required that any changes be at least communicated to the hedging bank, or more commonly, that the hedging bank's consent is obtained.

Maturity, Settlement and Counterparties

Technical clauses then address the Settlement mechanism, ensuring that, upon successful transaction completion, the bank proceeds with executing the FX or interest rate swap. For Share Purchase Agreements, the timing of settlement is crucial and must occur within narrowly defined windows. If involving FX conversion, the settlement process must be carefully coordinated, considering each currency's "cut-off times" to ensure timely fund delivery to the beneficiary while ensuring the customer has necessary funding, possibly provided by a consortium of banks.

Additionally, clauses concerning the DCH agreement's expiry account for potential extensions in the transaction's completion time. In some instances, I've seen the introduction of a daily price adjustment formula relative to the "base" expiry date defined by the DCH, thankfully employing simple linear formulas that avoid complicating the DCH's economic profile (i.e. x basis points or pips per each day of delay).

For interest rate DCs, identifying the bank's long-term counterparty is crucial, whether a project company in Project Financing or a BidCo or OpCo in leveraged acquisitions.

This distinction is significant since, unlike FX DCs where the derivative concludes with the currency exchange, interest rate swaps may entail a prolonged trade relationship between the bank and customer, with credit risk and capital absorption considerations impacting the derivative's viability and pricing.

In Long Form Confirmations for interest rate swaps, unless settled in cash at closing, clauses specify the continuing counterparty and whether a novation of the swap to a higher-credit entity, like the OpCo to mitigate structural subordination, is necessary, ensuring the bank's exposure is to the entity closest to the cash flow.