Deal Contingent Hedging

What is a Deal Contingent trade...

Deal Contingent Hedging trades, available in various forms like Deal Contingent Forwards and Swaps, offer a unique feature that proves invaluable under certain conditions.

In all derivative transactions, including these, there's a buyer, a seller, an underlying asset (such as foreign exchange or interest rate), and a mutually agreed-upon price. Up to this point, it's standard fare.

However, the distinctive aspect of DCH is that the agreement becomes ineffective, with no residual obligations for either party, if a specific "external" event, initially deemed highly probable, fails to occur within a set timeframe.

Consider a cross-border acquisition awaiting approval from a regulatory body like Antitrust. Typically, there's a lengthy gap between reaching an agreement and completing the share transfer, during which exchange rate fluctuations could drastically affect the purchase price, potentially making it prohibitive or incompatible with the buyer's financial strategy or funding capabilities.

To mitigate this risk, the acquiring entity might opt for a traditional FX forward contract to purchase the foreign currency in advance. However, this exposes them to the risk of the deal falling through (possibly due to Antitrust rejection), turning the forward contract into a speculative venture with potential for significant mark-to-market gains or losses.

An alternative might be buying a call option on the foreign currency, avoiding the worst-case scenario if the acquisition doesn't proceed. Besides considerations related to its material cost, which is non-recoverable even should the deal fail, companies often hesitate to incur substantial additional expenses for securing optionality on an exchange rate for what is considered a high-probable transaction.

Areas of Application

Moreover, M&A transactions aren't the only situations where DCH can be an effective risk management tool. For instance, in Project Financing (PF), sponsors must satisfy various conditions, not always within their control, before accessing financing from banks. For example, there may be Conditions Precedent that require the obtaining of environmental approvals or the issuing of a government concession for carrying out a regulated activity.

Given the often large scale and long duration of PF deals (that may well exceed 10-15 years), ensuring a fixed interest rate for a portion of the financing becomes crucial to keep financial costs within defined boundaries throughout the project's life.

The question then becomes whether to preemptively manage risk by negotiating an interest rate swap early, risking high mark-to-market losses if the deal doesn't proceed, or wait for Conditions Precedent (CPs) to be satisfied. In principle, a Deal Contingent Swap could also be considered here.

An interesting case of DCH, in FX, I worked on in the past assisted a takeover bid, launched by a company with a base currency different from that in which the shares of the target company were denominated. The uncertainty about the need for FX conversion stemmed from two components: 1) the percentage of shareholders' acceptance, also knowing that the largest investors typically wait until the last moment to communicate their decision; and 2) the risk that the takeover could "fall apart" if the subscriptions did not reach a minimum percentage of the share capital as specified in the public offer. The negotiation of a Contingent Forward Deal allowed the buyer to protect himself against these risks and manage the FX very effectively in a period of significant market turbulence.

While there are other scenarios where Deal Contingent Hedging could be a viable risk management option, I hope these examples have provided a clear understanding of the product and its applications.