Deal Contingent Hedging

Yes, and for several good reasons. Implementing a DCH necessitates extensive Due Diligence, involving expertise from various fields such as Legal, Credit, Commercial, and Product Structuring. This process incurs significant fixed costs which need to be offset by the operation's margin to be economically viable. Consequently, smaller transactions may not generate enough return to justify the required effort.

It's worth noting that the minimum transaction size has decreased over time due to increased competition, the streamlining of processes within banks, and standardized documentation, which simplifies the Due Diligence phase. While deals under $200 million were not considered a decade ago, amounts as low as $40-50 million are now feasible for FX transactions.

While a classic DCH typically does not settle if Completion does not occur, there are indeed structures that require Settlement within defined minimum and maximum limits based on contractual parameters. An example would be the outcome of a public purchase offer in foreign currency, where the exact shareholder participation, and thus the required FX amount, is unknown beforehand.

The question refers to the possibility of using DCH to manage FX risks within the company's ordinary operations. For example, a company that exports retail products will not know the amount of future turnover in foreign currency until the end of the commercial cycle and will therefore have to base its hedging decisions on internal estimates.

While it is understandable how a Deal Contingent could be useful to “get” exactly the amount of hedging needed, it is extremely unlikely that any financial service provider would be able to offer a DCH for this eventuality.

This is because there is no formal event to define Completion, making it contractually challenging to manage the product effectively. Additionally, sales volumes could be significantly influenced by the company's own commercial and pricing strategies, introducing a level of unpredictability that banks are typically unwilling to accept.

Like most derivative products, Deal Contingent products fall under EMIR/UK EMIR regulations. 

A point of discussion has been whether DCHs, particularly FX-related ones, should be subject to collateralization and Variation Margin obligations. The prevailing view is that since DCHs result in a physical FX exchange at maturity, these obligations may not apply to many users.

In theory, any bank authorized to offer derivative products could provide a DCH. However, effectively managing such products requires extensive infrastructure, expertise, and risk management capabilities, typically found only in the largest banks. 

Critical considerations include conducting thorough Due Diligence, understanding the economic sector involved, managing the absence of a dedicated market for pricing these products, and ensuring collaboration among internal stakeholders within tight timelines. These factors significantly influence a bank's ability to engage in DCH transactions effectively

Just to mention a few critical issues:

• Conducting an effective Due Diligence, to appreciate the risks of failed Completion, requires, on the part of the bank, in-depth knowledge of the economic sector in which the company operates, who the main competitors are, who the Authorities are who can intervene in the process. Think of a DCH that supports a hostile takeover bid: how would the bank appreciate the risk of failed Completion due to a counter-bid launched by a competitor if this bank did not know the competitive framework of that sector inside out? Or how would it assess the risk of a stop by the Regulator, if it were no longer familiar with the most recent regulatory (or even political) dynamics of that sector?

• Deal Contingent products do not have their own market in which to find prices to buy or sell: these deals therefore remain on the bank's balance sheet. Does the bank have sufficient risk appetite and financial capacity to sustain even high losses in the event of failure to Completion?

• Has the bank developed internal processes to ensure that its internal actors (lawyers, M&A specialists, product structurers, credit analysts) can collaborate effectively in the very short time frame usually available to carry out all the work necessary to produce a DCH proposal ? Note that, in my experience, this last factor plays a key role in a bank's ability to systematically enter into DCH transactions.

In theory, it is not necessary for the bank, supplier of DCH, to also be a Lender (if a Financial Package is involved) or to have a role as M&A Advisor (if it is an M&A deal).

It's not essential but it helps a lot!

• In fact, let us remember that the possibility of offering a DCH with competitive pricing requires the bank to have access to complete Due Diligence, or most of it, in order to correctly evaluate the risks of the transaction. An outsider, even if invited by the client company, could have access to this information with greater difficulty than an insider.

• The matter then becomes more complicated when changes to the documentation occur during the "window" period (i.e. in the period of time between the negotiation of the DCH and the Completion date). In a previous post we saw how it is essential for the hedge provider to be made aware of, and possibly have the right to "veto", changes that would alter the probability of Completion. If the hedge provider is not an insider in the underlying trade, it becomes more difficult to derive these rights for him.

• If it were then a Deal Contingent Swap, which turns into a long-term Fixed-Floating swap, it will most likely be a question of understanding how to protect the rights of the Hedge Provider who is not also a Lender, avoiding it ending up in a subordinate position compared to other creditors.

As you can see, nothing is impossible, but there would certainly be a lot more work for lawyers!