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Risk Management. P.V. Viswanath. Class Notes for FIN 648: Mergers and Acquisitions. Transaction Risk: Sources & Types. Decline in buyer’s share price

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risk management

Risk Management

P.V. Viswanath

Class Notes for FIN 648: Mergers and Acquisitions

transaction risk sources types
Transaction Risk: Sources & Types
  • Decline in buyer’s share price
    • In share-for-share deals, they buyer’s share price drives the monetary value of the bid; however, this could vary after the deal announcement date.
      • The market may believe that the buyer overpaid.
      • The use of stock may be interpreted as buyer overvaluation.
      • The buyer’s financial performance could deteriorate.
  • Preemption by Competing Bidder
    • A high price can prevent this; but this reduces the value of the merger to the buyer.

P.V. Viswanath

transaction risk sources types1
Transaction Risk: Sources & Types
  • Disappointed Sellers
    • Target shareholders could balk and vote against the deal
  • Appearance of formerly hidden product liabilities.
    • Guidant
  • Loss of Key Customers by Target
  • Problems in Target’s Accounting Statements
  • Regulatory Intervention
  • Litigation by Competitors
  • Disagreement over social issues
    • Status of executives after merger

P.V. Viswanath

types of risk management
Types of Risk Management
  • Before the Public Announcement of the Deal
    • Toehold stake
      • A buyer may acquire upto 4.99% of the stock of a public target without revealing this to the public. In the event that another firm makes a successful bid, the profit earned on this toehold stake could make up the expenses incurred by the losing suitor.
      • A toehold stake could also discourage other buyers when it becomes known.
    • Antitakeover Defenses
      • Could provide flexibility in dealing with intending buyers.

P.V. Viswanath

risk management after announcement
Risk Management after Announcement
  • Termination fees
    • Awarded to losing bidder; also called breakup fee. Can be valued using option techniques.
  • Lockup option
    • the right of the buyer to acquire 19.9%of target’s stock or other key assets in the event a competitor crosses a threshold in trying to acquire the target.
  • Exit clauses
    • Conditions under which the buyer can terminate the deal without paying termination fees. These are a hedge against the uncertainty of what the buyer may discover in due diligence research.
  • Representations, warranties, covenants and closing conditions.

P.V. Viswanath

risk management after announcement1
Risk Management after Announcement
  • Caps, Collars and Floors
    • The value of the deal to the target may drop if the buyer’s share price drops in a stock merger. Target shareholders can reduce this risk by putting a floor on their exposure.
    • Buyer shareholders may put a cap to reduce the unlimited upside potential of the target shareholders if the acquirer’s stock price goes up.

P.V. Viswanath

after consummation
After consummation
  • Escrow accounts and post-transaction price adjustments
    • The buyer may seek to hold back some of the money in an escrow account pending an audit of the target post-merger.
  • Contingent Value Rights
    • In stock-for-stock deals, the target shareholders may be granted the right to put their shares back to the buyer within a certain time period.
  • Earnouts and other contingent payments
    • These allow the target to participate in the benefits to be created by the target firm. Also provides an incentive, where target managers continue to work in the firm, post-merger.
  • Staged Investing
  • Cash payment – this is complete insurance for target shareholders.

P.V. Viswanath

stock for stock payment profiles
Stock-for-stock payment profiles
  • Fixed Exchange Ratio deal
    • The number of shares to be issued to the target is fixed, but the value of the deal is uncertain.
  • Fixed Value Deal
    • The total value of the deal is fixed; the number of shares to be issued is inversely propotional to the price of the buyer’s shares.
  • Floating Collar
    • The number of shares might be fixed, as long as the buyer’s share price does not go outside a specified range.
  • Fixed Collar
    • The value of the deal is fixed as long as the buyer’s share price does not go outside a specified range; out of this range, the deal value depends on the buyer’s share price.

P.V. Viswanath

valuing collars at t
Valuing Collars: AT&T
  • In 1999, AT&T offered the shareholders of MediaOne two alternatives:
    • Either $85 cash per share of MediaOne or
    • 1.4912 shares of AT&T common stock, plus a collar.
    • If AT&T’s share price, S < $57, MediaOne shareholders would receive cash equal to 1.4912(57-S).
    • Max cash payment of $8.50 per MediaOne share, i.e. if S dropped more than $5.70 (i.e. 8.5/1.4912), or below $51.30, payment would not increase beyond $8.50.

P.V. Viswanath

valuing collars at t1
Valuing Collars: AT&T

P.V. Viswanath

valuing collars at t2
Valuing Collars: AT&T
  • The value of the collar is equivalent to 1.4912 times (the value of a put on AT&T stock with an exercise price of $57 less the value of a put on AT&T stock with an exercise price of $51.30).
  • Under the assumption of a 5% risk free rate, current AT&T stock price of $57, volatility of 15% p.a., and a time to maturity of 180 days, the value of the long put works out to 1.74.
  • The value of the short put is 0.30.
  • The value of the collar is 1.4912(1.74-0.3) = 2.147

P.V. Viswanath

valuing collars at t3
Valuing Collars: AT&T
  • The value of the collar for a time to maturity of 90 days is 1.4912(1.36-0.1) = $1.879.
  • For a time to maturity of 360 days, the value of the collar is 1.4912(2.12-0.61) = $2.252.
  • If a probability weight of 25% is put on the extreme values and 50% on the intermediate value, we get a collar value of 2.106.
  • Hence the true value of the offer was 57(1.4912) + 2.106 = $87.10

P.V. Viswanath

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