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Risk Management

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Title: Risk Management


1
Risk Management
  • P.V. Viswanath

Class Notes for EDHEC course on Mergers and
Acquisitions
2
Transaction Risk Sources Types
  • Decline in buyers share price
  • In share-for-share deals, they buyers 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 buyers 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.

3
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 Targets Accounting Statements
  • Regulatory Intervention
  • Litigation by Competitors
  • Disagreement over social issues
  • Status of executives after merger

4
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.

5
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 19.9of
    targets 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.

6
Risk Management after Announcement
  • Caps, Collars and Floors
  • The value of the deal to the target may drop if
    the buyers 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 acquirers stock price goes
    up.

7
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.

8
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 buyers shares.
  • Floating Collar
  • The number of shares might be fixed, as long as
    the buyers share price does not go outside a
    specified range.
  • Fixed Collar
  • The value of the deal is fixed as long as the
    buyers share price does not go outside a
    specified range out of this range, the deal
    value depends on the buyers share price.

9
Valuing Collars ATT
  • In 1999, ATT offered the shareholders of
    MediaOne two alternatives
  • Either 85 cash per share of MediaOne or
  • 1.4912 shares of ATT common stock, plus a
    collar.
  • If ATTs share price, S lt 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.

10
Valuing Collars ATT
11
Valuing Collars ATT
  • The value of the collar is equivalent to 1.4912
    times (the value of a put on ATT stock with an
    exercise price of 57 less the value of a put on
    ATT stock with an exercise price of 51.30).
  • Under the assumption of a 5 risk free rate,
    current ATT 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

12
Valuing Collars ATT
  • 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
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