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.

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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.

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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

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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