Market Swings and Mergers: Protecting the Deal and Arb Opportunities

The recent market swings and declines impact mergers in many ways.  Let's consider two.  First, we have the parties involved in making a deal.  These are numerous, but for convenience let's just focus on the firm to be acquired (target) and firm doing the acquiring (bidder).

If cash is the form of payment and a fixed price is set, target shareholders are in a fairly secure position.  I say fairly, because extreme swings can threaten any deal (e.g. Dow Chemical's Acquisition of Rolm and Hass right after the 2008 market crash).  The bidder may nevertheless squirm as market shakeups impact the value of the target and the related projection of future cash flows.

In stock deals, things get more interesting.  Suppose, for example, a deal is set with a one to one stock swap.  If the price of the target changes relative to the price of the bidder, the value received and paid can be quite different than originally envisioned.

One way to mitigate this risk is the use of collars - essentially boundaries framing a range of values in which a deal will take place, depending on the price of the shares at closing.  This can offer upside protection to a bidder (a maximum payment or ceiling) and downside protection to a target (a minimum payment or floor).  For more detail on this, see our previous post Acquisition Risk, Collars, and the Time Warner Deal.

Another group active in mergers and affected by market swings are merger arbs, essentially trying to buy at one price, sell at another and minimize the risks.  For example, the Beta of The Merger Fund (MERFX) is 0.08 - taking close to zero market risk.  Again, see our related post Speculation Spreads and the Market Pricing of Proposed Acquisitions.

However, volatility and market dips can widen spreads and make arbitrage opportunities more attractive.  This works particularly well if, as mentioned, the arbs can appropriately hedge market (and where possible, deal) risk.  An interesting example of this comes from The Deal's post Stock Market Volatility Creates Opportunities for Merger Arbs.

All the best,

Ralph

Business Risk and Acquisition Finance

There are two main types of risk that companies face: Business Risk and Financial Risk.  A basic tenet of acquisition finance is that companies with less business risk can afford to take more financial risk and vice versa.

Business risk deals with the inherent volatility of measures like sales, revenue,  EBIT or EBITDA.  For example,  Humphrey's (a popular restaurant chain in the Netherlands) has different business risk than say, TransCanada Corporation (a natural gas utility in Canada).  Business risks will be different because of country factors, size, governance and a host of other items.  But business risks are different right from the top of the income statement.  A restaurant chain is more likely to have greater swings in revenue (and the EBIT or EBITDA linked to that revenue) than the utility.  Because of this, the utility can afford more financial risk and is likely to be more highly levered.

How much debt is too much?  That is too complicated an issue to cover in a short blog, but earnings coverage ratios, tied to industry norms, are often used as a guide.  The larger swings in EBIT for the more volatile company mean less ability to safely 'cover' a given amount of interest.  Hence, the lower amount of debt.

Incidentally, as individuals, we face the same logic: you and I could have the same average yearly salary but if mine is based on commissions while yours is fixed, I will be unable to borrow as much as you.

Obviously, there is a lot more to structuring the deal than this, but matching the volatility of the assets to the mix of debt and equity is a fundamental principle.  Incidentally, this matching of asset volatility often extends (or should extend) to the way executive compensation is structured, but that's a subject for some other time.


All the best,

Ralph