Briefing Note – Hedging related to the Acquisition of a Business or Asset

Acquiring another company or a material asset can be both exciting and stressful for management. Often it is pivotal – a “game changer” for the business. It may involve a change in capital structure, often with a requirement to finance all or part of the asset. In addition to operational, accounting and tax implications, management should be proactive in dealing with the financial risk around these “event” transactions.

The situation is more complex if the transaction is cross border. For example, lets look at a Canadian manufacturer buying a European business, and bidding for it in US dollars. If the company wins the bid and the transaction is closing is in one month, the company has the following risks:

1. a strengthening in the US dollar versus the Canadian dollar in one month's time

2. a weakening of the Euro versus the Canadian dollar. This is an ongoing risk assuming the asset of business being acquired generates Euro-denominated revenues and is essentially valued in Euro

3. if financing is done initially by way of a Canadian dollar bank “bridge loan” with an eventual “take out” financing done via bond issuance or bank term loan, there is interest rate risk that can be addressed

Lets put some numbers on this example and then discuss some hedging alternatives. The purchase price is USD 10 million. Lets say this is equivalent today to CAD 12.8 million or EUR 8.5 million. If the bid has been accepted, then the acquiring company can buy USD 10 million (selling CAD) in 1 month's time. This FX forward transaction will effectively lock the purchase price in Canadian dollars.

Since the Euro-denominated asset will be financed in Canadian dollars, the value of the asset must be protected from a Euro devaluation. This can initially be done using another 1 month FX forward, where the acquiring company sells EUR 8.5 million to buy CAD. This is commonly referred to as a net investment hedge. It creates a EUR liability against the EUR asset, effectively neutralizing the spot EUR exposure by “converting” the asset to CAD. Rather than physically settling this forward in one month's time, it is “rolled”. A couple days before settlement, two FX transactions are entered into simultaneously. The first is a buy of EUR 8.5 million to sell CAD. This is done to match the date on the initial FX forward and essentially offsets it. The second is a sell of EUR 8.5 million to buy CAD in, say, one month's time. The hedge can be rolled indefinitely in this way. IFRS and FASB grant hedge accounting methodology for net investment hedges, to ensure matching of the asset and hedge from a balance sheet standpoint. Rolling a short term hedge will have a cash flow impact. If the Euro appreciates versus CAD, the asset will be worth more in Canadian dollar terms but the hedge will be worth less. The hedge above will be settled monthly, the first resulting in cash outflows of CAD for the mark-to-market value of the hedge. This “settling up” can be delayed by entering into longer term hedges, such as long-dated FX forwards or cross currency swaps. Some firms choose a combination of hedging instruments, managing the EUR cashflows occurring in less than a year more actively using FX forwards, while hedging the longer term EUR value using a cross currency swap.

In situations where there are delays between bid submission and acceptance, options or deal contingent hedges can be used. Although the cost and economics of these two hedge types are different, they can simply be thought of as “insurance” which will protect against adverse market moves in the event the bid is accepted.

Lastly, any floating interest rate debt payments can be fixed using swaps to provide certainty to financing costs. If it is anticipated that fixed rate financing will be entered into to take out a bridge, a cash-settled forward starting swap can be used to protect against an increase in term rates between now and the take out of the bridge loan.

This information is purely illustrative, using simplified examples for educational purposes only. For more information, please contact me at edmurphyconsulting@gmail.com