Reducing Risk in Cross Border M&A Transactions

Deal professionals are settling into the new normals of today’s M&A environment, finding ways to continue to get deals done despite the circumstances. With that said, everything about the deal process has evolved over the last few months, notably, valuation considerations. With orders drying up and invoice settlement times increasing, cash flow risk is on the rise. The M&A implications of this harsh new reality make it difficult to rely on historical measurements of cash flow and market multiples to arrive at a fair valuation. What other core financial considerations should investors keep top of mind to help them comfortably continue to push forward towards successful closures?

Cross Border M&A Risks

While M&A always has inherent risks, there are additional risks associated with cross-border transactions, including political risk, FX risk,  and general risk associated with black swan events. This article will focus on reducing FX risk.

FX has a potentially deal-killing impact on valuations. The spot rate between buying and selling parties at deal inception determines the value in buyers and sellers currency. This includes valuation of hard assets and liabilities as well as long-term cash flows. A due diligence period of several months and the resulting FX movement will cause the buyers and sellers valuations to drift apart, potentially stopping the deal in its tracks. Lest this be dismissed as immaterial, the current volatility for three months in one of the most stable pairs – EURUSD – is more than 7%.  For USDBRL, three month implied volatilities are north of 22%!

Managing Contingent FX Risk

Managing the FX component is a non-trivial task. The main complication is that the most common hedging instrument – forward contracts – are not suitable. The contract requires an exchange of currency in the future. If the deal does not settle, the buyer still must exchange currency per the contract, leaving the same (but opposite direction) level of FX risk. 

One of the newest and best alternatives is using a machine learning-determined basket of currencies. Conceptually, the idea is simple. The relationship between the parties’ currencies and a basket of 4-5 currencies is far more stable than the binary relationship between the buyer’s currency and the seller’s currency. The IMF makes use of this concept with its Special Drawing Rights (SDR) concept. The use of an SDR basket would reduce the volatility between the buyer’s and sellers currencies, but not optimally so. 

A basket can be identified which minimizes valuation changes for both buyers and sellers during the due diligence period. Advances in machine learning (ML) have facilitated optimization of the hedging basket. The authors have run experiments and back testing over multiple currency pairs and tenors. Several ML algorithms were evaluated, including Bayesian, Ridge and SGD Regression. Bayesian regression, with its probability distributions rather than point estimates proved to be very robust and effective.  

The following timeline shows how this would work in practice:

1. Letter Of Intent
2. Optimal basket and weights determined through Bayesian Regression
3. Buyer converts his ccy into the currency basket, held in escrow or block chain mechanism
4. Buyer deal due diligence
5. if deal will proceed, seller converts the basket basket to his ccy
6. if deal falls through, buyer converts the basket back to his own ccy

Using machine learning determined baskets results in valuation changes less than 1% for typical due diligence periods, making it cheaper than options, while also requiring much simpler (eg no ISDA) FX arrangements than options would. All the buyer and seller are doing are spot transactions, with no derivatives required.

Conclusions

Cross-border M&A FX risk can be managed using several tools, including options, deal-contingent forward contracts, and optimally-chosen baskets. The latter has multiple advantages: 

• Baskets are always available, unlike deal contingent forwards
• They’re far simpler and cheaper to use than FX options
• Low valuation volatility

This article was a guest submission from Matthew Fotheringham and Paul Stafford, Partners at Deaglo.

About Deaglo

Deaglo is a cross-border advisory firm providing the next generation of FX risk management, execution and offshore banking to fund managers, institutional investors and their portfolio companies. Deaglo educates and empowers their clients Investment and Finance teams to take control of their FX risk and manage their cross-border transactions more effectively.