Risk Management

P.V. Viswanath

Class Notes for FIN 648: Mergers and Acquisitions

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Transaction Risk: Sources & Types

Decline in buyer’s share price In share-for-share deals, they buyer’s 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 buyer’s 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.

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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 Target’s Accounting Statements Regulatory Intervention Litigation by Competitors Disagreement over social issues

Status of executives after merger

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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.

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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 19.9%of target’s 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.

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Risk Management after Announcement

Caps, Collars and Floors The value of the deal to the target may drop if the

buyer’s 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 acquirer’s 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.

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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 buyer’s shares.

Floating Collar The number of shares might be fixed, as long as the buyer’s share price

does not go outside a specified range. Fixed Collar

The value of the deal is fixed as long as the buyer’s share price does not go outside a specified range; out of this range, the deal value depends on the buyer’s share price.

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Valuing Collars: AT&T

In 1999, AT&T offered the shareholders of MediaOne two alternatives: Either $85 cash per share of MediaOne or 1.4912 shares of AT&T common stock, plus a collar. If AT&T’s share price, S < $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: AT&T

51.30 57.00

5.70

Price of AT&T at collar expiration

0.00

Value of Collar/1.4912

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Valuing Collars: AT&T

The value of the collar is equivalent to 1.4912 times (the value of a put on AT&T stock with an exercise price of $57 less the value of a put on AT&T stock with an exercise price of $51.30).

Under the assumption of a 5% risk free rate, current AT&T 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: AT&T

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