Risk Management

1. Risk Management P.V. Viswanath Class Notes for FIN 648: Mergers and Acquisitions

2. 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. P.V. Viswanath

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 Target’s Accounting Statements • Regulatory Intervention • Litigation by Competitors • Disagreement over social issues • Status of executives after merger P.V. Viswanath

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. P.V. Viswanath

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 19.9%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. P.V. Viswanath

6. 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. P.V. Viswanath

7. 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. P.V. Viswanath

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 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. P.V. Viswanath

9. 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. P.V. Viswanath

10. Valuing Collars: AT&T P.V. Viswanath

11. 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 P.V. Viswanath

12. 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 P.V. Viswanath