Addressing Market Volatility and Risk in M&A Agreements

Edward D. Herlihy is partner at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell memorandum by Mr. Herlihy and Jacob A. Kling. Related research from the Program on Corporate Governance includes Are M&A Contract Clauses Value Relevant to Target and Bidder Shareholders? by John C. Coates, Darius Palia, and Ge Wu (discussed on the Forum here); Allocating Risk Through Contract: Evidence from M&A and Policy Implications by John C. Coates, IV (discussed on the Forum here); The New Look of Deal Protection by Fernan Restrepo and Guhan Subramanian (discussed on the Forum here); and Deals in the Time of Pandemic, by Guhan Subramanian and Caley Petrucci (discussed on the Forum here).

Significant volatility continues to disrupt the equity markets, with the major stock indexes swinging multiple percentage points often on a daily basis. Inflation, rising interest rates, the Ukraine crisis, continuing effects of Covid-19, lasting supply chain issues, a difficult regulatory environment, and uncertainty regarding the global and U.S. economies have had an undeniable impact on the pace of M&A activity so far in 2022. While the opening months of 2022 have witnessed a number of significant transactions despite these headwinds, most have been all-cash deals, with only a handful of large stock or cash and stock mergers announced to date, among them the Take-Two / Zynga cash and stock transaction and, most recently, Intercontinental Exchange’s $16 billion acquisition of Black Knight announced last week. Many M&A professionals have seen at least one, and in some cases multiple, potential transactions fall victim during the negotiation stage to the effects of economic uncertainty and market volatility over the past few months, and overall M&A is down roughly 25% globally in 2022 as compared to 2021.

These issues are compounded by the increased scrutiny of and potential regulatory opposition to large scale M&A from the antitrust agencies, and the resulting extension of the interim period between transaction signing and closing. This additional regulatory delay means that transactions, and in particular deals involving stock consideration, are increasingly vulnerable to market risk over a longer time horizon. We outline below certain transaction structures that can be deployed to shift or address certain of these risks to account for the greater volatility in the current market environment. Which structure makes sense in any given transaction will depend on the parties’ objectives, the perception of the relative risks in the particular transaction, and bargaining power. Traditional fixed exchange ratio deals remain by far the most common pricing structure for all or part stock transactions, but as this period of economic, regulatory and market uncertainty persists, we expect that transaction participants may increasingly consider certain variations as possible alternatives to shift or address market risk and volatility during a protracted sign to close period.

Fixed Exchange Ratios

The most common and simplest pricing structure in M&A transactions involving all or some stock consideration (especially in the context of larger transactions) is a fixed exchange ratio set at the time the merger agreement is signed. The advantage of a fixed exchange ratio for the acquirer is that it allows the acquirer to determine at the outset how much stock it will have to issue, so that it can assess the per share earnings impact of the transaction with some certainty. From the perspective of target shareholders, a fixed exchange ratio allows them to share in the upside from increases in the acquirer’s stock price between signing and closing and from any positive market reaction to the potential combination.

With a fixed exchange ratio, the target’s shareholders bear market risk as it relates to the acquirer’s stock. This includes stock price movements resulting from general macroeconomic or industry changes, as well as those resulting from acquirer-specific events. But the acquirer is also at risk from a value perspective should its intrinsic value per share rise. Fixed exchange ratio transactions reflect a basic premise, applicable to many strategic stock mergers, that, absent an underlying change in either party’s business that rises to the level of a material adverse effect, market fluctuations during the interim period between signing and closing should not, in and of themselves, alter either party’s obligation to complete the transaction or affect the agreed upon pro forma ownership split of the combined company between the target’s and acquirer’s shareholders.

But even in fixed exchange ratio transactions, parties need to make certain pricing determinations that could be influenced by market volatility and other market factors. One is how to set the exchange ratio—for example, whether to value the stock consideration based on the acquirer’s closing price on a particular day shortly ahead of signing, or whether to use a volume weighted average price (VWAP) over a longer period to dampen the impact of outlier trading days. We expect to see parties increasingly look to VWAP-based approaches to set exchange ratios in the current volatile market, particularly where the acquirer’s stock price has fluctuated significantly in the lead-up to an announcement.

Another question relevant to fixed exchange ratio transactions with mixed cash and stock consideration is whether to give all target shareholders the same consideration mix or instead offer them an election, and, if so, how to structure the election and proration mechanics. In a cash-stock election deal, the parties may include a formula designed to equalize the value of a cash election and stock election as of closing in order to avoid a situation where the more valuable form of consideration is significantly oversubscribed (which results in substantial proration and disadvantages shareholders who fail to make an election). These mechanics can be complex, and require careful thought and planning with deal counsel early on in the negotiation process.

Floating Exchange Ratios and Collars

At the opposite end of the spectrum from a fixed exchange ratio is a floating exchange ratio, where target shareholders receive a fixed dollar value of consideration at closing, and accordingly the number of shares to be issued by the acquirer is determined on the basis of the value of the acquirer’s stock at the time of closing or on the basis of the average price of the acquirer’s stock price (which can be expressed as a VWAP or an average of sequential closing prices) over a period shortly ahead of closing. Under this structure, target shareholders have downside protection because, if the acquirer’s stock price has declined in the period between signing and closing, the exchange ratio is increased in inverse proportion to maintain the same dollar value of consideration. The flip-side is that, in a pure floating exchange ratio transaction, target shareholders do not benefit from any appreciation in the acquirer’s stock price between signing and closing, since they receive fewer acquirer shares to counteract that appreciation.

And acquirers lose the benefit of dilution certainty. If the acquirer’s shareholders could be required to vote on the transaction under state law or stock exchange rules, which typically require an acquirer shareholder vote if 20% or more of the acquirer’s common shares are issued in the transaction, care needs to be taken to ensure that a transaction does not inadvertently cross that threshold due to a change in the anticipated number of shares to be issued in the transaction if the acquirer’s stock price falls. For all of these reasons, pure floating exchange ratio transactions remain uncommon.

When a floating exchange ratio pricing formula is used, a collar can limit the risks to the acquirer of exchange ratio adjustments. A collar protects the acquirer by placing an upper limit on the amount of stock it will be required to issue in the event of a decline in the price of its stock between signing and closing. Within the collar, the acquirer is assured of issuing, and the target’s shareholders of receiving, a number of shares having a value equal to the agreed-upon dollar deal price at signing. Once the share price is outside the collar range, no further adjustments are made and the exchange ratio becomes fixed at its upper or lower limit (as is currently the case in the pending Take-Two / Zynga transaction). Outside of the collar, the risks are the same as a fixed exchange ratio: target shareholders bear value risk of acquirer stock price declines, and the acquirer bears value risk of acquirer stock price gains. Target companies considering proposing a collar should be aware that collars are often symmetrical, in which case a collar not only provides some downside protection for target shareholders, but also limits some of the upside potential in the stock consideration.

Walk-Aways

In some stock transactions, target companies may seek to include termination provisions that give the target the right to walk away from the transaction if the price of the acquirer’s stock falls below a certain level during a defined period before closing. A walk-away provision might permit termination if, at the time the transaction is to close, the acquirer’s stock price has decreased by a specified percentage (and sometimes also require that the acquirer’s stock has decreased by a specified percentage relative to a defined index of peer companies, in order to exclude industry-wide market price changes, referred to as a “double trigger” walk-away), subject to a potential option on the part of the acquirer to increase the exchange ratio or merger consideration as required to avoid the target’s right to terminate (sometimes called a “kill or fill” feature). These provisions can raise disclosure issues that need to be considered in the event the thresholds are breached, and may create other unintended consequences. They are rarely seen in M&A agreements (and material adverse effect definitions typically include carve outs for changes in each party’s stock price), particularly outside the context of bank mergers, and even among bank deals such walk-away provisions are not common.

Pricing Mechanisms Related to Regulatory Approval

The current regulatory environment is likely to cause some transacting parties to consider mechanisms to allocate the risk of failing to obtain regulatory approval for the transaction or the potential for unforeseen delay in the regulatory approval process. These mechanisms may include a reverse termination fee payable by the acquirer if regulatory approval is not received and the merger agreement is terminated in certain circumstances. Rarely, but occasionally, the size of the reverse termination fee may ratchet up depending on the timing of the termination of the transaction, as was the case in the recent Microsoft / Activision transaction. In a small minority of deals, an acquirer agrees to pay a ticking fee, by which the merger consideration increases for every incremental day of delay in closing after a target date, as in TD Bank’s pending acquisition of First Horizon. Target companies sometimes argue for ticking fees as a way to incentivize acquirers—who generally have principal control over the regulatory application process—to move as quickly as they can to secure approval. From the acquirer’s perspective, however, the increased uncertainty in the current regulatory climate makes it difficult to agree to bear the risk of regulatory delays that are often outside of the acquirer’s control through a ticking fee, and a ticking fee may be seen as tantamount to paying interest on top of the negotiated merger consideration. For that reason, ticking fees are uncommon and are often thought to undercut the principle that, absent a breach of the merger agreement, both parties should share the risk of regulatory delay.

Deciding on the Right Pricing Structure

The pricing structure used in a particular transaction, and the allocation of market risk between the acquirer and the target and their respective shareholders, will depend on the specific characteristics of the deal, market conditions, relative bargaining power of the parties and other transaction-specific factors. A pricing structure used in one deal may, for a variety of reasons, be entirely inappropriate for another. For instance, the pricing structure in an acquisition involving entities of significantly different size may be very different from that employed in a merger of equals or similar transaction, where the business understanding reflects the fact that the target company’s shareholders should participate in both the opportunities and the risks of the combined company. Moreover, if a party’s shareholders are required to vote on the transaction, there is some implicit protection against significant declines in the value of the other party’s stock, at least for the period through the shareholder meeting to approve the deal.

As with anything that creates possible uncertainty about whether or not the transaction will close or about deal pricing, collars, walk-aways and other special termination rights may attract attention from hedge funds and arbitrageurs and therefore have the potential to increase trading pressure on the stock prices of the parties to the deal. These considerations should be taken into account in deciding whether any of these types of pricing provisions are appropriate in a given situation. In many cases the parties will decide that a typical fixed exchange ratio is in fact the structure that makes the most sense.

Nonetheless, as the current volatility and uncertainty in the equity markets continues with no clear end in sight, and as parties prepare for longer interim periods between signing and closing as a result of regulatory headwinds, we expect that transaction parties, especially in all or part stock deals, will want to evaluate the menu of potential options for mitigating market risk during the sign to close period, and that these issues may take on greater focus in negotiations than they have in the past. Transaction participants and their advisors should carefully consider and weigh the benefits and risks of different pricing structures early on during deal discussions and determine what makes sense for their particular transaction.

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