Dealers turn to mid-cap and EM deal-contingent trades

Premiums of more than 25% are attractive to banks battling low vol and increasing competition

Vietnam: dealers are increasingly looking at medium-sized and emerging market transactions

With falling foreign exchange volatility and increased competition eating into lucrative deal-contingent hedge revenues, dealers are increasingly looking at medium-sized and emerging market transactions.

The hedges give purchasers protection against FX movements between the announcement of an M&A deal and its completion. Increased competition in this space has seen the price of the hedges slide from 25% of the cost of an equivalent option in 2015 down to as low as 15%.

As a result, dealers are said to have started targeting mid-cap and emerging market M&A deals in an attempt to capture more business. Benoit Duhil de Benaze, a director at hedging adviser Chatham Financial, says that while deal-contingent trades typically used to be offered for deals with a minimum size of $150–200 million five years ago, today trades can be done for deal sizes as low as $50 million. 

Market participants say prices for deal-contingent trades in the mid-cap space can be north of 25%, reflecting the higher deal failure risk with parties less familiar with the M&A process.

“The mid-market space is as competitive as the large-cap market was five years ago, so it is definitely an exciting area to follow as deal contingents are now relevant for smaller deals,” says Duhil de Benaze.

François Jarrosson, a hedging and derivatives adviser at Rothschild & Co, says it used to be difficult to get deal-contingent hedges for deals below $100 million. “Now that costs have compressed, I would not be surprised if banks are looking for better risk return by accepting smaller but better-priced deals,” he says.

In today’s markets, banks need to play smart and maximise opportunities, which explains the success of deal-contingent hedging
Benoit Duhil de Benaze, Chatham Financial

The appeal for the deal-contingent purchaser is a risk-free hedge in exchange for upfront payments – if the deal fails, the hedge is extinguished. 

On the bank side, a deal failure would leave them with a naked hedge. But the appeal for the bank is a juicy premium on a trade that stays on the books for a limited time and thus attracts lower regulatory capital. The premium is the percentage of the price of the relevant at-the-money FX option.

Side business

It is not just the premiums that are attractive; Chatham’s Duhil de Benaze says winning dealers can attract more side business with clients. For example, as deal contingents often tend to be placed before an M&A deal reaches financial close, a winning bank is more likely to be able to offer additional services.

“There’s an incentive for banks to offer deal contingents at even more attractive prices in order to get their foot in the door of a sponsor’s company and position for additional ancillary services. In today’s markets, banks need to play smart and maximise opportunities, which explains the success of deal-contingent hedging, which is now seen as a strategic product rather than a niche one,” he says.

However, with implied volatility on one-year euro/US dollar options below 5% – the lowest since the creation of the European single currency – there is less premium available to earn on the structures. 


“We continue to use the FX option market as a reference to calculate deal-contingent charges, and as implied volatility has been decreasing it’s had the effect of dampening the prices banks can charge,” says an FX structuring head at one large dealer. 

While the total pot of premium available is shrinking, rising competition from dealers has meant that the proportion of the pot that banks can charge is also getting squeezed. 

Nevertheless, deal-contingent hedges have been one of the few bright spots for FX derivatives businesses faced with tightening spreads on vanilla options products. Clients are also more interested in the products as they’re cheap from their perspective, so banks have continued to pile into the space as a result, even on private-to-private deals with very little risk of deal failure.

Big players have seen their market share decrease because where there used to be maybe only five banks that could offer deal contingents five years ago, now there’s around 15
Chris Towner, Chatham Financial

“Big players have seen their market share decrease because where there used to be maybe only five banks that could offer deal contingents five years ago, now there’s around 15 that can do so,” says Chris Towner, a director at Chatham Financial. 

This has meant that for some banks, trades they would have been comfortable to bid for in the past no longer make economic sense.

“At the start of the fiscal year it was a case of ‘God, how are we printing at these levels?’ So over the last six months we’ve adopted more of a deal-by-deal basis to trades and we’ve been a little bit more selfish on deals we haven’t liked, but also more aggressive on deals we do like. Sadly, even with volatility at 4.8%, trades are still getting printed at 15% of at-the-money premium, which is where we have to just walk away from the trade,” says the FX structuring head 

While there have been no large deal failures since Apollo’s attempted takeover of RPC Group last March, the risk is ever present. A study by Chatham Financial that examined M&A activity between 2008 and June 2019 showed the probability of deal failure could range from 2% to 10%, depending on the year, industry and deal structure.  

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