Mergers and Acquisitions - Collar Contracts

Transcription

1 Mergers and Acquisitions - Collar Contracts An Chen University of Bonn joint with Christian Hilpert (University of Bonn) Seminar at the Institute of Financial Studies Chengdu, June 2012

2 Traditional M&A deals Traditional M&A deals: two main payment methods to the target all cash deals: fixed price deal stock-for-stock exchange: fixed ratio deal Risks involved in traditional M&A transactions: Pre-closing risk: the possibility that fluctuations of bidder and target stock prices will affect the terms of the deal and reduce the likelihood the deal closes. Post-closing risk: after the closing the possible failure of the target to perform up to expectations, thus resulting in overpayment major risk for the shareholders of the bidder An Chen Mergers and Acquisitions - Collar Contracts 2

3 Pre-closing instruments: Collars Collars were introduced to protect against extreme price fluctuations in the share prices of bidder and target: Fixed price collars and fixed ratio collars Collar-tailored M&A deals have both characteristics of traditional all-cash or stock-for-stock deals. Collars can be used by bidders to cap the payout to selling shareholders An Chen Mergers and Acquisitions - Collar Contracts 3

4 Fixed price collar (taken from Officer (2004)) First Community Banccorp Inc. - Banc One Corp., 1994, with K = 31.96$, U = 51$, L = 47$, a = , and b = Payoff Bidder stock price An Chen Mergers and Acquisitions - Collar Contracts 4

5 Fixed ratio collar (taken from Officer (2004)) BancFlorida Financial Corp. - First Union Corp., 1992, c = 0.669, U = $, L = $, K 1 = 28$, and K 2 = 30$. Payoff Bidder stock price An Chen Mergers and Acquisitions - Collar Contracts 5

6 Pre-closing instruments: walking-away provision A walking-away provision (sometimes referred to market out provision) was incorporated in a traditional M&A deal, as an alternative to or in conjunction with a collar offer. The walking-away feature allows one or both of the parties to terminate the negotiated mergers and acquisitions. Walking-away option (known as a sudden birth option): The target has the option to walk away from the deal if the bidder stock price falls below a certain level The bidder has the option to walk away from the deal if the bidder stock price exceeds a certain level An Chen Mergers and Acquisitions - Collar Contracts 6

7 Collar Offers and walking-away provisions Collar offers and walking-away provisions are usually not standardized and sometimes provided in complex forms. Examples: Verizon and Qwest Bid for MCI (2005); Walking-away provisions might be based on some index performance There might be multiple barriers in walking-away provisions. An Chen Mergers and Acquisitions - Collar Contracts 7

8 Collar offers and walking-away provisions Collars 12.98% 13.14% 16.39% 13.97% 13.10% 10.94% Walkaways 29.01% 24.82% 28.69% 27.94% 21.45% 9.38% Percentages of collars offers and walking-away provisions in M&A deals in the US (Source: An Chen Mergers and Acquisitions - Collar Contracts 8

9 Literature on collar offers Officer (2004, Journal of Finance): The main question: why are collars included in M&A transactions? The main result: the use of collars can reduce the possibility of renegotiation such that the ex ante expected costs of negotiation over the entire bid period can be reduced through collar offers. Officer (2006, Journal of Business): The author valued the implicit collar options in the M&A transactions. The author highlighted the need for more sophisticated approaches to valuation of collar options An Chen Mergers and Acquisitions - Collar Contracts 9

10 ...Literature Introduction Fuller (2003, The Financial Review): Collar offers are associated with significant positive abnormal returns for the target and significant negative abnormal return for the bidder Caselli et. al. (2006, Journal of Applied Corporate Finance): emphasize the use of collar contracts was mainly caused by the increasing stock market volatility. Little theoretical work done so far in valuing collar offers in a merger deal after the M&A announcement has been made and before the deal either goes through. An Chen Mergers and Acquisitions - Collar Contracts 10

11 What we do in our paper From the perspective of target, we develop an arbitrage-free and complete model to value fixed price and fixed ratio collars particularly value the walking-away provisions in the regular collar offers analyze the welfare implications of using collar contracts Objectives: The model is intended to be a tool to understand the prices for collar offers and to use it effectively in controlling risks involved in M&A deals. An Chen Mergers and Acquisitions - Collar Contracts 11

12 Agenda Introduction Introduction ( ) Model setup Payoff structure of target under a collar offer Adding the walking-away provision Valuation framework Conclusion An Chen Mergers and Acquisitions - Collar Contracts 12

13 Two Types of Collars Fixed price collar: Ψ FP (S 1 (T )) :=K1 {L<S1 (T )<U} Fixed ratio collar: + as 1 (T )1 {S1 (T ) L} + bs 1 (T )1 {S1 (T ) U} Ψ FR (S 1 (T )) :=cs 1 (T )1 {L<S1 (T )<U} + K 1 1 {S1 (T ) L} + K 2 1 {S1 (T ) U} [L, U]: collar width. a, b, K 1 and K 2 are usually chosen such that collars display continuous payoffs An Chen Mergers and Acquisitions - Collar Contracts 13

14 Fixed price collar First Community Banccorp Inc. - Banc One Corp., 1994, with K = 31.96$, U = 51$, L = 47$, a = , and b = Payoff Bidder stock price An Chen Mergers and Acquisitions - Collar Contracts 14

15 Fixed ratio collar BancFlorida Financial Corp. - First Union Corp., 1992, c = 0.669, U = $, L = $, K 1 = 28$, and K 2 = 30$. Payoff Bidder stock price An Chen Mergers and Acquisitions - Collar Contracts 15

16 Model Setup Introduction Black Scholes economy (under Q): Stocks dynamics : ds 1 (t) =(r q 1 )S 1 (t)dt + σ 1 S 1 (t)dw Q 1 (t), S 1(0) = S 1 (bidder s share price) ds 2 (t) =(r q 2 )S 2 (t)dt + σ 2 S 2 (t) (ρdw Q 1 (t) + ) 1 ρ 2 dw Q 2 (t) S 2 (0) = S 2 > 0 (target s share price) An Chen Mergers and Acquisitions - Collar Contracts 16

17 Pricing Formulas Time-zero arbitrage-free price of the fixed price collar: Π FP (S 1 ) =e rt K [ Φ ( ) ( )] Ū2 Φ L2 + as1 e q1t Φ ( ) L 1 bs 1 e q1t Φ ( ) Ū 1 Time-zero arbitrage-free price of the fixed ratio collar: Π FR (S 1 ) =ce q 1T S 1 [ Φ ( Ū 1 ) Φ ( L1 )] + K1 e rt Φ ( L 2 ) + K 2 e rt Φ ( Ū 2 ) An Chen Mergers and Acquisitions - Collar Contracts 17

18 Walking-away provisions Target payoff: Ψ Walk i = Ψ i (S 1 (T ), S 2 (T ))1 {τ>t } + S 2 (T )1 {τ T } Stopping times: Π Walk i τ L := inf{t : S 1 (t) L} τ U := inf{t : S 1 (t) U} τ := min{τ L, τ U } (S 1, S 2 ) available in semi-closed form in Black-Scholes model. An Chen Mergers and Acquisitions - Collar Contracts 18

19 Parameter choices The initial target s and bidder s share price is fixed at S 1 = S 2 = 100. We use r =0.05, T = 1, q 1 = q 2 = 0, σ 1 =σ 2 = 0.2, L = 80, U = 120, ρ = 0.5. Collars usually display continuous payoffs a = K L, b = K U, K 1 = c L, and K 2 = c U The price K and the exchange ratio c are determined such that the today s price of fixed price collar or fixed ratio collar equals the initial target price S 2. An Chen Mergers and Acquisitions - Collar Contracts 19

20 Effect of walking-away: fixed price collar Ρ 0.5 Ρ 0 Ρ An Chen Mergers and Acquisitions - Collar Contracts 20

21 Effects of σ 1 probability of size of payoff probability of premature size of payoff survival (τ > T ) upon survival walk-away (τ T ) upon premature walk-away (ρ > 0) σ 1 ( ) (ρ < 0) The today s price of this payoff Ψ tar can be roughly decomposed into the following sum of two products probability of survival size of payoff upon survival + probability of premature walk-away size of payoff upon premature walk-away An Chen Mergers and Acquisitions - Collar Contracts 21

22 Effect of walking-away: fixed ratio collar Ρ 0.5 Ρ 0 Ρ An Chen Mergers and Acquisitions - Collar Contracts 22

23 Power Utility Introduction Assume that the target s shareholders are assumed to own power utility: u(x) = x 1 γ 1 γ, γ > 0, γ 1 Share prices under real world measure P: Stocks dynamics : ds 1 (t) = (µ 1 q 1 )S 1 (t)dt + σ 1 S 1 (t)dw1 P (t) ( ds 2 (t) = (µ 2 q 2 )S 2 (t)dt + σ 2 S 2 (t) ρdw1 P (t) + ) 1 ρ 2 dw2 P (t) S 1 (0) = S 1 S 2 (0) = S 2 An Chen Mergers and Acquisitions - Collar Contracts 23

24 Expected utility - fixed price collar The expected utility of the target s shareholder: E P [u (Ψ FP )] [ = 1 as 1 e 1 γ + 1 [ 1 γ K 1 γ Φ [ + 1 bs 1 e 1 γ ( ] 1 γ µ 1 q 1 σ2 1 2 )T ) e 1 2 (1 γ)2 σ 2 1 T Φ ( L (1 γ)σ1 T (Ũ) )] Φ ( L ( ] 1 γ µ 1 q 1 σ2 1 2 )T ( e 1 2 (1 γ)2 σ 2 1 T Φ Ũ + (1 γ)σ ) 1 T. Semi-closed form solution if walk-away option included. An Chen Mergers and Acquisitions - Collar Contracts 24

25 Expected utility - fixed ratio collar The expected utility of the target s shareholder: E P [u (Ψ FR )] = 1 1 γ K 1 γ [ + 1 cs 1 e 1 γ [ Φ ) 1 Φ ( L + 1 ( ) 1 γ K 1 γ 2 Φ Ũ ( µ 1 q 1 σ2 1 2 )T ] 1 γ e 1 2 (1 γ)2 σ 2 1 T ) )] (Ũ (1 γ)σ1 T Φ ( L (1 γ)σ1 T Semi-closed form solution if walk-away option included. An Chen Mergers and Acquisitions - Collar Contracts 25

26 Certainty equivalents σ 1 CE NoM&A CE Cash CE Stock CE FP CE FR CE WA FP CE WA FR Certainty equivalents under different M&A deals for varying σ 1 of the bidder. We have chosen µ 2 r σ 2 = µ 1 r σ An Chen Mergers and Acquisitions - Collar Contracts 26

27 Certainty equivalents γ CE NoM&A CE Cash CE Stock CE FP CE FR CE WA FP CE WA FR Certainty equivalents under different M&A deals for varying risk aversion of the target. An Chen Mergers and Acquisitions - Collar Contracts 27

28 Conclusion Introduction Pricing of walking-away provisions (semi-closed form) Value depends heavily on underlying volatilities Collars can increase expected utility Mixed evidence for walking-away rights An Chen Mergers and Acquisitions - Collar Contracts 28