July 28, 2023 – As a young boy, a memorable morning to look forward to was waking up on Christmas day to a burst of pure excitement and anticipation for the presents that awaited under the tree. Christmas morning embodied the essence of childhood exhilaration and the magic of the holiday season.
“I’m so lucky!”
“I wonder what this present is?”
As an adult, the closest experience to the elation felt during Christmas morning is waking up to find out one of your equity investments is to be acquired at a large premium to its closing price. Reading the initial press release with a large disclosed premium can result in an exhilarating rush of success. The realization that careful research and strategic decision-making have paid off fills one with a sense of validation and accomplishment.
“I’m a great investor!”
Once the initial exhilaration wears off, reality sets in.
“What exactly am I getting for my shares?”
To the layman, the buyout of their shares in a merger or acquisition is a straightforward exercise – “I’m getting $50.00 per share, which represents a great return.”
However, the value of a typical merger consideration is not so simple. In fact, the consideration paid by an acquiror to a target’s shareholders can be quite complex. While the simple all-cash consideration is relatively straightforward to understand, many times a merger consideration can involve the issuance of securities, or the inclusion of complex structures, that must be analyzed to reveal its true value.
In this memo, we review various merger consideration structures that occur in the context of North American M&A.
A) All-Cash Offer
The all-cash offer is the most common and simple consideration paid to target company shareholders in a merger or acquisition. It represents a set dollar value to be paid for the shares upon deal closing. The consideration’s value is the cash value, inclusive of any dividends paid over the deal cycle, and is not dependent upon the acquiror’s share price.
The certainty of value in an all-cash offer isolates target company shareholders from market risk, given its value will not fall if the market declines (assuming the deal closes at the original terms).
Source: Booz Allen Hamilton
From an arbitrageur’s perspective, one does not need to hedge an all-cash offer. Therefore, it is not necessary to short the acquiror’s stock.
However, one nuance regarding the all-cash offer is the currency of the consideration. If the currency of the consideration differs from the currency in which the shares trade, an arbitrageur must hedge out the F/X risk to lock in the arbitrage spread.
An example of an all-cash offer was Elon Musk’s acquisition of Twitter at $54.20 cash per share.
B) All-Share Offer
The second-most common consideration paid by an acquiror is the all-share offer.
An all-share offer involves a share swap of the acquiror’s stock for the target company’s shares, according to a set exchange ratio.
Therefore, the dollar value of the consideration will change as the acquiror’s share price changes, and the target company’s shareholders bear the equity market risk. If structured properly, all-share offers may provide tax benefits in certain scenarios.
Source: Booz Allen Hamilton
In order to lock in an arbitrage spread for an all-share offer, one must short-sell the acquiror’s stock according to the share exchange ratio. Once the merger closes and the acquiror’s shares are issued to the target company investor, the short position gets covered by the newly issued shares, and the arbitrage profit is crystallized.
A key aspect to be aware of that affects the value of the consideration is the dividends paid by the acquiror over the deal cycle, which reduce the consideration’s dollar value. For example, if the acquiror’s stock is worth $100, and it pays a $2 dividend, its share price will drop to $98 (all things being equal). If the consideration is 0.5x acquiror shares per target company share, then the consideration value is $49, not $50.
In addition, if one is to hedge out the exposure of the acquiror’s stock to lock in the arbitrage spread, the cost to borrow the shares to short must be taken into account.
One example of an all-share offer was Extra Space Storage’s merger with Life Storage for 0.895x shares.
C) Cash + Share Offer
The cash and share offer is the third most popular M&A consideration paid, behind the all-cash consideration and the all-share consideration.
In essence, the consideration value exposure provided by the cash and share offer is a blend of A) and B) above. A target company shareholder will receive a fixed dollar value for the cash portion and a variable value for the share portion. If one wants to hedge this exposure, one would hedge only the share portion by shorting the acquiror’s stock according to the disclosed exchange ratio.
One feature that can further complicate cash and share offers is the potential for consideration proration. What proration means is that target company shareholders are offered the choice of either the acquiror’s stock or cash for their shares, subject to a capped aggregate amount. The ability for shareholders to choose cash and/or stock, and the resulting proration, can add uncertainty to the exact mix of cash and shares that a target company shareholder is to receive.
In addition, depending on whether the default election is cash or shares (for those target company shareholders who do not actively elect whether they want cash or shares), this opens up the potential for upside optionality or additional value. For example, say the acquiror’s share price is $100, the share consideration is 0.5x (worth $50), the cash option is $50, and the total aggregate paid for both cash and shares is prorated (capped) at 50% of the consideration each. At the deal announcement, the cash and share considerations, or a combination of both, are worth the same dollar value of $50. However, if the acquiror’s shares rally to $120 over the deal cycle, making the share consideration worth $60, and the default election is the $50 cash consideration (many target company investors do not actively elect), this frees up more of the higher-value share consideration for those actively electing to receive shares. This scenario represents upside optionality for the target company shareholder under a prorated cash and share offer.
A current example of the cash and share offer is TransAlta Corporation’s merger with TransAlta Renewables for 1.0337x shares and $13.00 cash, subject to proration such that the aggregate cash consideration represents 58% of the total while the share consideration is 42%.
D) All-Share Offer with Set Value
Believe it or not, share considerations can become more complex from the basic all-share offer discussed in B) above.
One structure with moderate complexity is the all-share offer with a set dollar value. This is a variable exchange ratio that is pegged to a certain dollar value.
For example, if the consideration is $50.00 per share in value, the exchange ratio will be selected right before closing such that at the time it is set, it will be worth $50.00. To further complicate matters, typically the pricing mechanism to compute the $50.00 exchange ratio is calculated according to a 10-day VWAP of the acquiror’s share price, or a similar weighted average share price.
In this scenario, in order to hedge the dollar value of the consideration, an arbitrageur must short the acquiror’s stock according to the VWAP schedule disclosed in the merger agreement. If the share exchange ratio is based on the 10-day VWAP before the deal closing, then the best proxy is to short 1/10th of the shares on each of the 10 days prior to closing to best estimate the share exchange ratio.
For those who do not hedge the all-share offer with the set dollar value, note that the share exchange ratio is set before closing according to the acquiror’s share price at that time. Once the deal closes and the acquiror’s shares hit your brokerage account, the dollar value will likely be different (given the natural volatility of the stock market on the acquiror’s share price).
One example of an all-share offer with a set value occurred in 2016 when Exxon Mobil acquired Interoil for $45.00 in shares based on the 10-day VWAP before closing. Also, this deal included an additional consideration in the form of a Contingent Resource Payment (CRP), which was paid according to a formula of a resource certification of a gas well.
E) All-Share Offer with a Fixed-Price Collar (aka “Travolta”)
After the moderate complexity of D) above, the occasional merger consideration becomes highly complex.
Complexity increases significantly with the introduction of collars.
An M&A collar is a contractual agreement that tailors the economics of the consideration in a share-based merger beyond the basic choices of a fixed-price or fixed exchange ratio agreement.
M&A collars help customize share-based merger considerations and may draw features from either fixed exchange ratio or fixed-price deal structures, both in terms of risk and economics.
The all-share offer with a fixed-price collar is an example of a complex merger consideration paid to target company shareholders.
This consideration, nicknamed the “Travolta”, has a fixed dollar value within the share price collar, with a set share exchange (with variable dollar values) outside of the share price collar.
Source: Booz Allen Hamilton
Doesn’t it remind you of a collar worn by a stylish 1970s-era John Travolta?
If the acquiror’s share price is within the collar, the exchange ratio fluctuates but its value stays constant. Above the top end of the collar, the share exchange ratio is fixed. Also, below the bottom of the share price collar, the share exchange ratio is also fixed, albeit at a different ratio than the above range exchange ratio.
This exposure can be thought of as equivalent to a long call option on the acquiror’s stock at the above collar exchange ratio with a strike price equal to the top of the collar, combined with a short put option position at the below collar exchange ratio with a strike price equal to the bottom of the collar. Ergo, in order to hedge this consideration, an arbitrageur could implement opposing positions, including a short call and a long put position. Also, one would hedge out the stock exposure within the collar once the hedge ratio is set before or at the closing of the deal.
To further complicate matters, the Travolta may be utilized for the share consideration in a cash and stock deal. In this scenario, the cash portion is fixed and the value of the collared shares behaves as shown in the figure above.
For example, the Travolta fixed-price collar was used by Brookfield Infrastructure (BIPC) in the share portion of its acquisition of Triton International:
“The stock portion of the consideration is subject to a collar, ensuring Triton shareholders receive the number of BIPC shares equal to $16.50 in value for every Triton Share if the ten-day VWAP of BIPC Shares (measured two days prior to closing) (the “BIPC Final Stock Price”) is between $42.36 and $49.23. Triton shareholders will receive 0.390 BIPC Shares for each Triton Share if the BIPC Final Stock Price is below $42.36, and 0.335 BIPC Shares for each Triton Share if the BIPC Final Stock Price is above $49.23.”
F) All-Share Offer with a Fixed Exchange Ratio Collar (aka “Egyptian”)
If you’re old enough to remember the 1986 pop hit Walk Like an Egyptian by The Bangles, then the fixed exchange ratio collar, also known as the “Egyptian”, may seem familiar.
Source: Booz Allen Hamilton
The way an Egyptian collar works is that the share consideration is fixed (with a variable dollar value depending on the acquiror’s share price) within the collar, with a higher fixed dollar value of shares above the collar and a lower fixed dollar of shares below the collar.
Below the collar, more acquiror shares are issued the lower its share price goes, while above the collar, fewer acquiror shares are issued as its stock price goes higher.
This exposure can be thought of as the acquiror’s stock at the set exchange ratio within the collar, combined with a short call option at the equivalent ratio struck at the top of the collar, combined with a long put option position at the same ratio with a strike price at the bottom of the collar. In order to hedge this exposure, an arbitrageur would implement the opposite position, including a short position in the acquiror’s stock along with a long call option and a short put option.
To make this consideration more complex, below the bottom of the collar, cash may be used in lieu of the stock top-up in order to reduce dilution and limit share issuance as the acquiror’s share price falls.
A recent example of a modified Egyptian was used by Brookfield Reinsurance in its acquisition of American Equity Investment Life. Sensing a pattern here? Brookfield seems to like complex M&A considerations. This consideration’s complexity was further increased as they were issuing another company’s stock for the equity consideration, although it was shares of its related entity Brookfield Asset Management:
“As part of the agreement, each AEL shareholder will receive $55.00 per AEL share, consisting of $38.85 in cash and 0.49707 of a Brookfield Asset Management Ltd. (NYSE, TSX: BAM) (“BAM”) class A limited voting share (“BAM Shares”) having a value equal to $16.15 (based on the undisturbed 90-day volume-weighted average share price (“VWAP”) of the BAM Shares on June 23, 2023), subject to adjustment; If based on the 10-day VWAP of the BAM Shares (measured five business days prior to closing of the transaction) (the “BAM Final Stock Price”), the BAM Shares are trading at a price such that the aggregate consideration per AEL share would be less than $54.00 per share, the number of BAM Shares delivered for each AEL Share will be increased such that the value of the aggregate consideration delivered for each AEL Share will equal $54.00 and Brookfield Reinsurance will have the option to pay cash in lieu of some or all of the share portion of the Merger Consideration. In the event that the BAM Final Stock Price would result in the aggregate Merger Consideration per AEL Share being greater than $56.50, the number of BAM Shares delivered for each AEL Share will be decreased such that the value of the aggregate consideration delivered for each AEL Share will equal $56.50”
G) Bonus – Contingent Value Receipt
A Contingent Value Receipt (CVR) is a financial instrument issued to shareholders of a target company as part of a merger consideration (usually combined with cash and/or shares). CVRs serve as a means to provide additional compensation to the target company shareholders based on the achievement of certain pre-defined milestones or contingencies after the deal is completed. These milestones are typically related to specific events or developments that could impact the value of the merged entity, such as a clinical trial for an experimental drug.
CVRs are used when there is uncertainty surrounding the future performance of the acquired company and the merging parties want to offer target company shareholders an opportunity to participate in the potential future value creation. CVRs are most often utilized in biotech mergers, given the uncertain value and spectrum of future outcomes for unproven treatments.
H) Other
Merger agreements can be flexible and executives, boards, investment bankers, and lawyers can get very creative when structuring a deal. Therefore, there really is no limit as to what is included in a merger consideration. Some examples of additional consideration paid to target company shareholders, beyond the structures discussed above, include the inclusion of shares of a spin-off, shares of another company’s stock, preferred shares, convertible debentures, private company shares – and the list goes on. Some of these other considerations may or may not be hedgible by target company shareholders.
While a child may be anxious and excited to open their presents on Christmas morning, it takes the unwrapping of the gift to finally determine if the anticipation and elation were worthwhile (was it the Nintendo you wanted or a CD of the band you don’t care for?). Similarly, an investor may be over the moon upon reading about a stock that they own being acquired. However, they should withhold their enthusiasm until they unwrap the consideration and figure out exactly what it is worth. As shown through the various examples above, truly understanding the value of the consideration paid in the context of an M&A transaction may involve more than meets the eye.
The AlphaRank.com Merger Monitor below represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized returns of all outstanding merger arbitrage spreads and is typically viewed as an alternative to fixed income yield.
Each individual merger is assigned a risk rating:
- AA – a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
- A – a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
- BBB – a merger arbitrage rated ‘BBB’ is of investment grade and has a high probability of closing.
- BB – a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
- B – a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
- CCC – a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
- NR – a merger-rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.
The AlphaRank merger analytics database is utilized in running the Accelerate Arbitrage Fund (TSX: ARB), which may have positions in some of the securities mentioned.
* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). Visit Alpharank.com for more information. Disclaimer: This research does not constitute investment, legal or tax advice. Data provided in this research should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this research is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Accelerate may have positions in securities mentioned. Past performance is not indicative of future results.
