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Derivations® Demystifying Risk Management Solutions

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Derivations® Demystifying Risk Management Solutions DERIVATIONS® DEMYSTIFYING RISK MANAGEMENT SOLUTIONS VOLUME NO. 17 USING DERIVATIVES TO FACILITATE THE CHALLENGE SHARE REPURCHASE PROGRAMS Corporate use of derivatives has broadened Direct Share Repurchase Programs far beyond currencies and interest rates. Share repurchase programs have achieved wide application today as a corporate capital This issue of Derivations offers insight into management tool. Companies undertake open market repurchases or formal share tender how companies can use equity derivatives programs to: as a complement to or substitute for share · Accumulate shares for use in dividend reinvestment or executive/employee grant repurchase programs. programs; · Take advantage of temporary share price undervaluation; · Send a positive signal to shareholders about the prospects for the company's performance; · Improve financial performance against key investor measures-especially ROE and EPS. Reducing the equity layer in a company's capital structure has the effect of increasing its leverage, (unless it has no debt at all) regardless of how the buy-back is financed. If new debt rather than cash is used, which is the direction most buy-backs take, the impact on the company's debt /equity ratio is double-barreled-equity drops and debt goes up. A company is unlikely to enter into a repurchase program unless it expects that the beneficial effects of the buy-back will significantly outweigh the impact of a higher debt/equity ratio on its bankers, debt holders and rating agencies. There are, however, some problems associated with direct share repurchase programs. These include: · To attract the target number of shares, the repurchaser may have to offer a premium to the current market price of the stock; · Transaction costs, particularly for tender offers, can be stiff; · The cost of reissuing shares later when the company's capital structure objectives have changed can be significant. Synthetic Share Repurchases using Equity Derivatives While there is no question that a share repurchase program can be completed without resorting to derivative strategies, we believe there are situations in which a derivative solution can produce superior results. For example, sometimes repurchase economics can be improved using a derivatives based approach because the derivative has minimal impact on corporate liquidity and cash flow. In other situations a derivative-based repurchase strategy will be favored because it has a limited impact on the balance sheet or more favorable accounting treatment. “DERIVATIONS: DEMYSTIFYING RISK MANAGEMENT SOLUTIONS” is a registered trade-mark of Bank of Montreal, used under licence. DEMYSTIFYING RISK MANAGEMENT SOLUTIONS CONTINUED Key derivative strategies which can be used either in conjunction with, or as a substitute for, a share repurchase program include: · Forward Equity Purchases · Total Return Swaps · Selling Puts · Buying Call Options Forward Equity Purchase A Forward Equity Purchase has similar economics to a stock buy-back financed by debt. Consider this example: ABC Company, whose shares are trading today for $42, enters an agreement with BMO Nesbitt Burns in which the company agrees to buy 1 million shares of ABC from the bank at a price of $50. The transaction will be settled in 3 years, when BMO Nesbitt Burns delivers the stock and the company pays $50,000,000. A synthetic repurchase can also be cash settled at the contracted purchase date, avoiding the need for physical delivery. Cash settlement is very useful when the company's principal repurchase objective is to take advantage of perceived low market valuation. In its simplest form, that is the entire transaction, but it is interesting to delve into some of the details. For example, where does the price of $50 come from? The current spot price is $42, so the $50 forward price must include the cost of financing the purchase for 3 years. To hedge the position the derivative creates, the bank purchases ABC shares at the inception of the transaction and holds them until the final settlement. The bank incurs a cost to financing its hedge and this cost is passed on to the client in the form of a higher forward share price. There is an alternative way to pay the cost of financing: the company could agree to pay today's spot price for the shares in 3 years, but make quarterly fixed or floating swap payments to the bank over the 3-year period. To ABC, the economics of a forward purchase are similar to an actual spot buy-back, financed with 3-year debt. In order to choose between a direct buy-back and an equity derivative program, ABC will have to consider other economic factors that reflect the different cashflow consequences and their effects on: · Balance Sheet Presentation · Financial Ratios and Debt Covenants · Regulatory Treatment · Taxes · EPS DEMYSTIFYING RISK MANAGEMENT SOLUTIONS CONTINUED Total Return Swap The Total Return Swap is another derivative alternative to a direct share repurchase. The swap simulates a long position in the company's stock, but requires no direct investment. Unlike a classic interest rate swap, in which floating and fixed flows always move in opposite directions, if the total return on the stock is negative, then the stock cashflow goes in the same direction as the interest cashflow. Total Return on ABC Stock Fixed or Floating Financing Rate ABC Corp We believe the total return structure offers considerable flexibility. For example, if the swap terminates in 3 years, then it is similar to a long position in the stock that is liquidated at the market price in 3 years. The swap can also be arranged with physical settlement, so that actual shares are delivered to the company at the swap's maturity. Furthermore, by incorporating options features into the swap, total return cashflows can be restricted to a specific target range of share values. Using Options in Share Repurchase Programs Selling Put Options An increasingly popular strategy for lowering the cost of shares acquired in a buyback program is to complement the repurchase program by writing out-of-the-money over-the-counter put options against the company's shares. The premium received by the company today can reduce the cost of the share repurchase program. The put strike price is set at a level the company deems attractive. If the options expire out-of-the-money, the company adjusts the strike price and renews the put writing program. If the price of the shares fall such that the put options are ultimately exercised, the company takes delivery of the shares at a price well below its original repurchase price threshold (albeit above market at the time of exercise). Buying Call Options Buying call options on the company's shares helps protect a repurchase program from market volatility and the higher costs of acquiring shares in a rising market. Moreover, if the price of the stock declines, owning calls rather than shares allows the company to take advantage of declines in price to lower the average cost of its repurchased share inventory. Buying calls works best when the price of the stock is volatile. However, in a dull market, a call-based strategy will often underperform outright purchases, forward purchases or total return swaps. DEMYSTIFYING RISK MANAGEMENT SOLUTIONS CONTINUED Regulatory Issues Surrounding Buyback Programs In the United States securities laws and regulations usually require the same procedures and filings for a stock buyback program executed through the derivatives market as for a direct physical buyback. In both instances disclosure rules and insider-trading rules need to be observed. Guidelines covering execution procedures, such as the anti-manipulation safe harbor rules, will apply to the derivative, and possibly to the hedging of the derivative, just as they apply to the company's direct purchases. While Canadian laws and regulations covering share repurchase are similar in many respects, there are areas of difference. Because the rules in this area can be quite complex, companies contemplating a stock buyback-direct or synthetic-need to consult with suitable expert counsel. SUMMING UP Equity derivatives are an increasingly popular complement to direct stock buyback programs. While few companies rely exclusively on derivative solutions to effect a share buyback, derivatives in the form of equity forwards, total return swaps and options purchase and sale programs can, in certain circumstances, offer the prospect of improved cashflow, increased flexibility, lower acquisition costs, and reduced exposure to adverse share price movements. Website address: www.bmo.com/treasury/trcom/ For more information, please contact your GFP risk management specialist. Standard Report Disclaimer The opinions, estimates and projections contained herein are those of BMO Nesbitt Burns Inc. ("BMO NBI") as of the date hereof and are subject to change without notice. BMO NBI makes every effort to ensure that the contents herein have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. However, BMO NBI makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions which may be contained herein and accepts no liability whatsoever for any loss arising from any use of or reliance on this report or its contents. Information may be available to BMO NBI, which is not reflected herein. This report is not to be construed as, an offer to sell or solicitation for or an offer to buy, any securities. BMO NBI, its affiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein as principal or agent. BMO NBI may act as financial advisor and/or underwriter for certain of the corporations mentioned herein and may receive remuneration for same. BMO NBI is a wholly owned subsidiary of BMO Nesbitt Burns Corporation Limited, which is a majority-owned subsidiary of Bank of Montreal.
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