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Mergers and Acquisitions - Collar Contracts 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 Introduction Model setup and valuation Value change through WA Welfare analysis 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 Introduction Model setup and valuation Value change through WA Welfare analysis 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 Introduction Model setup and valuation Value change through WA Welfare analysis Fixed price collar (taken from Officer (2004)) First Community Banccorp Inc. - Banc One Corp., 1994, with K = 31.96$, U = 51$, L = 47$, a = 0.6267, and b = 0.68. 34 33 32 Payoff 31 30 29 44 46 48 50 52 54 Bidder stock price An Chen Mergers and Acquisitions - Collar Contracts 4 Introduction Model setup and valuation Value change through WA Welfare analysis Fixed ratio collar (taken from Officer (2004)) BancFlorida Financial Corp. - First Union Corp., 1992, c = 0.669, U = 44.875$, L = 41.857$, K1 = 28$, and K2 = 30$. 31 30 29 Payoff 28 27 40 41 42 43 44 45 46 47 Bidder stock price An Chen Mergers and Acquisitions - Collar Contracts 5 Introduction Model setup and valuation Value change through WA Welfare analysis 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 Introduction Model setup and valuation Value change through WA Welfare analysis 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 Introduction Model setup and valuation Value change through WA Welfare analysis Collar offers and walking-away provisions 2004 2005 2006 2007 2008 2009 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: www.mergermetrics.com). An Chen Mergers and Acquisitions - Collar Contracts 8 Introduction Model setup and valuation Value change through WA Welfare analysis 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 Introduction Model setup and valuation Value change through WA Welfare analysis ...Literature 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 Introduction Model setup and valuation Value change through WA Welfare analysis 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 Introduction Model setup and valuation Value change through WA Welfare analysis Agenda √ Introduction ( ) Model setup Payoff structure of target under a collar offer Adding the walking-away provision Valuation framework Welfare analysis Conclusion An Chen Mergers and Acquisitions - Collar Contracts 12 Introduction Model setup and valuation Value change through WA Welfare analysis Two Types of Collars Fixed price collar: ΨFP (S1(T )) :=K1{L<S1(T )<U} + aS1(T )1{S1(T )≤L} + bS1(T )1{S1(T )≥U} Fixed ratio collar: ΨFR (S1(T )) :=cS1(T )1{L<S1(T )<U} + K11{S1(T )≤L} + K21{S1(T )≥U} [L, U]: collar width. a, b, K1 and K2 are usually chosen such that collars display continuous payoffs An Chen Mergers and Acquisitions - Collar Contracts 13 Introduction Model setup and valuation Value change through WA Welfare analysis Fixed price collar First Community Banccorp Inc. - Banc One Corp., 1994, with K = 31.96$, U = 51$, L = 47$, a = 0.6267, and b = 0.68. 34 33 32 Payoff 31 30 29 44 46 48 50 52 54 Bidder stock price An Chen Mergers and Acquisitions - Collar Contracts 14 Introduction Model setup and valuation Value change through WA Welfare analysis Fixed ratio collar BancFlorida Financial Corp. - First Union Corp., 1992, c = 0.669, U = 44.875$, L = 41.857$, K1 = 28$, and K2 = 30$. 31 30 29 Payoff 28 27 40 41 42 43 44 45 46 47 Bidder stock price An Chen Mergers and Acquisitions - Collar Contracts 15 Introduction Model setup and valuation Value change through WA Welfare analysis Model Setup Black Scholes economy (under Q): Stocks dynamics : Q dS1(t) =(r − q1)S1(t)dt + σ1S1(t)dW1 (t), S1(0) = S1 (bidder’s share price) Q p 2 Q dS2(t) =(r − q2)S2(t)dt + σ2S2(t) ρdW1 (t) + 1 − ρ dW2 (t) S2(0) = S2 > 0 (target’s share price) An Chen Mergers and Acquisitions - Collar Contracts 16 Introduction Model setup and valuation Value change through WA Welfare analysis Pricing Formulas Time-zero arbitrage-free price of the fixed price collar: −rT −q1T ΠFP (S1) =e K Φ −U¯2 − Φ −L¯2 + aS1e Φ −L¯1 −q1T bS1e Φ U¯1 Time-zero arbitrage-free price of the fixed ratio collar: −q1T −rT ΠFR (S1) =ce S1 Φ −U¯1 − Φ −L¯1 + K1e Φ −L¯2 −rT + K2e Φ U¯2 An Chen Mergers and Acquisitions - Collar Contracts 17 Introduction Model setup and valuation Value change through WA Welfare analysis Walking-away provisions Target payoff: Walk Ψi = Ψi (S1(T ), S2(T ))1{τ>T } + S2(T )1{τ≤T } Stopping times: τL := inf{t : S1(t) ≤ L} τU := inf{t : S1(t) ≥ U} τ := min{τL, τU } Walk Πi (S1, S2) available in semi-closed form in Black-Scholes model. An Chen Mergers and Acquisitions - Collar Contracts 18 Introduction Model setup and valuation Value change through WA Welfare analysis Parameter choices The initial target’s and bidder’s share price is fixed at S1 = S2 = 100. We use r =0.05, T = 1, q1 = q2 = 0, σ1 =σ2 = 0.2, L = 80, U = 120, ρ = −0.5. Collars usually display continuous payoffs K K a = , b = , K = c L, and K = c U L U 1 2 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 S2. An Chen Mergers and Acquisitions - Collar Contracts 19 Introduction Model setup and valuation Value change through WA Welfare analysis Effect of walking-away: fixed price collar Price Diff of FPP by adding walking-away 0.2 0.0 -0.2 r=-0.5 -0.4 r=0 r=0.5 -0.6 0.05 0.10 0.15 0.20 0.25 0.30 s1 vola of bidder's asset An Chen Mergers and Acquisitions - Collar Contracts 20 H L Introduction Model setup and valuation Value change through WA Welfare analysis Effects of σ1 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) σ1 ↑ ↓ ↑↓ ↑ − (−) ↓ (ρ < 0) The today’s price of this payoff Ψtar 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 Introduction
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