When Montagu Private Equity agreed to buy part of US medical firm RTI Surgical in January, the European investor wanted a way to avoid losing out if the euro fell materially against the US dollar before the US$490m deal closed.
Notable hurdles remained to the acquisition getting over the line, including a shareholder vote and sign-off by the US government. But that did not stop banks competing fiercely to provide a risky type of derivative contract that would let Montagu hedge its currency exposure cheaply.
Such deals have become commonplace as the market for so-called deal-contingent options has roughly doubled in size over the past few years, according to industry experts.
Now, intensified competition to provide these hedges against the backdrop of historically low currency volatility is raising questions over the rigour of banks’ underwriting processes – and whether some could be opening themselves up to meaningful trading losses down the road.
"There are valid questions to be asked over whether underwriting standards are slipping. Accidents will happen at some point. It's been going remarkably well for a sustained period, and that's unlikely to last,” said Jeroen Rombouts, co-head of corporate derivatives in EMEA at Goldman Sachs.
Deal-contingent derivatives trace their origins to private-equity deals in the mid-2000s. For clients, they look like the perfect hedge: a derivatives contract that protects against adverse currency moves in the months between when a cross-border acquisition is announced and when it closes. The best bit: if the deal fails, you can walk away without paying for the derivative.
For the banks that provide them, though, they are fraught with risks. If a deal falls through, they could find themselves on the hook for sizeable losses if currency markets have moved against them.
Most banks that have long been prominent in this space have seen deals fail over the years, including Citigroup, Credit Suisse, Deutsche Bank and Goldman Sachs, according to sources familiar with the matter. No major blow-ups have come to light so far, though some believe it may only be a matter of time given the number of new entrants to the market.
“It's a risky product for the banks. We've seen a number of public deals go wrong. It's not a pile them high and sell them cheap kind of business,” said Tim Owens, EMEA head of structuring at Nomura.
The increase in cross-border M&A, which more than doubled from 2013 to peak at over US$1.5trn in 2018, has helped fuel the growth of the deal-contingent market. A concurrent slump in currency volatility has also cheapened the cost of these derivatives for clients, even as it leaves less room for error for the banks selling them.
So far, that hasn't deterred bankers generally short of profit-making opportunities in the now highly-electronified FX business.
Some of the trades – and so potential gains and losses – are huge, such as the deal-contingent hedge sources say JP Morgan provided for Takeda Pharmaceutical’s £46bn acquisition of Shire, which closed last year. JP Morgan declined to comment.
Competition is less fierce on these jumbo M&A trades given the higher risks involved. But there has been a sharp compression in prices in the private-equity segment of the market, with the cost of these derivatives declining by around a third in recent years to about 20% of the cost of a regular FX option.
Banks must fight hard to win this business, with sponsors likely to be unimpressed by anyone not competing on price, terms and speed, said Mark Beaumount, head of risk management for Europe at consultancy PMC Treasury.
“We know from [banks'] reaction times and behaviour that those approval processes internally can be very different,” he said.
Bankers can take some comfort that private-equity firms are professional investors strongly incentivised to get deals over the line. Their failure rates average 10% per year over the past decade compared with 19% for corporate cross-border deals, according to Refinitiv data. Even so, this is still a risky business.
"Ultimately there is always a portion of risk that isn't hedge-able,” said Sabine Chappard, EMEA head of strategic FX at Credit Suisse. “You can be as diligent as you like, but some deals will fail that you can't possibly foresee."
There are no shortage of examples of failures. It could involve another investor swooping in with a higher offer, such as in Temenos’ doomed bid for UK financial technology group Fidessa in 2018, or Apollo Global Management’s failed takeover of plastics giant RPC Group (the latter resulting in a windfall gain for banks thanks to currency moves).
Banks have also been blindsided by failed deals re-emerging later on, confounding so-called phoenix clauses designed to guard against such eventualities.
US private equity firm HabourVest didn't have to pay for a deal-contingent option accompanying its initial failed bid for SVG Capital in 2016, according to sources, by instead later buying the UK-based firm’s investment portfolio (which made up the vast majority of its assets). The pound fell against the US dollar during that period, effectively making the option worthless.
The risks facing banks providing these hedges was again shown when a contingent option linked to Bain Capital's investment in Germany's Stada timed out after a failed bid, only for the US firm and co-investor Cinven to succeed with a follow-up offer later on.
Banks can "end up with large concentration risk" on their books from deal-contingent options, said Benoit de Benaze, a director at consultancy Chatham Financial.
"Trades are often in the same currency pairs, same direction and some are jumbo trades."
Faced with such risks, some will only bid on deals they think are sure things. Differences in risk tolerance were apparent in the Montagu deal, where the winning bid came at below 20% of the price of the option, sources said, while another bank priced it at over double that level.
“[We] won’t trade unless we are comfortable with the risk,” said Antoine Jacquemin, global head of the market risk advisory group at Societe Generale.
Others say trying to get some measure of diversification is the right approach given the likelihood that some deals won’t get over the line.
"If individual banks are doing a meaningful number of deals a year, it's almost certain a few of those are going to fall over,” said Logan Campbell, global head of FX derivatives at Deutsche Bank.
“That's why we feel it's about having a portfolio approach to spread your risks around. We also need to be active in hedging a deal when there are warning signs."