Investment Banking

Chapter 7: Regulations and Risk Management

Thach H. Pham (PhD)1

February 10, 2024

1
thach.ph@ou.edu.vn
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Outline

1 Differences of Opinion

2 Collar

3 Merger Arbitrage
Key Concepts & Skills

Risk of overpayment of the Bidder

An earnout agreement
Contingent value rights and collar
Merger arbitrage strategy

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Topic

1 Differences of Opinion

2 Collar

3 Merger Arbitrage
Earnout

The difference of opinion between the Bidder and the Target

Uncertainty about cash flows and/or discount rate
Possible outcomes:
No deal
Closing at some point
An earnout agreement

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Pros of An Earnout

Screen out Targets misrepresenting their potential performance

Bridge the valuation gap between the two parties, making the
deal possible
Provides an incentive to the Target’s owner/ manager to remain
with the firm after the sale and to pursue an aggressive strategy,
because part of the payment is pegged to Target’s results
Like a vendor loan (which is a loan provided to the Bidder by
the Target itself)

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Cons of An Earnout

Difficult to negotiate an earnout when the Target is fully

integrated into the Bidder
Demotivating the management (the portion of price is too small)
Problematic when the computation of the contingent payment is
too complex or ambiguous
The Target’s shareholders run the default risk of the Bidder (the
risk of Bidder being unable to pay the contingent payment)

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Earnout Valuation

DCF
Value according to the Bidder > Consideration at closing + Bidder’s
valuation of Earnout
Value according to the Target < Consideration at closing + Target’s
valuation of Earnout

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Earnout Valuation (contd.)

An Example
The Bidder thinks that the Target value is €30 ml, while Target
thinks the fair value is €40 ml. The Bidder believes that the EBITDA
growth rate for next few years cannot be greater than 5% per annum.
In contrast the Target thinks that a reasonable growth rate is 30%
They negotiate the following consideration: (a) €20 ml cash and (b)
1 times the EBITDA at year-end five. Target’s current EBITDA is
€10 ml. Assuming a discount rate equal to 10% (for both parties),
the deal appears convenient to both Bidder and Target.

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Earnout Valuation (contd.)

Earnouts as Options
EBITDA = b × R + a
The payoff of an earnout:

[ ]
H−a
M × Max[b × R + a − H; 0] = M × b × Max R − ;0
b

Suppose that the threshold is set at EBITDA0 . The payoff of the

earnout is then:

M × b × Max[RT − R0 ; 0]

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Earnout Valuation (contd.)

An Example
The agreement:
2X Max[EBITDA5 - €10 ml; 0]
Assume the following Revenues-EBITDA function:
EBITDA = 0.5 x R - €5 ml
R0 = €30 ml

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Earnout Valuation (contd.)
Call (Bull) Spread

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Earnout Valuation (contd.)

Techniques
The analytical approach (Black-Scholes or any closed forms):
theorectical (unrealistic), not flexible
Monte Carlo simulations: chosen distribution, flexible

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Contingent Value Rights (CVRs)

Negotiate a price guarantee against a price drop of the

combined shares
Range from plain vanilla to exotic options, sometimes structured
as binary (or digital) options (i.e., all-or-nothing payment)
Can take the form of cash compensation or the issuance of new
shares by the combined firm

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Topic

1 Differences of Opinion

2 Collar

3 Merger Arbitrage
Fixed-Exchange Collar

A fixed-exchange collar specifies a constant exchange ratio over

a range of Bidder stock prices, with adjustments outside that
range
The ownership structure of the combined firm (i.e., the Bidder
post-merger) is therefore defined, but the value that the
Target’s shareholder will receive at closing is uncertain, as it
depends on the Bidder stock price on that date

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An Example

The exchange ratio is 2 and it is based on stock price equal to

€5 and €10 for Bidder and Target, respectively
Target has 1,000 shares outstanding
Two alternative scenarios about Bidder stock price at closing
(several months later): (a) the price per share is €10 and (b)
the price per share is €1
Suppose that the Target stock price is unchanged (€10)
Fixed-exchange collar: the number of shares will be fixed if
Bidder stock price is between €2 and €8

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Payoff of a Fixed-Exchange Collar

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The Value of a Fixed-Exchange Collar

Equal to the premium of a put with strike at the minimum price

of the range less the premium of a call with strike equal to
maximum price of the range

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Fixed-Payment Collar

The Bidder and the Target decide to fix the value to Target’s
shareholders
Whatever the Bidder stock price at closing, the value to Target
shareholders is certain: however the ownership structure is
uncertain, as the number of shares is adjusted according to the
Bidder stock price

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Payoff of a Fixed-Payment Collar

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The Value of a Fixed-Payment Collar

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Topic

1 Differences of Opinion

2 Collar

3 Merger Arbitrage
The Arbitrage Spread

Once a deal (M&A) is announced, the “arbs” long on Target

shares and short on Bidder shares. This position is at the risk of
the deal, but not exposed to the market risk.
The difference between the current Target’s price and the bid
price offered by the Bidder is the “arbitrage spread”
The arbs’ problem is to maintain the spread until the merger is
consummated
The main risk for the merger arbs is that the deal may not go
through: this risk is particularly high in hostile tender offers (due
to competing bids of just to the failure of the offer).

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An Example

Suppose a stock deal is announced with exchange ratio equal to

1. The Bidder and Target stock prices (post-announcement) are
€10 and €8 respectively
The arbs’ short sells one Bidder share, getting €10, and
purchases one (since the announced exchange ratio is 1) Target
share, paying €8, thereby indirectly acquiring one Bidder’s share
(if the merger succeeds): they now gains €2
At closing the profit from the long position is: (pB – €8), while
the profit from the short position is (€10 – pB ). The net profit
is €2 for any pB .

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The Interpretation of the Arbitrage Spread

The Interpretation
The current Target stock price can be seen as the
probability-weighted average of two outcomes:
the deal is consummated and the Target’s shareholders get the
bid price
the merger fails and the Target price is at its stand-alone level

The Formulas
PCurrent
T = Prob. × pBid Alone
T + (1 − Prob.) × pT

pCurrent
T − pAlone
T
Prob. =
pBid
T − pAlone
T

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The Interpretation of the Arbitrage Spread (contd.)

An Example

What is the implied probability of successful deal completion?

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