By: Edward D. Herlihy and Jacob A. King (CLS Blue Sky Blog)
Significant volatility continues to disrupt the equity markets, with the major stock indexes swinging multiple percentage points often on a daily basis. Inflation, rising interest rates, the Ukraine crisis, continuing effects of Covid-19, lasting supply chain issues, a difficult regulatory environment, and uncertainty regarding the global and U.S. economies have had an undeniable impact on the pace of M&A activity so far in 2022. While the opening months of 2022 have witnessed a number of significant transactions despite these headwinds, most have been all-cash deals, with only a handful of large stock or cash and stock mergers announced to date, among them the Take-Two / Zynga cash and stock transaction and, most recently, Intercontinental Exchange’s $16 billion acquisition of Black Knight announced last week. Many M&A professionals have seen at least one, and in some cases multiple, potential transactions fall victim during the negotiation stage to the effects of economic uncertainty and market volatility over the past few months, and overall M&A is down roughly 25% globally in 2022 as compared to 2021.
These issues are compounded by the increased scrutiny of and potential regulatory opposition to large scale M&A from the antitrust agencies, and the resulting extension of the interim period between transaction signing and closing. This additional regulatory delay means that transactions, and in particular deals involving stock consideration, are increasingly vulnerable to market risk over a longer time horizon. We outline below certain transaction structures that can be deployed to shift or address certain of these risks to account for the greater volatility in the current market environment. Which structure makes sense in any given transaction will depend on the parties’ objectives, the perception of the relative risks in the particular transaction, and bargaining power. Traditional fixed exchange ratio deals remain by far the most common pricing structure for all or part stock transactions, but as this period of economic, regulatory and market uncertainty persists, we expect that transaction participants may increasingly consider certain variations as possible alternatives to shift or address market risk and volatility during a protracted sign to close period.
1. Fixed Exchange Ratios
The most common and simplest pricing structure in M&A transactions involving all or some stock consideration (especially in the context of larger transactions) is a fixed exchange ratio set at the time the merger agreement is signed. The advantage of a fixed exchange ratio for the acquirer is that it allows the acquirer to determine at the outset how much stock it will have to issue, so that it can assess the per share earnings impact of the transaction with some certainty. From the perspective of target shareholders, a fixed exchange ratio allows them to share in the upside from increases in the acquirer’s stock price between signing and closing and from any positive market reaction to the potential combination.
With a fixed exchange ratio, the target’s shareholders bear market risk as it relates to the acquirer’s stock. This includes stock price movements resulting from general macroeconomic or industry changes, as well as those resulting from acquirer-specific events. But the acquirer is also at risk from a value perspective should its intrinsic value per share rise. Fixed exchange ratio transactions reflect a basic premise, applicable to many strategic stock mergers, that, absent an underlying change in either party’s business that rises to the level of a material adverse effect, market fluctuations during the interim period between signing and closing should not, in and of themselves, alter either party’s obligation to complete the transaction or affect the agreed upon pro forma ownership split of the combined company between the target’s and acquirer’s shareholders…
