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Managing market volatility in the context of scrip consideration

01 June 2022 | Australia
Legal Briefings – By Adam Charles and Lachlan Johnson

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In Australia, market volatility has been a theme of 2022 and one many expect to continue to be relevant in the immediate future. We analyse how market participants can address this volatility in the context of deals with a scrip consideration component.

In brief 

  • Listed equities investors have already experienced much volatility in 2022, and many experts predict such volatility to persist in the immediate future. Nevertheless, 45% of public M&A deals in the year to date have involved scrip consideration.
  • There are a variety of protections that parties to scrip deals may utilise in order to protect value in the period between signing and completion – including collars, mixed consideration, cash top ups, hedging, ticking fees and market fall termination rights.
  • As the current volatility in equity markets continues, we expect market participants to consider the options available to mitigate market risk.

Introduction

Listed equities investors have experienced much volatility already in 2022 and many experts predict the rest of the year won’t be any smoother.

Significantly, 45% of public M&A deals during the year to date have involved scrip consideration. However, whether this trend continues may be impacted by volatility in bidders’ share prices.

In this context, it is a useful time to discuss a key issue in deals involving scrip consideration – value protection for target shareholders and the bidder during the period between signing and completion.

Fixed v floating exchange ratios

Broadly speaking, the parties to a scrip consideration transaction must select between:

  • a fixed exchange ratio, whereby the bidder agrees to issue a specified number of its shares in exchange for a target share; or
  • a floating exchange ratio (sometimes called a “fixed value” deal), whereby the bidder agrees to pay a fixed dollar value, in the form of bidder shares, for a target share.

The vast majority of scrip transactions undertaken in Australian are structured using a fixed exchange ratio. For example, in the year to date, only one takeover or scheme has been structured using a floating ratio, excluding acquisitions of listed investment companies - being Qantas’ acquisition of Alliance Aviation Services, as discussed below.

However, between the two book-ends of a fixed v floating exchange ratio, there is a wide spectrum of alternative structures that can be adopted.

Fixed exchange ratios

A fixed exchange ratio allows the bidder and the target to know, on entry into the implementation agreement, precisely how many bidder shares will be issued on completion of the transaction.

For this reason, a fixed exchange ratio has a logical appeal in the case of mergers of equals and other transactions where the parties are focused on allocating the post transaction equity in the bidder on the basis on the fundamental value of the businesses being combined, and potential movements in the bidder’s share price between signing and completion are considered less material.

However, given that the number of shares to be issued is fixed:

  • if the bidder’s share price appreciates between signing and completion, the bidder is effectively paying more for the target than was contemplated on signing and diluting its own shareholders; whereas
  • if the bidder’s share price depreciates between signing and completion, the bidder is effectively paying less for the target than was contemplated on signing.

The outcome will also be driven by movements in relevant exchange rates in the case of foreign currency denominated scrip.

Absent the use of available protections (as described below), the potential for value to transfer presents risk to both the bidder and target shareholders.

From the bidder’s perspective, this is particularly unappealing insofar as the target shareholders effectively hold a free option – that is, they get to elect to participate in positive movements in the bidder’s share price (and relevant foreign exchange rates) by voting in favour of the scheme or accepting the takeover (as applicable), at least to the extent such movements occur prior to the scheme meeting or the date of acceptance.

However, the parties may take the view that this risk is not sufficiently material to warrant adopting an alternative approach. For example, if the parties are in the same sector and/or their historic share prices have moved together, the parties may expect that their prices will be similarly impacted by sector-wide or ASX-wide price movements going forward and any bidder-specific issues that cause movements in its price can be addressed via other protections in the implementation agreement. Alternatively, in a distressed scenario, the target may not have the requisite leverage to negotiate an alternative structure.

Floating exchange ratios

Where a floating exchange ratio is used, the bidder agrees to pay a fixed dollar value of bidder shares in exchange for each target share, with the number of bidder shares to be determined with reference to the bidder’s share price at the time of closing.

For example, under Qantas’ current proposed acquisition of Alliance Aviation Services via scheme of arrangement, it is proposed that each Alliance shareholder will receive $4.75 in Qantas shares for each Alliance Airways share they hold, with the number of shares to be determined with reference to Alliance 20 day VWAP preceding the scheme record date.

This structure may appeal insofar as it may encourage target shareholders to view the offer as a fixed cash offer.

However, given that the number of shares to be issued will float:

  • if the bidder’s share price appreciates between signing and completion, the transaction will be less dilutive to its shareholders, and the target shareholders will own less of the bidder post transaction, than was contemplated on signing; whereas
  • if the bidder’s share price depreciates between signing and completion, the transaction will be more dilutive to its shareholders, and the target shareholders will own more of the bidder post transaction, than was contemplated on signing.

This uncertainty in the bidder’s capital structure is the fundamental issue with floating exchange ratios. Among other things, it will impact the EPS accretion / dilution as a result of the transaction, the pro forma allocation of equity as between the bidder’s and target’s shareholders, may give rise to the need for the bidder’s shareholders to approve the transaction under ASX Listing Rule 7.1 and equivalent foreign listing rules and securities laws, and trigger debt and other contractual change of control triggers.

A critical issue when using a floating exchange ratio is the date for determining the number of shares to be issued. For example, in the case of a scheme, there are three available windows:

  • after the first court hearing, but before the scheme meeting;
  • after the scheme meeting, but before the second court hearing; or
  • after the scheme is effective.

If the determination is made before the scheme meeting, target shareholders will be left with an option to vote the scheme down with reference to the determination and any subsequent movement in the AUD value of the bidder’s share price prior to the meeting.

If the determination is made after the scheme meeting, the bidder will have removed the risk that target shareholders vote down the transaction because of the determination or any subsequent movement. However, in that scenario, the target shareholders will be at risk of a downward movement in the bidder’s share price until they receive the shares.

That risk could be addressed by the target shareholders hedging their exposure to the bidder’s share price. However, until the second court hearing, the scheme will still be conditional, such that the hedging will present some risk to the target shareholders. Accordingly, it might be most advantageous to make the determination once the scheme becomes unconditional.

In addition, it may be attractive for an investment bank to offer a fixed cash price for the scrip consideration via a share sale facility, if the determination is made once the scheme becomes unconditional.

Protections

As noted above, a share sale facility is one option for dealing with the risks presented by a floating exchange rate. However, there are various other available mechanisms to address the risks arising from both fixed and floating ratios.

As with anything that creates possible uncertainty about pricing or whether a transaction will complete, the protection mechanisms outlined in this article may attract attention from arbitrageurs and place pressure on the bidder’s and target’s respective share prices.

Collars

In order to address the risks presented by fixed and floating exchange ratios, the parties can adopt a “collar” feature in the pricing mechanic.

Fixed exchange collars

In the case of a fixed exchange ratio, to protect the target shareholders from a fall in the bidder’s share price and the bidder’s shareholders from overpaying where it’s share price appreciates, the terms of the offer can provide that the target shareholders will receive a fixed number of shares unless the price of the bidder’s shares moves outside of a specified range. If the bidder’s share price moves outside of the range, the number of shares would adjust.

Floating exchange collar

In the case of floating exchange ratio, the terms can provide that the bidder will only issue a specified maximum number of shares if its share price falls below a specified price. In that scenario, the target shareholders will have lost the opportunity to receive the value that would otherwise have been received.

The target may seek for the collar to provide that the bidder must issue a specified minimum number of shares if its share price rises above a specified price.

However, in any event, as with a fixed exchange ratio, target shareholders will have a free option to take up the value on offer or not.

Asymmetrical collar

Whilst collars are commonly symmetrical, they can also just provide protection against only rises or falls in the bidder’s share price.

An example of such a mechanism was the US takeover of Frontier Corporation by Global Crossing in 1999. In that transaction, Global Crossing’s share price had risen significant immediately prior to entry into the merger agreement and Frontier wanted to ensure that it received adequate protection in the event of a decline. Frontier secured a floating exchange ratio that adjusted for up to a 30% decline in the bidder’s share price and a termination right in the event this was exceeded; however, in the case of an appreciation in the price, Frontier agreed that the ratio did not become fixed until there had been a 10% appreciation. The 30% threshold was in fact exceeded post signing and the parties negotiated a higher fixed ratio deal.

Mixed consideration

If the consideration is a mixture of cash and scrip, the cash component will mitigate the value impact of movements in the bidder’s share price

Cash top up mechanism

The consideration could be comprised of a floating exchange ratio of scrip and a variable cash component, with the cash component to be adjusted so as to offset movements in the bidder’s share price.

Market fall termination rights

In addition to collars, either the target or the bidder may also seek a termination right triggered by a fall in the bidder’s share price or the market generally. These can be drafted so as to have only a single trigger referable to the bidder’s share price or a double trigger that requires that the bidder’s price must decline by a specified threshold relative to a basket of peers or a market index.

Termination rights linked to a collar

For example, in the case of a floating exchange collar, the target may require a termination right in the event that a fall in the bidder’s share price triggers the collar and results in the target shareholders missing out on value that would otherwise have been received. In that scenario, the termination right could be triggered at the same price as the collar or a specified lower price.

In the case of such a termination right, the bidder could seek a right to top-up the consideration before the termination right can be exercised.

General termination rights

In addition to a termination right linked to a collar, the target may also seek a termination in the event that the bidder’s share price falls below a specified price.

Equally, where a floating exchange rate is used, the bidder may seek a termination right where its share price falls below a specified price, as an alternative to a floating exchange collar.

Hedging arrangements in relation to the bidder’s share price

The bidder could utilise various types of hedging arrangements with reference to its own equity in order to minimise the impact of the exchange ratio.

For example:

  • in the case of a floating exchange ratio, the bidder could enter into a net share settled put option in order to protect against dilution resulting from a depreciation in its share price;
  • in the case of a floating exchange ratio that operates subject to a ceiling and floor, the exchange ratio could be fixed within the ceiling and the floor prices using a put and call structure; or
  • in the case of variable cash consideration and a fixed exchange ratio, the bidder could enter into a cash settled put option to protect against increases in the cash consideration resulting from a depreciation in its share price.

Ticking fees

The period of time between signing and closing is often primarily driven by the time required to secure necessary regulatory consents. In that sense, contractual mechanisms that incentivise a bidder to move quickly to secure the necessary consents will act as an indirect mitigant of the market risk attaching to the bidder’s share price.

One such mechanism is a “ticking fee”.

The classic ticking fee takes the form of an increase in the per target share consideration as the period of time between signing and completion passes certain milestones. Conventionally, ticking fees are paid in cash; however, there is no reason why a fee could not take the form of scrip consideration.

Alternatively, a ticking fee could take the form of a permitted dividend to be paid by the target, fully or partly franked. The recently announced acquisition of Alliance Aviation Services by Qantas, referred to above, included such a mechanism. 

Whilst these fees may not adequately provide economic compensation for volatility in the bidder’s share price, they may otherwise address this risk. In addition, these fees may be useful in compensating target shareholders for the opportunity cost of an extended period to completion if interest rates rise.

Select market examples of the protections

The below table sets out certain examples of how market participants have used mechanisms to protect against market volatility.

Target & bidder

Date

Description

Mitula / LIFULL

2018

  • Scheme of arrangement.
  • Mitula shareholders who did not make an all scrip election would be entitled to receive (i) $0.80 cash per Mitula share for their first 20,000 Mitula shares and (ii) 0.0753 LIFULL shares for each remaining Mitula share, subject to the below.
  • Under the original terms agreed between the parties:
    • If there was a decline of 10.7% or less between the Australian dollar equivalent of the LIFULL share price prior to entry into the implementation agreement and the LIFULL 10 VWAP preceding the scheme record date, the share exchange ratio would correspondingly increase.
    • If there was an increase of 8% or less between the Australian dollar equivalent of the initial LIFULL share price and the LIFULL 10 VWAP preceding the scheme record date, then the exchange ratio would not be adjusted.
    • If there was an increase of more than 8%, then the exchange would correspondingly decrease.
  • No termination rights linked to bidder’s share price, market indices etc.
  • The parties subsequently agreed to amend the consideration mechanism such that, if the value implied by the LIFULL share price was less than $0.80 per share, an additional amount of money equal to $0.80 minus the value of the scrip would be added to the scrip consideration (up to a maximum of $10 million).

AXA APH and AMP & AXA SA

Nov 2010

  • Scheme of arrangement.
  • AXA APH shareholders would receive (i) 0.73 AMP shares and (ii) a variable cash component with reference to the AMP share as follows:
    • if the AMP 10 day VWAP following the effective date was between $4.50 and $5.60, the total value received by shareholders would equal $6.43;
    • if the AMP 10 day VWAP was higher than $5.60, shareholders would receive 50% of the benefit of the increase in the value of the share component (with the increase in the value of the share component being partially offset by a reduction of the cash component equal to 50% of the increase in the share component value); and
    • if the AMP 10 day VWAP was less than $4.50, the cash component would be fixed at $3.145.
  • The independent AXA APH directors were entitled to terminate the implementation agreement if the AMP 10 day VWAP at any time prior to the scheme meeting was less than $4.50 (without a break fee being payable). The implementation agreement could not be terminated if the VWAP post the effective date was less than $4.50.

Dyno Nobel / Incitec Pivot

March 2008

  • Scheme of arrangement.
  • Dyno Noble shareholders would receive (i) 0.01406 IPL shares and (ii) $0.70 per Dyno Nobel share, subject to the below.
  • If the IPL 10 day VWAP preceding the second court hearing was less than $138.16, the exchange ratio would be increased so that that the value of the consideration equalled $2.64 per Dyno Nobel share.
  • If the IPL 10 day VWAP was less than $126.96, IPL was entitled to terminate the implementation agreement (without a break fee being payable).

HPAL / Salmat

Sept 2007

  • Scheme of arrangement.
  • HPAL shareholders who did not make a cash election would be entitled to receive between 0.5040 and 0.5784 Salmat shares per HPAL share.
  • The exchange ratio was determined by dividing the cash consideration offered by the Salmat 10 day VWAP preceding the scheme meeting.
  • If the Salmat 10 day VWAP preceding the scheme meeting was between $4.40 and $5.05, the exchange ratio would be calculated by dividing the cash consideration offered by the Salmat 10 day VWAP.
  • If the Salmat 10 day VWAP was equal to or less than $4.40, the exchange ratio would be 0.5784.
  • If the Salmat 10 day VWAP was equal to or greater than $5.05, the exchange ratio would be 0.5040.
  • If the number of shares to be issued >33m, a pro rata scaleback would apply (with cash consideration being paid in lieu of the balance).
  • No termination rights linked to bidder’s share price, market indices etc.

Healthscope / Symbion

May 2007

  • Scheme of arrangement.
  • Symbion shareholders would receive (i) $1.90 and (ii) between 0.409 and 0.4642 HSO shares per Symbion share.
  • The exchange ratio was determined with reference to the HSO 10 day VWAP preceding the scheme meeting.  
  • If the HSO 10 day VWAP was equal to or less than $5.30, the exchange ratio would be 0.4642.
  • If the HSO 10 day VWAP was greater than $5.30 but less than or equal to $5.60, the exchange ratio would be between 0.4633 and 0.4401.
  • If the HSO 10 day VWAP was equal to or greater than $5.60 but less than or equal to $6.05, the exchange ratio would be 0.4092.
  • If the HSO 10 day VWAP was greater than or equal to $6.06 but less than $6.51, the exchange ratio would be between 0.4398 and 0.4092.
  • If the HSO 10 day VWAP was equal to or greater than $6.51, the exchange ratio would be 0.4089.
  • If HSO 10 day VWAP was less than $5.30, Symbion could elect to terminate the implementation agreement (without a break fee being payable).
  • If the S&P/ASX200 fell 15% or more below its level on entry into the implementation agreement, HSO could terminate the implementation agreement (without a break fee being payable).

TAB / TABCORP

2004

  • Hostile takeover offer.
  • Bid consideration was (i) $2.00 and (ii) between 0.20 and 0.22 TABCORP shares per Tab shares.
  • The exchange ratio was determined with reference to the TABCORP 10 day VWAP following the bid being declared unconditional.
  • If the TABCORP 10 day VWAP was equal to or less than $11.36, the exchange ratio would be 0.22.
  • If the TABCORP 10 day VWAP was between $11.36 and $12.50, the exchange ratio would be determined by dividing $2.50 by the VWAP.
  • If the TABCORP 10 day VWAP was equal to or greater than $12.50, the exchange ratio would be 0.20.
  • No termination rights linked to bidder’s share price, market indices etc.

Independent expert’s report

Material movement in the bidder’s share price may raise a question as to whether an independent expert’s opinion should change and its report be supplemented (irrespective of a change).

In the event of a material change in circumstances affecting a report, or a statement in a report becoming misleading or deceptive, a failure to provide a supplementary report may constitute misleading or deceptive conduct.

If a supplementary report is to be provided, the question arises as to what form it should take.

This issue arose in the case of Block’s recent acquisition of Afterpay.

In light of a significant depreciation in Block’s share price prior to the scheme meeting, Afterpay sought a reconfirmation from the expert in the week prior to the meeting that it continued to consider that the scheme was fair and reasonable.

The expert provided the reconfirmation via a supplementary letter and ASIC questioned whether the reconfirmation was appropriate unless the valuation was effectively re-calculated using all of methodologies disclosed in the original report.

The court concluded that ASIC’s approach would give rise to practical challenges in periods of volatility, given that any recalculation could be made redundant by continued volatility.

Target directors’ recommendation

Movement in the bidder’s share price will also bring into question the target directors’ recommendation.

Market practice is that, in the case of an agreed transaction, the target directors will be required under the implementation agreement to recommend the transaction subject to the expert concluding (and continuing to conclude) that the transaction is fair and reasonable (or in the best interests of shareholder) and there being no superior proposal.

However, the directors are required by their fiduciary and statutory duties to monitor the situation and advise shareholders if they change their recommendation.

A depreciation in the bidder’s share price could conceivably require a change in recommendation in circumstances where the expert has not changed its recommendation and no superior proposal has emerged. In this scenario, target directors may be forced to cause a breach of the implementation agreement and trigger a break fee obligation, in order that their duties are discharged.  

Conclusion

Although the majority of transactions will continue to utilise a fixed exchange ratio, if the market continues to be volatile, market participants may have to revisit some of the techniques considered in this article in order to get transactions agreed.

Nonetheless, as the current volatility in the equity markets continue, we expect that market participants will consider the available options for mitigating market risk.

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