I'd be interested to see how others are managing this risk.
In a cross-border leveraged buyout the assets of the acquired firm are denominated in a foreign currency, affecting leverage and important deal metrics (debt coverage ratios, internal rate of return.) The valuation of those assets is exposed to FX risk, as is the company valuation. Post-close, FX risk exists in the discounted value of the future cash flows translated from a foreign currency into the functional currency of the parent.
Because negotiations, due diligence and closing period can take 6-9 months or longer, and more importantly, the deal may not even close; hedging the value of the assets against FX moves can be difficult. Forwards cannot be used because the asset will remain in the possession of the hedger if the deal closes – it is not like hedging a future cash flow. Hedging with a vanilla option is quite expensive for long tenors.
I've come up with three alternatives for managing value of foreign currency denominated assets pre-close:
- The first is a contingent premium option. It is similar to a vanilla European Put or Call, except that the premium is not paid up front, but deferred to expiry, and then only paid if the option expires in the money. This obviates the need for the acquiring entity to put any money at risk until the close. Still, there is the risk that the option will expire only slightly in the money.
- The second is a compound option. A compound option is an option on an option – in other words, an option to trade another option. A premium is first paid for the compound option. At the expiry, the holder decides whether to exercise the compound option. If it is exercised, the holder receives an option on the underlying but has to pay a second premium. If both options are exercised, then the compound option will be more expensive than an vanilla option on the underlying. Two sets of parameters, one each for the underlying and compound option, are required. As such, the combined volatility (that is, the volatility of volatility) of both options significantly affects their price.
- The last alternative is a cancelable cliquet option. This is an option that periodically settles and resets its strike price at the level of the underlying (e.g. the currency pair current spot). At the reset dates, the option locks in the difference between the old and new strike and pays that out as profit. If the underlying spot has moved the “wrong” way, there is no payout and the hedger loses the premium.
Post-close, hedging the foreign cash flow for long periods (similar to managing translational FX risk) with cross-currency interest rate swaps works well.
I'd be interested in others experience in this area.