Driving deals through choppy waters – deal contingent hedging in 2024

RegCORE Client Alert | Capital Markets Union

QuickTake

Completion risk is certainly not new… however heightened geopolitical and trade tensions, increased volatility across capital markets, persisting inflation plus an uncertain outlook for economic growth across G-20 economies are all reshaping how various M&A deals and non-recourse financing transactions are structured, executed and how long they on average take to close and/or complete. In addition, certain transactions are exposed to delays in regulatory, competition and/or other governmental approvals along with other risks that can radically alter a party’s expected return profile for longer than before. In response, many financial services firms are offering institutional investors, other financial market participants or non-financial corporates (NFCs) (collectively users) deal contingent hedging (DCH) arrangements. When structured and documented correctly they can offer a flexible (and sensible) means to mitigate and hedge risks.

Even if markets may remain choppy for some time, the brightening outlook and appetite for deal volume, whether M&A, IPOs but also take private and non-recourse financing transactions, DCH arrangements may likely be very much in demand. In short, if deals are to be done, especially during greater uncertainty, there are risks that need to be hedged through to completion. Choosing the right DCH dealer is important but so too is the documentation so as to ensure the DCH arrangement does not lead to a costly misfire. 

This Client Alert focuses on some of the contractual, legal, regulatory obligations and other issues that users may want to (re-)familiarise themselves when considering how to structure and document DCH arrangements both domestically as well as cross-border, whether in the EU or further afield. This is particularly important as the market for DCH may grow in the EU, so too will the supervisory scrutiny. 

Advantages of DCH arrangements and differences to other tools

Risks that can be priced (or at least marked-to-market or marked-to-model) typically can be hedged. In terms of exposures, DCH arrangements have historically been used to primarily manage FX and interest rate risks in the context of M&A transactions. In recent years they have also expanded to hedge bond yields as well as a range of other underlying deals including infrastructure and project finance deals as well as IPOs and take-privates. 

When a user enters into a DCH arrangement with a DCH dealer, the user and dealer agree to lock in a price or rate that is contingent on a specified event – usually the closing of a particular underlying deal – occurring. If the specified event occurs, the hedge applies. If the underlying deal fails to close, the DCH is cancelled without any cost to the user. In economic terms, DCH arrangements are essentially a composition of one or more OTC derivative transactions that are entered during an early stage of a deal but before satisfaction of all conditions to closing (including specific milestones, such as obtaining regulatory and/or governmental approval) have occurred. 

DCH arrangements can be contrasted with other OTC derivatives in the traditional deal-related risk mitigation toolkit. Some of these more traditional tools include forwards, options, forward starting swaps or swaptions (an option to buy a swap), regardless of whether used as a pre-hedge (more on that below). Aside from breakage costs, forward starting swaps are useful when a completion date is known but less so when there is completion uncertainty. Swaptions are generally viewed as too expensive to price. Such traditional tools are also at times also costly to run with mark-to-market exposures or premiums due in addition to collateral needing posting as well as custody.

The main benefit to a user of a DCH arrangement is that where the specified contingent event (usually completion) does not occur, the DCH falls away at no cost to the user i.e., the non-DCH dealer party. This is in contrast to their plain vanilla counterparts where two parties agree at the outset (and not only upon a contingent event occurring) that the swap, forward, option etc., as an obligation, is to be settled on a pre-specified date in the future. 

Moreover, many DCH-dealers, require no or only nominal upfront payments to lock in the forward rate and the DCH arrangement. DCH dealers (which internally may involve multiple desks and disciplines to quickly, competitively and consistently price DCHs) focus much of their assessment (including on advice of counsel and traditional as well as AI powered due diligence – see for example how we use Rule Scanner to track, triage and tackle legal and regulatory developments) on the likelihood (above a certain confidence level) of completion occurring in light of all external and internal factors relevant to a transaction. 

The economic reward for DCH dealers is a premium on a contingent trade that, from their perspective, is only on their books for a limited period and at a lower regulatory capital treatment when compared to a traditional hedge. However, in the event completion does not happen the DCH dealer risks losing the premium that would have been payable to the dealer by its client seeking DCH protection so interests are typically perhaps more aligned that a contingent event occurs and a DCH arrangement comes about. Yet, if the deal and/or DCH arrangement misfires, the DCH dealer may have to settle any back-to-back trades to hedge the dealer’s own risk and thus possibility of crystallising a significant loss. 

Key contractual considerations in DCH arrangements

The majority of DCH arrangements are contractually constructed using well-established but nevertheless very bespoke tailored application of principles that stem from the ISDA Master Agreement documentation suite. In most instances, instead of documenting DCH arrangements under an existing ISDA Master Agreement and Schedule, a DCH arrangement is transacted using a heavily modified standalone Long Form Confirmation (LFC) – which are contractually and conceptually subject to either (i) a hypothetical i.e. “deemed” ISDA Master Agreement and/or (ii) a commitment by the parties to, by a certain date, enter into an ISDA Master Agreement and incorporate the respective legal and economic terms into that hypothetical ISDA Master Agreement, as modified by its hypothetical Schedule and as supplemented by a Trade Confirmation. 

The LFC is always transacted subject to a “deemed ISDA” with a view that the parties will sign a full ISDA and Schedule plus Confirmations at a later date (if at all). The LFC is used to achieve such flexibility (equally in speed of negotiating terms) but equally to ring-fence the DCH arrangement from any broader economic relationship in existence or which may be contemplated between the parties.

From a practical drafting perspective, a LFC will incorporate certain terms from the hypothetical ISDA Master Agreement and a limited number of elections and modifications typically set out in an ISDA Schedule as well as stipulated in published ISDA Protocols and Definition Booklets that are incorporated, by reference, into the LFC. 

The non-economic (i.e. legal and party-specific) terms of the LFCs may differ between various banks offering DCH solutions inasmuch as the economic terms of each LFC will be bespoke to the transaction and risk exposure it aims to hedge. DCHs should not therefore be confused as constituting a set of plain vanilla derivatives and the provisions of the LFCs are certainly not conceptually equivalent to terms in plain vanilla ISDA or other (such as German or French) Derivatives Master Agreement documentation suites, but rather are highly bespoke and tailored. Like their traditional counterparts though, the overriding requirement of any DCH arrangement, certainly from a user’s perspective, is that the hedge is in place at the time of closing, completion or whatever the contingent event is and the DCH arrangement is capable of settling. Careful consideration and drafting of contractual terms is therefore recommendable.

Some of the key contractual considerations that parties may typically want to review/amend include:

• Clearly and definitively establishing what constitutes “completion”: while this sounds simple, this is an area of negotiation and often fundamental disagreement – depending on deal type – as to whether to use the terms and definitions, as used in the underlying transaction documentation, or to modify such terms further. This is crucial, as the chosen definition in the LFC will constitute the contingent event for the DCH to apply or, if not satisfied, to otherwise fall away. Getting the definition right, and at the outset, aims to avoid risks of future (costly) disputes further down the line. The same is true when establishing who and when confirms that a completion condition is satisfied – i.e., regulatory/governmental clearance is an event with sufficient certainty as to when a notification is published, however other circumstances, in particular where there is no reliance on a third party’s independent assessment of a condition being satisfied, may require closer assessment and careful negotiation.
• Drafting of bespoke Additional Termination Events (ATEs) in the LFC: to cater for specific conditions to completion and/or pari passu treatment in respect of any guarantees and collateral package (depending on the deal) and more broadly, for the parties (in most instances the DCH dealer) to terminate the DCH arrangement prior to completion. A sensitive point for negotiation may be around liability issues in the context of when an ATE arises. Importantly, while not spelled out in full, LFCs are still subject to standard ISDA events of default or termination events, including breaches of covenants, representations and warranties, unless the parties have agreed to the contrary. An Early Termination Date and termination payments will be due if these events are triggered. 
• How to deal with amendments in underlying transaction documents: deals are living transactions and underlying transaction documentation may be subject to changes during the period between a LFC being entered into and the eventual trigger of completion, the occurrence of an ATE or any other event. Negotiations concerning underlying transaction documents need to be carefully considered as to how they may impact the terms or rights under the LFC. In many instances the LFC may impose notification requirements in respect of proposed as well as actual amendments that may be made to underlying transactions. Negotiation will focus on what information can actually be notified and what pre-clearance can be granted depending on the role and/or interest of the user and observing also applicable rules on insider information (more on that below). 
• Ratcheting: some DCH arrangements may include a ratcheting structure with clauses that allow for a price reduction if the underlying transaction closes earlier than expected. Equally, such clauses may also be drafted to include higher pricing if closing takes longer to achieve. In such circumstances the DCH dealer aims to be compensated for providing protection for a longer period than anticipated. 
• Lookback or phoenix clauses: are clauses that aim to mitigate the DCH dealer’s risk exposure under any back-to-back trade it has entered into in connection with a DCH arrangement. The aim of these clauses are to ensure that even if the underlying transaction subject to the DCH arrangement fails to complete but another transaction (or series thereof) which is deemed as “equivalent” (what is equivalent will be subject to negotiation) to the underlying transaction completes within a specified period (equally subject to negotiation) these clauses require a true-up between the DCH dealer and the user as its client. The aim of this clause and the true-up is to place the parties on the same footing and thus to compensate the parties by such means as if the original deal subject to a DCH arrangement had completed within the specified time period. It is also a contractual means of preventing parties form delaying or avoiding completion so as to circumvent the payment obligations that are due in situations where underlying rates, whether in spot markets or elsewhere, of what is being hedged have moved in favour of the protection buyer, i.e., the client of the DCH dealer. Agreeing the length of the lookback period and what is “equivalent” requires careful negotiation. Attention should also be given to the basis and methodology upon which a dealer calculates its loss or gain in an “equivalent” transaction.
• LFC settlement: while LFCs and their settlement follow well established concepts, rights and obligations as set out in ISDA Master Agreements, it may be recommendable to ensure that that the settlement arrangements of the LCF follow the underlying transaction’s funding arrangements, so as to not delay underlying deal considerations. 
• Interrelation between LFC and other DCH related trades or unrelated trades: in many instances a LCF for a DCH arrangement may be flanked by other trades or may co-exist with other trading and hedging relationships with the respective DCH dealer. Ensuring that the LCF and its bespoke arrangements are not a victim nor a contributor to cross-default or cross-pollution risks in increased risk exposure to that DCH dealer and/or its affiliates will of course be important for the user, both in the LCF but in on-going monitoring of the counterparty and other transaction risk exposures over time of the given trade(s) as well as the underlying transaction. 

While there is no official established set of standard terms (including in respect of the issues highlights above), there is market consensus on what constitutes good and bad drafting. That consensus however has by and large not (as of the time of writing hereof) been tested in respective courts or other dispute resolution venues and certainly not in those in the EU.

Moreover, even if the European market is increasingly attractive to DCH dealers delivering on the demands of DCH users, the default drafting of governing law and jurisdiction clauses in the LFC, in turn referring to the hypothetical ISDA Master Agreement, is English law with parties irrevocably submitting disputes to the jurisdiction of the English courts.It should be noted that neither the Irish or French version of the ISDA Master Agreements have been particularly used for LFCs, let alone LFCs for DCH arrangements. Equally, the German and other European Master Agreement OTC derivatives documentation suites are rarely used for LCH arrangements.Show Footnote While this may work well for large parts of the market, some NFCs and other EU-domiciled users, may have reservations (rightly or wrongly) whether due to Brexit or otherwise. Despite these clauses being the default drafting in DCH arrangements, working with EU onshore based derivatives counsel, which can advise on the interplay between English and EU plus laws of the Member States is equally advantageous for users in alleviating their concerns efficiently. This is particularly the case as DCH arrangements are subject to a number of further legal, regulatory and other obligations plus issues that are equally applicable to their conceptual cousins in the traditional transaction completion risk mitigation toolkit. 

Further legal, regulatory and other obligations plus issues

As with traditional OTC derivatives, DCH arrangements are fully in scope for UK and EU EMIR and thus have no alleviation from respective regulatory requirements due to their contingent nature. There is however a current prevailing market consensus (absent legislative, regulatory and/or court-driven clarifications other commentary to the contrary) that DCH arrangements are physically settled forwards, which for many (but not all) underlying risks hedged plus counterparty relationships, means they are outside the scope of mandatory variation-margin collateralisation requirements. If collateralisation were to apply, then users of DCH arrangements need to post daily cash collateral against the mark-to-market value of the DCH arrangement, which may impact the user’s liquidity position and a number of other attractive benefits of DCH arrangements. 

A further, perhaps even more fundamental consideration is whether the DCH arrangement is actually a hedge at all or otherwise more akin to a speculative position. Distinguishing between hedgingHedging: Involves taking a position in a financial instrument to offset potential losses in another investment or business operation. The primary goal is risk management, not profit generation. For deal contingent hedging, the hedge should be directly related to the underlying exposure of the underlying deal.Show Footnote and speculationSpeculation (in the sense of but in contrast to hedging): Involves taking a position in the market with the intention of making a profit from market movements. Speculators accept the risk of loss in exchange for the potential of significant gains.Show Footnote is critical for regulatory (including pre-hedging) as well as accounting and tax purposes and requires a clear demonstration that the hedging activity is intended for risk mitigation which is directly associated with the underlying transaction and risks for which protection has been sought. 

On 12 July 2023, the European Securities and Markets Authority (ESMA) published its Final ReportAvailable here.Show Footnote on the feedback to the 2022 Call for EvidenceAvailable here.Show Footnote on pre-hedging. As ESMA notes, the practice of pre-hedging is not defined in EU law. Nevertheless, ESMA and financial market participants understand it as a practice which takes place when liquidity providers aim to hedge their “inventory risk” in an anticipatory manner. ESMA describes “inventory risk” as the situation when market makers set bid and ask prices for financial instruments on a continuous basis and the risk that they are exposed to when buy or selling a security as prices of assets on their inventories could potentially move against them. ESMA was required to examine pre-hedging following the Final Report on the EU’s Market Abuse Regulation review.Available here.Show Footnote While the review was narrow and focusing on inventory risk and while ESMA concluded that pre-hedging is a voluntary market practice which might give (but must not necessarily result in a) rise to conflicts of interest or abusive practices. Accordingly, ESMA did not find sufficient arguments to ban pre-hedging when it published its Final Report. ESMA however did flag that the risks it identified (beyond just inventory risk linked pre-hedging) when issuing further guidance. ESMA also committed to promoting and contributing to the development of global regulatory principles applicable to pre-hedging and thus further supervisory guidance on the subject (more generally) from ESMA.

A similar issue on hedging and speculation arises when assessing the accounting treatment for DCH arrangements. Some users may be required to disclose their hedging activities to their shareholders and regulatory bodies. This includes details on the nature of the hedge, the underlying risks being hedged plus the potential impact on the user’s financial position. Moreover, some users may be required to mark the DCH to market through their income statements on a quarterly basis. 

Other users may seek to qualify their DCH arrangements for hedge accounting purposes with a view to obtaining preferential treatment. A key determining factor will focus on being able to demonstrate that the underlying transaction being hedged is likely (i.e., over 80%) to occur. In some circumstances this may be difficult to achieve or definitively demonstrate. As a result, parties may need to assess whether they have to use mark-to-market accounting before being able to adapt and apply hedge accounting and only do so once the underlying transaction is in a suitable position as being ascertained as “more certain” to complete. 

The tax treatment of DCH arrangements can also be complex and will vary by jurisdiction and facts specific to the underlying transaction and parties involved plus their roles, which may differ across the entirety of what a DCH arrangement is aiming to achieve. Accordingly, users may wish to carefully consider the potential tax consequences of their hedging strategies, including the timing and recognition of gains or losses generally but certainly for DCH arrangements specifically. 

At all times during the course of any DCH arrangement both the DCH dealer and the user should be very aware of their compliance obligations generally but specifically with market conduct rules (which also apply to DCH arrangements in full) so as to avoid practices (documented or non-documented) that could be considered as constituting market manipulation or insider trading. This is especially the case when the hedging activity is based on non-public information about the pending underlying deal/exposure to which the DCH arrangement is being entered into. More generally, market participants may need to weigh up how their DCH arrangements, including how documented, evidence compliance with ESMA’s supervisory expectations on pre-hedging.

Outlook

Undoubtedly, DCH arrangements can be very powerful and offer cost-effective means of hedging completion as well as other risks across M&A plus a number of other transactions and underlying risks. However, the contractual, legal, regulatory complexities and other considerations should not be underestimated.

Accordingly, avoiding deal and DCH arrangement disappointments, let alone misfires, not only requires NFCs to carefully select a dedicated DCH dealer, as a partner, but equally engage independent professional and legal advisors as no two transactions are identical. This is particularly the case for complex as well as cross-border transactions. 

The more complex a transaction and a DCH arrangement, the greater the risk(s), which may warrant an even greater necessity to identify, mitigate and manage as well as to validate assumptions on the underlying deal plus how and where to structure, execute and book the DCH arrangements. This applies not only so as to ensure compliance with all legal and regulatory obligations applicable to both the underlying transaction and DCH arrangement and how this is drafted in the LFC but also the tax and accounting treatment. Firms that apply such greater detail in diligence may be better placed to ensure that their DCH arrangements (and any other relevant hedges or other trades) are structured and executed efficiently and do not exacerbate risk exposures and real loss or otherwise attract adverse supervisory scrutiny.

About us

PwC Legal is assisting a number of financial services firms and market participants in forward planning for changes stemming from relevant related developments. We have assembled a multi-disciplinary and multijurisdictional team of sector experts to support clients navigate challenges and seize opportunities as well as to proactively engage with their market stakeholders and regulators. We are one of the few firms that has English and New York qualified derivatives lawyers onshore in the EU along with dedicated Irish, French and German qualified derivatives and regulatory lawyers. 

Moreover, we have developed a number of RegTech and SupTech tools for supervised firms, including PwC Legal’s Rule Scanner tool, backed by a trusted set of managed solutions from PwC Legal Business Solutions, allowing for horizon scanning and risk mapping of all legislative and regulatory developments as well as sanctions and fines in real time from more than 1,500 legislative and regulatory policymakers and other industry voices in over 170 jurisdictions impacting financial services firms and their business. 

Our Rule Scanner tool allows clients’ M&A teams and Trading Desks to stay ahead of the curve in tracking, triaging and tackling developments that can impact deals and ensure early action can be taken to hedge completion risks. 

Equally, in leveraging our Rule Scanner technology, we offer a further solution for clients to digitise financial services firms’ relevant internal policies and procedures, create a comprehensive documentation inventory with an established documentation hierarchy and embedded glossary that has version control over a defined backward plus forward looking timeline to be able to ensure changes in one policy are carried through over to other policy and procedure documents, critical path dependencies are mapped and legislative and regulatory developments are flagged where these may require actions to be taken in such policies and procedures.

If you would like to discuss any of the developments mentioned above, or how they may affect your business more generally, please contact any of our key contacts or PwC Legal’s RegCORE Teamvia de_regcore@pwc.com or our website.