Introduction
Many Nigerian businesses and founders are seeking opportunities outside the Nigerian markets. Access Bank, First Bank, United Bank for Africa (UBA), etc. have long scaled their businesses beyond Nigerian markets. Flutterwave announced on 9th February 2023 its expansion into Egypt. Many more Nigerian and African businesses are likely to go beyond home markets, especially when the African Continental Free Trade Agreement (ACFTA) is fully implemented.[1]
In scaling to new markets, one of the penetration tools available to businesses is mergers and acquisitions (M&A). Scaling businesses are likely to enter new markets by buying stakes in existing businesses in those markets because M&A provides assets on the ground, a customer base and a staff pool to immediately work with at the completion of the transaction. M&A involving businesses operating in different countries is called cross-border M&A.
Cross-border M&A has significant deal elements that distinguish it from local M&A transactions. The most significant, and sometimes determinant, factor in this type of M&A is currency risk. Currency risk, also known as exchange rate risk, refers to the potential financial loss that can occur due to fluctuations in the currencies of the countries involved in a transaction.[2] Exchange rate fluctuations can also lead to an appreciation or decline in a target’s valuation before the close of a transaction. Currency risk is assessed from the time of negotiation of the deal to completion and post-acquisition integration. To illustrate, if a Nigerian company negotiated to acquire a Kenya company for $50 million in April and the deal lasted over an 8-month period, the value of the deal in Naira (the acquirer’s local currency) on the closing date in October will be NGN39.5 billion as against NGN23.2 billion which was the deal value in April. The increase in the purchase price between the start date and the closing date is a currency risk.
Transactions affected by currency fluctuations as in the scenario above may lead to a deal collapse/pull-out or financial strain to the acquirer if the deal pulls through. This article will provide a guide on measures to manage currency risks in cross-border M&A transactions.
Mitigation Strategies for Currency Risk in Cross-border M&A
The ways to manage currency risk in cross-border M&A transactions may be broadly classified into contract mechanisms and hedging instruments.[3] Contract mechanisms are provisions in the transaction documents that protect the deal from exchange rate fluctuations. Common contract mechanisms include fixed price provisions, purchase price adjustment, and escrow holdback. Hedging instruments are financial arrangements used to reduce or eliminate adverse price movements in transactions.[4] The usual types of hedging instruments used in cross-border M&A transactions are forward contracts, currency options, and currency baskets. Each of these devices shall be briefly discussed below.
- Fixed Price Provisions: this is a provision in the share purchase agreement or asset purchase agreement that sets a pre-determined valuation of the target and unchanging purchase price for the transaction. Such a clause usually states the currency in which the transaction will be denominated and paid and a peg rate at which the other currency will be exchanged.
While a fixed price provision provides stability to the transaction as the parties are certain of their financial positions from the beginning, the buyer bears the risk of currency fluctuations as they are held to the fixed price even where the exchange rate falls below the price. The seller’s only exposure is where the company increases in value but is closed out based on the valuation before the increase. Using fixed price provisions requires careful drafting, proper valuation and accurate exchange rate forecast to ensure that the margin of difference is not so wide as to have a party feel undone after the deal. One simplistic approach to fixed price negotiation is to agree on payment of the purchase price in a stable neutral currency like the USD. Each party bears the risk of fluctuation between its local currency and the currency of the deal.
- Purchase Price Adjustments: A Price Purchase Adjustment (PPA) provision is a term in an M&A document that outlines a method/mechanism of arriving at the final purchase price of the transaction at closing rather than providing a definite deal value during negotiations. This way, the parties are protected from fluctuations that impact the valuation of the target or the conversion rate between the currencies. The important elements to include in PPA provisions are as follows:
- A baseline value and metrics that will be used for calculating the final purchase price.
- A mechanism for adjusting the purchase price at the transaction closing based on any changes between the target valuation or conversion rate due to currency fluctuations.
- The party or person responsible for calculating the final purchase price at closing and how any adjustment will be reflected.
The background to PPA clauses is that the contracting parties do not have the data necessary for a concrete calculation at the time of negotiating the purchase price.[5] Therefore this option is a ready tool where the target’s valuation is primarily based on turnover and the exchange rate is very volatile.
3. Escrow Holdback: an escrow holdback provision is primarily used as a mechanism to protect the buyer from defaults of the seller that occur between the negotiation date and the closing date. It entitles the buyer to keep a part of the purchase price in an account designated as an escrow account from which he may deduct monies to compensate for defaults of the seller that cause a reduction in the valuation of the target at closing. An escrow holdback provision can also be used to hedge against currency fluctuations.
Just like in ordinary use cases, a term is added to the M&A document to state that the acquirer shall deposit a mutually agreed amount to compensate for currency fluctuations between the negotiation date and the closing date. The term will nominate an escrow account to receive the buffer amount and specify the conditions that must exist at the closing date for the fund to be released to the seller. If the conditions do not exist on the closing date, the fund is recovered by the acquirer.
4. Forward Contracts: a forward contract is an agreement between parties who negotiate to trade an asset on a specific date in future at a fixed price agreed at the time of negotiation. In the context of M&A, a forward contract is a stand-alone agreement usually made between the acquirer and a financier. With the forward contract, the acquirer ensures that they can exchange their currency at the agreed-upon rate, regardless of how the exchange rate fluctuates in the market. This helps the acquirer know exactly how much of its own currency it needs to pay when the deal closes.
5. Currency Options: Currency options are financial instruments that give the holder the right (but not the obligation) to buy or sell a specified amount of one currency for another currency at a predetermined exchange rate, known as the strike price, within a specified period. Unlike forward contracts, the holder can choose to exercise the option or not.
There are two types of options contracts- call options and put options. A call option gives the holder the right to buy a specified amount of foreign currency at the strike price within the agreed period. A put option works in reverse, it gives the holder the right to sell the specified amount of foreign currency at the strike price within the agreed period.
In the context of cross-border M&A, parties can use either a call or put option to mitigate exchange rate fluctuations depending on their market prediction. If the acquirer predicts that the exchange rate might go up, he can purchase a call option to buy the payment currency at a strike price. If the prediction is that the exchange rate will go down, the acquirer may use a put option.
6. Currency Baskets: a currency basket is a portfolio of selected currencies with different value weightings. Like an Exchange Traded Fund (ETF) in stocks, it is a combination of different currencies with different values, called weightings. As a hedging instrument in cross-border M&A, an acquirer can arrange a currency basket as a way of protecting the fluctuation of his currency relative to the foreign currency.
The Role of Lawyers in Helping Parties Navigate Currency Risk in Cross-Border M&A
The role of legal counsel in helping parties navigate currency risk in cross-border M&A is to advise them on the best strategies to hedge against the potential loss of value of the investment due to fluctuations in exchange rates. Some of the services that legal counsel can provide to help mitigate currency risk are:
- Drafting proper hedging provisions: since M&A documents are drafted by lawyers, it is the role of lawyers advising on the transaction to understand the components of the type of hedging clause the parties have agreed to during negotiations. Proper contract drafting will ensure that the provision is adequate to cover all foreseeable circumstances.
- Guiding negotiations: although currency and payment conversations are commercial terms negotiated by the parties themselves, a good lawyer reviews the term sheet and other pre-contract documentation and can recommend the best hedging option to be agreed upon between the parties.
- Due diligence: certain currency risk protection depends on the existence of conditions that are discoverable by due diligence. Thorough due diligence is one of the services lawyers provide in M&A
Conclusion
The expansion of Nigerian businesses beyond their domestic markets is a growing trend, with notable examples like Access Bank, First Bank, and Flutterwave venturing into international territories. As the ACFTA gains full implementation, the prospects for more businesses seeking opportunities outside their home countries are likely to increase.
When these businesses scale into new markets, especially through M&A, they face unique challenges, with currency risk being a prominent concern in cross-border transactions. The volatility in exchange rates between different currencies can significantly impact the value of deals, exposing companies to potential financial losses.
To mitigate currency risk in cross-border M&A transactions, various strategies and instruments are available. The article outlines key measures, such as fixed price provisions, purchase price adjustments, and escrow holdback, which are contract mechanisms embedded in transaction documents to protect against exchange rate fluctuations. These mechanisms provide stability to the deal by addressing potential changes in target valuation or conversion rates.
Additionally, the article discusses the use of hedging instruments, including forward contracts, currency options, and currency baskets. These financial arrangements offer ways to manage and minimize the impact of adverse currency movements on the overall transaction. Each instrument has its unique features and considerations, providing flexibility for businesses to choose the most suitable approach based on their risk tolerance and market predictions.
Legal counsel plays a crucial role in guiding parties through the complexities of currency risk management in cross-border M&A. Lawyers are responsible for drafting proper hedging provisions, guiding negotiation discussions related to currency and payment terms, and conducting thorough due diligence to uncover conditions that may impact currency risk protection.
In essence, as Nigerian and African businesses continue to explore opportunities beyond their borders, the effective management of currency risk in cross-border M&A transactions becomes paramount. Employing a combination of contract mechanisms and hedging instruments, guided by knowledgeable legal counsel, can enhance the resilience of businesses against the uncertainties associated with currency fluctuations in the dynamic landscape of international mergers and acquisitions.
[1] https://guardian.ng/business-services/how-nigerian-businesses-can-compete-globally/
[2] https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/getting-a-better-handle-on-currency-risk
[3] This is not a standard classification, and it is only deployed in this article for convenience.
[4] https://www.ig.com/en/trading-strategies/what-financial-instruments-can-i-use-for-hedging–190726
[5] https://www.legal500.com/developments/thought-leadership/purchase-price-provisions-in-ma-transactions/ Accessed 5th December 2023.
