As forex markets turn choppy, demand for M&A-related hedging revives

By Denny Thomas and Saikat Chatterjee

HONG KONG (Reuters) - Some hedging products that were used only sparsely for years are making a comeback now, driven by a surge in cross-border mergers and acquisitions to a record at a time of heightened currency volatility, bankers say.

Products such as Deal-Contingent Forwards (DCFs) have become popular with M&A participants because they provide insurance against big currency-related losses if a deal gets stuck or unravels.

The deal frenzy, sparked by cheap financing and plentiful cash at companies, comes during unsettled times for global financial markets due to the prospect of higher U.S. interest rates and a sharp slowdown in China's economy.

A JPMorgan FX volatility index which measures the implied swings of currencies is at its highest level in nearly two years, indicating markets expect currencies to remain volatile, according to foreign exchange traders.

Demand for DCFs and other hedging products used by M&A participants has grown by more than 50 percent over the past year, three top investment bankers said.

"There is definitely a strong desire to hedge risk during M&A transactions as currency markets are much more volatile," said Simon Lau, head of interest rate and forex structuring at Asia ex-Japan for BNP Paribas. "Clients are also demanding more structured product solutions even though they can be more expensive."

Hedging deals are closely guarded secrets of banks, for competitive reasons. In a rare instance of these private deals coming to light, a person familiar with the matter said Japan's Nomura Holdings <8604.T> earned about $12 million in fees by selling DCFs when SAB Miller (NYSE: SAB) bought Australian beer maker Foster's Group for $10.2 billion in 2011.

Nomura earned more than the $8.5 million each of SAB's four M&A advisers made, according to Freeman & Co estimates. Nomura and SAB declined to comment.

The DCF is similar to a currency forward contract, typically used for hedging. But unlike a plain vanilla forward contract, it allows a client to walk away from the hedging agreement if the M&A deal falls through.

Given the currency volatility, companies are uncomfortable in taking only a forward hedge because they have to pay whether or not a deal goes through. With DCFs, they can walk away depending on how a deal progresses.

SLOW TAKEOFF

Deals worth $384 billion have been pulled so far in 2015 globally, Thomson Reuters data shows.

British retailer Tesco plc (NASDAQ: TSCO) hedged its entire currency risk when it sold its South Korean unit Homeplus for $6 billion earlier this year, with Barclays running the hedging process, a person familiar with the matter said.

The Korean won fell 10 percent against the British pound during the Homeplus sale process, underscoring Tesco's rationale. Tesco and Barclays declined to comment.

Launched in the aftermath of the 2008 financial crisis, DCFs until recently failed to gain traction because forex markets were relatively stable.

DCFs can cost 3-4 percent of the notional value of a transaction, far more than simple currency forwards. But end users are warming up to them.

Peter Keehn, global head of private equity at U.S.-based Allstate Investments, said he favors the use of such products.

"Despite the prohibitive cost, hedging the currency risk on its direct private equity investments is something Allstate always prefers."

(Additional reporting by Elzio Barreto; Reporting by Denny Thomas and Saikat Chatterjee; Editing by Muralikumar Anantharaman)

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