Worried the M&A bull market is close to a peak? Consider, as evidence, the re-emergence of “put” options in big deals. These risky structures, popular at the time of the last deal frenzy at the turn of the century, have appeared in three big recent transactions.
Take Vodafone Group and Pirelli, which have both wired puts into their latest deals. The UK telecom group offered one to the minority shareholder in Hutchison Essar, the Indian wireless group it just bought a majority in. It could have to pay $5bn (Rs21,500 crore) in three-four years. Valued using the Black Scholes option pricing model, that’s equal to an $860m liability today.
Pirelli, meanwhile, is in talks to sell most of its stake in holding company Olimpia to AT&T and Carlos Slim’s American Movil. They might have to buy the remaining shares for the same price in a year’s time. Value that too using Black Scholes, and the buyers are taking on an extra liability with a present value of €580m.
Most complex of all is the deal Acciona has struck over its carve-up of utility Endesa. Acciona can sell a 25% stake to Enel for a minimum price that rises every year to reflect rolled-up interest less dividends. Alternatively, it can stake a claim on the assets of its choice. Given that the stake has a current value of €11bn, and that Acciona can exercise its put up to 2017, this is probably the most costly of all the recent crop of options.
Such puts may be fiendishly clever. But they expose the companies that issue them to big, one-sided risks. If the underlying shares do well, the put is likely to go unexercised. But if they do badly, the issuer, who has to buy back stock at a premium, gets stung. And, in a market crash—like the one that occurred early this century — the paper losses would be significantly greater even than the current values as calculated under Black Scholes.
Duff bets on put options, indeed, almost proved the downfall of companies like British Telecom and France Telecom. Both were throwing around put options to secure hot assets in the early 2000s—just as global deal-making was reaching its all-time peak—and both needed rights issues later to get them out of deep trouble.
That makes puts look like the sign of a seller’s market. For both Vodafone and Enel, issuing puts was arguably the only way to get the deals done. And in the case of Endesa, put-holder Acciona has managed to lock in a price that’s more than double what the Spanish utility was worth when the takeover saga began.
Of course, that doesn’t mean puts are always bad for issuers; just that investors should see them for what they are—a cost of the transaction. Take Vodafone’s deal. It’s offering $11bn for its two-thirds stake in Hutchison Essar. But include the $860m option value, and that rises by 8%. One might say these structures are little more than a roundabout way of overpaying for assets. That’s a classic sign of the top of the market.