M&A: Impacts on hedging operations
Mergers & Acquisitions (M&A) activity was very strong in 2018 with an estimated global transaction volume of USD 3100 billion. According to the Global Transactions Forecast 2019 study published by Baker McKenzie and Oxford Economics , activity is expected to remain high in 2019 - estimated at USD 2900 billion - despite rising rates and anticipated economic slowdown. In this context, we thought it would be useful to provide a reminder on the guidance applicable under IFRS related to the hedging operations of the acquiree.
IFRS 3 "Business Combinations" requires the acquirer to revalue the identifiable assets and liabilities of the target company at fair value in order to include them in its balance sheet at the acquisition date. The fair value of assets and liabilities is measured in accordance with IFRS 13: it corresponds to an “exit price” for a “market participant” and is, therefore, independent of the acquirer's intention. The difference between the price paid and the amount of the assets and liabilities thus revalued represents the “goodwill” that is recognized as an asset in the consolidated financial statements. This exercise of “Purchased Price Allocation” or PPA, must be completed within 12 months after the acquisition date.
The PPA exercise has no impact on the value of derivatives since they are already measured in the balance sheet at fair value in accordance with IFRS 9. However, equity reserve (or OCI) related to cash flow hedges (CFH) or net investment hedges in foreign operations (NIH) and revaluations of firm commitments for fair value hedges (FVH) are not included in the acquirer's balance sheet at the acquisition date.
In addition, the hedging relationships documented in the books of the target company cannot be maintained as they stand in the acquirer's consolidated financial statements. In accordance with the logic of IFRS 3, the acquirer purchases identifiable assets and liabilities that are assessed on an individual basis and are included in the opening balance sheet at fair value. As hedge accounting is an optional treatment under IFRS, it is up to the acquirer's management to decide whether or not to document the derivatives of the acquiree, purchased at fair value, in a new hedging relationship.
The documentation of these acquired derivatives in a new hedging relationship is not without surprise under IFRS. Indeed, the effective level of hedge that will be materialized in the income statement will correspond to market conditions at the acquisition date. It will therefore not be correlated to the contractual terms of the hedging instrument. For example, an interest rate swap exchanging a fixed rate of 2% against E3M that was documented as a cash flow hedge (CFH) of a debt paying a coupon of E3M + 1.25% enabled to secure a cost of debt of 3.25% in the financial statements of the target company before the M&A transaction. Assuming that market conditions are 0.5% against E3M at the acquisition date, the re-documentation of this interest rate swap in the acquirer's IFRS financial statements will result in a hedged level of 1.75% in financial results (0.5% + debt spread). In practice, the contractual coupons paid on the debt and the derivative in the amount of 3.25% will be offset in the income statement by reversing the negative fair value of the derivative at acquisition date, the amortization of this negative fair value having a positive impact on the income statement.
To further complicate things, the documentation of an off-market derivative in a new hedging relationship is a source of ineffectiveness under IFRS. The non-zero fair value of the derivative at the inception of the new hedging relationships carries additional sensitivity to changes in the interest rate curve. Although the risk of disqualification of the hedging relationship is much lower under the new IFRS 9 standard, this ineffectiveness shall be measured and recognized in profit or loss where appropriate.
The treasurer must therefore be vigilant in the case of hedging relationships involving derivatives inherited from an acquiree. There is indeed a risk of lack of correlation between the treasurer's “cash” vision and the impact in the IFRS consolidated financial statements, which takes into account additional entries related to PPA. In order to reconcile the two approaches, it may be useful to enhance the setting of the Treasury Management System or any other monitoring tool in order to integrate the impacts of M&A transactions on derivatives.