There has been a significant rise in the use of equity derivatives and convertible bonds in equity acquisitions. This trend is driven by several factors:

Benefits for acquiring companies:

•    Flexibility and capital efficiency: equity derivatives and convertible bonds offer flexibility in structuring the deal, allowing for tailored payouts based on performance or future events. This can be more efficient than upfront cash payments, especially for high-growth targets.
•    Risk mitigation: derivatives like options can hedge against potential downside in the targets stock price, protecting the acquirers’ investment. Convertible bonds, with their potential equity conversion, can also limit downside risk.
•    Staged acquisition: derivatives can be used to structure a phased acquisition, allowing the acquirer to gain control over the target gradually while monitoring performance before committing fully.

Benefits for target companies:

•    Access to capital: convertible bonds offer target companies immediate access to capital without diluting existing shareholders as much as traditional equity issuance.
•    Alignment of interests: convertible bondholders have an incentive for the targets stock price to rise, as their bonds convert into equity at a predetermined price. This aligns their interests with existing shareholders.
•    Exit strategy: derivatives can provide target companies with a potential exit path, allowing them to be acquired at a predetermined price if certain performance metrics are met.

Specific instruments:

•    Convertible bonds: these are the most common instrument, offering debt financing with the option to convert into equity at a predetermined price and interest rate.
•    Equity swaps: these allow acquirers to gain exposure to the targets stock price without actually owning the shares, providing flexibility and potential leverage.
•    Collars: these options contracts set a minimum and maximum price for the targets stock, limiting potential losses and gains for the acquirer.
•    Warrants: these give the holder the right to purchase shares in the target company at a predetermined price in the future, providing potential upside for the acquirer.

Challenges:

•    Complexity: structuring and accounting for these instruments can be complex, requiring specialised expertise.
•    Volatility: derivatives are sensitive to market volatility, which can introduce additional risk to the transaction.
•    Tax implications: the tax treatment of these instruments can be complex, requiring careful planning.

Overall, the increased use of equity derivatives and convertible bonds in equity acquisitions reflects their ability to provide flexibility, mitigate risk, and create win-win situations for both acquirers and target companies. However, its crucial to understand the complexities and potential challenges associated with these instruments before utilising them in transactions.