Capital markets and accounting considerations in real estate M&A
Mergers and acquisitions involve a multitude of complexities and risks. Speed and accuracy at every stage of an acquisition is critical to not only winning the deal but also giving the transaction the best chance of financial and strategic success. Financial risk associated with the valuation of a target company or portfolio of assets is paramount for all parties involved. Ensuring that accurate inputs of costs, benefits and risk measures inform capital markets strategies and accounting decisions, the odds of long-term M&A success can be improved. Chatham is a trusted partner for institutional investors to focus on aspects of M&A that are critical but may not be core areas of expertise for M&A deal teams. The following highlights important elements to consider at various stages of the acquisition process.
Successful M&A depends on evaluating target company data quickly and accurately.
- Prepayment estimates and derivatives fair values: Debt and derivatives prepayment costs can be prohibitively expensive. Long-term fixed-rate debt and swaps can be expensive to prepay. Accurately estimating prepayment costs — and how those costs will change between bidding and closing — is an important step to providing a competitive offer. Chatham has advised on over $177 billion in prepayment transactions, and we can help acquirers understand the full cost of debt repayment. Similarly, Chatham can provide independent, accurate, timely valuations of vanilla and complex derivatives positions, including a sensitivity analysis of how these valuations might change under different market conditions.
- Debt assumption: While an assumption of the target company’s liabilities might make strategic sense, debt covenants may restrict changes in ownership by prohibiting transfers or replacement guarantors. Acquirers should weigh the financial and operational tradeoff between assuming the target’s liabilities and paying them off. Chatham’s debt experts can help underwriting teams evaluate this tradeoff on a portfolio basis in confidence, backed by a comprehensive review of the loan documents. Chatham’s capital market research team can also provide detailed market insight to current pricing of similar instruments.
- Loan portfolio review and audit: Target companies with many mortgage loans increase the financial and due diligence burden. The acquirer needs to forecast cash flows, review covenant compliance, and summarize key terms. Large targets may have dozens or even hundreds of loans that need to be reviewed. Chatham’s debt experts have experience working with acquirers to provide operational support reviewing loan portfolios. Chatham’s technology tools, trusted by hundreds of top investment firms, give acquirers a centralized source for the target’s debt cash flows and terms where they can run reports across the entire portfolio.
- Currency risks: There are a few channels through which currency risks may impact the evaluation. For example, an adverse medium-term outlook, notwithstanding confidence in the performing of the target company, might lead to a certain adjustment in the bid. Also, if the target company operates in multiple countries and either earns revenues or incurs expenses in multiple currencies, then earnings in the functional currency will be subject to currency risks. Chatham can advise acquirers on hedging solutions or run sensitivity analyses on the EBITDA-at-risk.
Due diligence/Pre-closing period
The tough work of closing a transaction begins after the bid is awarded, and the decisions made during this period will have a long-lasting impact.
- Purchase price allocation, appraisal, and debt valuation: The purchase price allocation of the acquired real estate is deemed a critical audit matter with rigid reporting deadlines. Acquirers should begin the valuation process pre-closing not only to ensure adequate timing to complete but also supplement the due diligence phases in data retention and storage. Chatham’s asset and debt valuation experts are well-versed in the complexities of the valuation process for mergers and acquisitions and can provide services for both single asset and portfolio level transactions.
- Strategic financing: Chatham believes the debt strategy should support the asset plan. One debt program is rarely appropriate across the entire target company’s property portfolio as certain assets are repositioned, sold, or restructured. Financing should accommodate differences in hold period, lease-up, or capital improvement plans. Also, derivatives can be tactically used as part of the financing strategy. When acquirers receive more competitive spread or terms in loans denominated in a different currency, they can use derivatives like cross-currency swaps to manage the currency mismatch and take advantage of the competitive offers.
- Forward hedging: There are several instances where acquirers may proactively manage their currency or interest rate risks. Chatham has advised on deal-contingent forward contracts and vanilla products so that acquirers can reduce the risk of foreign currency appreciation causing the closing price in their home currency to be higher than their bid price. On the rates front, a range of products like swaptions, deal-contingent swaps, rate locks, etc. are available to acquirers concerned about rising cost of debt between bid and close. Chatham advises on over $4 billion notional of derivatives transactions each business day.
- Hedge accounting: Hedge accounting can be very difficult to achieve on pre-close exposures. Debt issuances at closing have the greatest success rate, though deal-contingent hedging is challenging. If the horizon for hedging crosses a quarter end it may be necessary to explore non-GAAP measures to effectively communicate the hedging to stakeholders.
Closing and thereafter
Effective accounting designations and on-going management of the target supports seamless integration.
- Hedge accounting: There are a variety of treatments for existing hedging relationships. If there is no change in control and the hedged debt will continue, hedge accounting will probably go uninterrupted. If the transaction results in a change in control and/or the hedged debt is significantly restructured hedge accounting may be discontinued. Once the transaction closes, hedge accounting can usually be restarted, although qualifying for hedge accounting for seasoned derivatives requires much more complex effectiveness testing than for at-market trades. Clients that use Chatham’s hedge accounting advisory can anticipate P&L impacts and workloads surrounding transaction close.
- Debt management: Real estate is a debt-driven industry. Companies need to keep track of their upcoming maturities, covenants, and lender relationships. The pandemic showed the difficulty companies can face during downturns. Firms that did not have a centralized system to track their debt had to scramble to understand their payment obligations and operating covenant requirements. Clients that use Chatham’s market-leading debt management solution were able to stay on top of their debt obligations with on-demand portfolio reporting and dedicated account experts. Hundreds of companies rely on our technology platform to manage over $1.7 trillion in debt on an on-going basis.
- Valuation: The transaction price is often the most critical data point informing the valuation in future periods. Educating a new valuation provider of the deal nuances and impacts to pricing can be difficult if they are not ingrained in the transaction process. Chatham’s engagement capabilities from the deal stage to a quarterly valuation process, reduces unwarranted volatility, and fosters both fee and workflow efficiencies. Chatham currently performs recurring quarterly valuations on over 7,200 loans.
- Currency risks: Foreign currency depreciation against the home currency of the acquirers can put a severe dent on the M&A returns. There is no single risk management strategy that is optimal for every client or that outperforms across every market condition. Chatham takes into account the unique features of the M&A in order to craft a bespoke strategy.
Winning M&A strategies require companies to draw on a large breadth of disciplines. Chatham’s transaction advisory services offer integrated capital markets and accounting expertise. Our consultants and technology are used by the top private and public real estate investors, and they can be quickly deployed to answer the most complicated questions during all stages of the transaction.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0180
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