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The Devil in the Deal: Notes From an M&A Practitioner

A look at due diligence for energy transactions, and at what’s driving them.

Fortnightly Magazine - September 2007

who are using forecasts are not implementing valuation models correctly and are, in effect, producing neither result.

For instance, a common yet problematic practice is the use of a combination of forward curves and forecasts within a model, without the appropriate adjustments. This could involve the use of forward prices for market-visible tenors with a transition to forecasted prices beyond the observable horizon. This is in spite of the fact that forecasts represent the transactor’s (or third-party analyst’s) proprietary view of future spot prices, while forward curves represent the market’s expectations of future spot prices, but only if they can be adjusted for the presence of any risk premium. Nor is it appropriate to use risk-free rates with the price forecasts, so the discount rates need to be risk-adjusted. And so on and so forth.

Fortunately, the explosive growth in deal flow now provides transactors with the opportunity to estimate long-term forward curves and asset values based on market levels, rather than based on forecasts or other approaches. Implied forward curves that are consistent with transacted asset prices should help transactors overcome many of the limitations of current approaches and enable them to develop a market-based assessment of value and risk for physical assets.

Trade Portfolio

On the other end of the spectrum are the shorter-term transactions that comprise the trade portfolio. The portfolio typically is made up of thousands or tens of thousands of physical and financial positions, most of them plain-vanilla derivatives that span across geographic markets, commodity types, and underlying risk factors (volatility, basis, etc.). The tenors normally extend from the next day through several years into the future, although longer-term positions are not uncommon. So while curve visibility tends to be less of an issue, due diligence certainly should address other curve-related concerns. These may include which brokers or other sources are used for particular markets, and any systematic biases within the curve-marking process.

Given the potentially enormous quantity of positions involved, and the breadth and complexity of the exposures, quite a few other issues can present themselves in a portfolio transaction. One that probably should receive more attention than it normally does, however, is whether or not the reserves that have been designated for liquidity, credit, regulatory, and other risks are adequate. Reserve estimates are especially important because they are a key measure of the dollar impact such risks will have on the value the portfolio ultimately will realize and because they will often have a direct bearing on the transaction price.

When estimating liquidity reserves, for example, some practitioners focus primarily on the spread between bid and offer prices, or the “bid-ask spread.” They use the bid-ask spread to estimate the degree to which a “mid-based” ( i.e., average of bid and offer) forward curve underestimates the value that would be derived in the event that the position needs to be liquidated.

But liquidity risk can be much more dependent on the impact of a potentially large purchase or sale on the forward market than it is on the bid-ask spread. In fact, the more