July 21, 2000

Deals & Deal Makers

Firms Roll Out a Tool
To Save Doughboy Deal

By STEVEN LIPIN
Staff Reporter of THE WALL STREET JOURNAL

How do you quickly rescue a big merger deal that is about to fall apart over price? One way: Devise a finance tool that lets both sides value the deal differently, with a straight face.

Stacy Dick, a partner at the New York investment-banking boutique Evercore Partners, and top staffers at General Mills Inc. are getting kudos for coming up with just this type of derivative instrument, used in General Mills' $10.5 billion purchase of Pillsbury from Diageo PLC.

But much of the credit should probably go to two Nobel laureates, Fischer Black and Myron Scholes, who crafted the first workable model to price options on securities and thereby revolutionized finance.

The Pillsbury deal almost cratered because the two sides couldn't agree on terms. What bridged the gap was a little-used financial instrument called a "contingent value right" that increases in value if General Mills' stock declines. It is almost identical to a series of "put," or sell, options on General Mills' stock-options that could never have been priced without the Black/Scholes model.

The beauty of the tool: General Mills can say that it paid only $10 billion, while Diageo can say it received at least $10.5 billion.

"We genuinely believe this is a way in which they could have their cake and we could eat it too," said James Lawrence, chief financial officer of General Mills. "There's no question in my mind that absent this instrument we wouldn't have been able to reach this deal."

As previously reported, the two sides inked a deal early this week that would pay Diageo up to $10.5 billion in stock consisting of 141 million General Mills shares, plus debt. What's unusual is that the sum also includes a payment of $642 million, or $4.55 a share, tied to the contingent value right. If General Mills' stock is at $38 a share or below one year after the deal closes, Diageo can keep the payment. If instead the stock is higher than $38 a share on that date, Diageo must pay back all or part of the payment depending on the magnitude of the share-price increase.

That gives Diageo an insurance policy should its hefty chunk of General Mills stock decline in value. But it also gives General Mills executives, who naturally believe their shares will rise and say their investors are also confident, a legitimate method for computing their lower price tag for the deal.

Contingent value rights are a little-used corporate-finance tool that show up periodically to buttress the price of an acquisition. They were used in the merger that created Marion Merrell Dow in 1989 but ultimately cost parent Dow Chemical more than $1 billion to repurchase in 1991.

A few years later Viacom Inc. used a similar security in its deal-making spree, when it issued contingent value securities to help finance the purchases of Paramount Communications and Blockbuster Entertainment. Hilton Hotels Corp. added a contingent value stock to its failed bid for ITT Corp.

The instruments are somewhat controversial. In the case of Viacom, investors believed that the company was taking steps to get its stock up in the short-term to minimize any added payments it would have to make under the contingent value obligation. And in general, the securities can impact the acquirer's price, which discourages bidders from using them. Most deals use collars or caps to ensure value, rather than the more complicated contingent rights.

While some contingent value rights have open-ended obligations, General Mills made sure to cap its payments at no more than $4.55 a share. And Diageo has agreed not to sell its General Mills stock for a period around the deal's closing date's one-year anniversary. Unlike in prior deals, the rights won't be publicly traded but held only by Diageo.

The contingent value rights emerged as an option once both sides of the deal hardened their positions on price. They had negotiated for some time but were still as much as $1 billion apart on value. The vexing question: Just how much were Pillsbury and the doughboy worth? General Mills drew a line in the grain at $10 billion, while Diageo wanted at least $10.5 billion. Normally in such negotiations, the two sides split the difference. But in this case, neither side would budge.

That's when Mr. Dick of Evercore proposed this not-too-common financing tool, according to General Mills executives. The derivative instrument adjusts the purchase price depending on the stock price of General Mills.

The $38 cutoff for Diageo to keep the payment reflects the price at which General Mills was trading when the deal was negotiated. It was up 25 cents to $35.25 in 4 p.m. New York Stock Exchange composite trading Thursday.

If General Mills' stock price is $42.55 or higher, Diageo must return the payment. Between $38 a share and $42.55 the two sides split it evenly. In technical terms, the contingent value right is the equivalent of being short a put option at $42.55, and long a put at $38 a share.

Diageo effectively will receive at least $10.5 billion, as long as General Mills stock goes up. Despite the potential benefit from the contingent value rights, Diageo would benefit more from a stock-price increase.

General Mills, meanwhile, can easily hedge its own exposure to the stock swing through offsetting options, though it has not made a decision yet about whether to hedge any or all of its position.

If it chooses to hedge the position, it would likely cost $300 million to $400 million, according to General Mills' finance executives, less than the nominal value of the payment. General Mills has plenty of experience in risk management given its need to hedge its grain exposure. Mr. Lawrence said he has heard from investors who told him not to bother with the cost of hedging because they believe the shares will be trading above $42.55 a share.

Both companies found the solution workable. David Van Benschoten, General Mills' treasurer, called contingent value rights are another example of the "development of the use of [options] in the past 20 years as finance has come to first understand, and work with, the constructs of optionality."

Diageo executives, for their part, were initially skeptical, but the company and its advisers warmed to the idea after digging deeper. They also re-engineered the contingent right by requiring that the payment be made upfront and only credited back to General Mills if the stock rises above certain set levels.

"We still had a gap, and I think this was a pretty clever and innovative way of bridging a price gap," said Timothy George, a partner at Greenhill & Co., which was an adviser to Diageo along with UBS AG's UBS Warburg.

Of course, the real bet Diageo is making doesn't involve the contingent rights, but the one-third of General Mills that it will own once the deal closes.

Write to Steven Lipin at steve.lipin@wsj.com¹

For information about subscribing, go to http://wsj.com