No two organisations are exactly alike and, consequently, boards are faced with decisions around hedging policies that are normally bespoke to their circumstances.
I set out below some of the companies I have worked for, the differing decisions they have taken and why these were arrived at. I draw some high-level conclusions and also offer some thoughts on implementation.
At the time, this company’s costs were largely denominated in sterling due to its UK manufacturing base. It exported 97% of its sales from the UK and these were denominated in US dollars, euros and yen. It earned healthy margins and enjoyed very long-term relationships with its customer base.
Procurement decisions were made by the customers’ engineers, who would specify its product. As it supplied a very niche formulation, there were no directly competing suppliers then.
The company had experienced a significant shortfall in profitability due to currency fluctuation issues. The shareholders were very evenly split in their views as to what the management team should do.
An important point is to ensure the key arguments are expressed in a way that the board can understand them
Half of them believed the company should increase its prices to preserve margins, as the customers had no alternative sources and switching costs would be high. The other half believed that it was very important for the business to preserve its long-term relationships, and that frequently moving prices would jeopardise this.
The board eventually decided that it should hedge a substantial portion of its foreseeable FX exposure out to 15 months ahead so that it did not need to immediately react to short-term currency fluctuations.
This also bought the management team time to decide what the most appropriate commercial response might be to any large currency fluctuations, and also allowed them a significant lead time to communicate with customers as appropriate.
This group primarily consisted of a UK timber importing and wholesaling business (sourcing from Canada, Russia and Sweden) and a builder’s merchants chain.
The trading dynamics were such that the business was cyclical, driven by housing starts and repair, maintenance and improvement expenditure, and interest rates that were considerably higher than currently. The group had a maximum target gearing level of 40% and, when I joined, they were extremely close to this level.
The hedging policies for transactions were relatively straightforward and related to the import of timber. Pricing within the industry was driven by the purchase price of wholesale supplies translated at spot FX rates.
Consequently, we needed to maintain sufficient foreign-currency balances to meet short-term payment obligations, but did not undertake any longer-term hedging (as none of our competitors did).
The group had not previously undertaken any interest rate hedging. The board accepted the argument that rising interest rates caused a decline in trading in our industry leading to lower profitability. Rising interest rates would also increase our interest charge.
This meant that our interest cover covenant could be squeezed by a simultaneous fall in profitability combined with higher interest costs when gearing was at a historically high level.
Therefore, mitigating some of our covenant risk by introducing some interest rate hedging (we hedged 50% of our interest costs) made sense, and formed the basis of the policy that was ultimately approved.
A private equity- (PE) backed business I was involved with was based in Europe and reported in euros, but also earned strong US dollars and other currency denominated cash flows, which were expected to persist over time.
PE shareholders typically aim to exit their investment over a five-year time frame, and we had concerns as to whether adverse currency levels might inhibit a successful exit transaction at the relevant time. Given the dynamics of the debt markets at the time, the group had refinanced its borrowings in euros.
The analysis that the board eventually accepted was that any future sale price would probably be denominated in euros, but negotiated on multiples of EBITDA in the relevant currencies.
Consequently, if the US dollar was weak against the euro at the time of the exit, then the sale price achieved was likely to be reduced.
The solution was to introduce some US dollar and other currency debt equivalents in the form of cross-currency swaps, broadly in proportion to the relevant currency contributions to overall group EBITDA.
This meant that, say, a reduction in value of the US dollar income stream in such a case would be partially offset by the reduction of the US dollar leg of the cross-currency swap, significantly reducing the downside risk (and also upside opportunity due purely to currency rates) of the likely outcome, which was demonstrated by running scenarios at varying extreme FX levels.
It similarly reduced the amount of currency-driven upside opportunity, thereby limiting the likely range of possible outcomes.
These three real-life examples highlight the importance of understanding the risks boards tend to be concerned about and a sense of what their appetite is for mitigating such risks.
An important point is to ensure the key arguments are expressed in a way that the board can understand them, most obviously in outcomes, rather than the detailed technicalities of any process to be followed, which only those with treasury expertise will grasp.
There are a few methods that treasury professionals might like to consider associated with the operation of their treasury policies.
It sometimes helps to have other individuals involved in the management of a treasury policy rather than just the group treasurer and perhaps the CFO. For example, at the UK manufacturer, we formed a currency risk committee, which was chaired by the CEO and included the commercial director as well as the CFO and group treasurer.
The benefit of this was that, as the hedging decisions were taken based on our forward trading projections, the CEO and commercial director had input whenever decisions to hedge were taken. This led to a much richer and timely debate around the reliability of the forecasts, and led to better decisions than could have been achieved by the finance function in isolation.
Clear communication to the board of compliance with policies is an essential corporate governance requirement. This should also include an annual review of the policies to ensure they are not based on assumptions that are now out of date due to other corporate developments.
Similarly, clear communication to external interested parties, particularly shareholders, of what the policies aim to achieve and what they do not protect against is a valuable precaution, so they understand the group’s risk profile.
Finally, internal training for non-finance staff who may encounter currency issues can be valuable. In one project-based organisation, we developed internally a very simple half-day training programme on the management of FX risk.
This included a number of theoretical case studies, which we got groups of individuals to work through and discuss.
Naturally, each case study was based on a real-life project that had incurred losses within the group, which we could name and quantify, and which everyone could therefore immediately identify with – invaluable when it came to driving the message home.
David Tilston is interim CFO at Consort Medical.
This article was taken from the Dec 2016/Jan 2017 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership
