risk managementNET INVESTMENT HEDGING

Net the benefits

Like any hedging strategy, net investment hedging (NIH) is atool for companies to achieve the shape and desired levels offoreign exchange (FX) risk. From an accounting perspective, theterm is used for the hedging strategy by which an entity

creates a short position in a foreign currency to offset the risk of theforeign investment – either from translating the original investment, orfrom converting operating cashflows to the parent company functionalcurrency, which is also typically the group presentation currency. Inpractice, a company could borrow in the foreign currency (directly or

swapped), depending on availability and the all-in cost, and/or increasethe short position beyond available debt through the use of derivatives.

Most companies’ annual reports articulate three drivers for NIH: n concern about the balance sheet translation impact of foreign

subsidiaries;n hedging cashflows or earnings before interest, taxes, depreciation

and amortisation (EBITDA); and n cost/value-driven funding – borrowing in the currency with the

lowest interest rate.

AUGUST 2008 SAW STERLING’S ERA OF STABILITY END WHEN IT PLUNGED INTO ITS PRESENT PERIODOF VOLATILITY. AS A RESULT, NET INVESTMENT HEDGING PRACTICES HAVE BEEN UNDER INTENSE SCRUTINY,SAYS JOHANN KRUGER.

34 THE TREASURER NOVEMBER 2010

According to Lloyds’ research, companies continue the practice ofNIH. Over the last three years, although businesses may havechanged the magnitude of NIH, the research shows only a marginaldecrease in the practice among FTSE 100 companies (excludingfinancial services groups) despite the significant increase in FXvolatility of debt portfolios containing foreign debt. Another keyfinding is that there is no change in the proportion of FTSE 100companies which continue to top up foreign borrowing usingderivative overlays. Also, companies which indicate balance sheettranslation as the key driver for hedging far exceed those who citeearnings/cashflow distribution. In part this may be driven by thelimitations of external financial reporting, although there may bedeeper underlying reasons for this trend.

CRITICAL CONCERNS In practice, and as confirmed anecdotallyover time, the key concern for treasurers appears to be the earnings orcashflow misalignment at a group level in a given currency, ratherthan the effect FX revaluation has on their group equity. Companiescommonly issue foreign currency debt or swap domestic currencydebt to a foreign currency. But several supplement their foreign debtposition by transacting additional net investment hedges on top oftheir available domestic currency debt. This indicates that companiesconsider NIH as a valuable risk management tool beyond simplymodifying the composition of the debt portfolio.

In ascertaining the appropriateness of NIH for their business,companies must consider several factors. First, during the earlyyears of overseas investment, cashflows generated by the overseasactivities are typically reinvested locally. This will change though,as the business matures and becomes cash-generative or whenthere are plans for a disposal. In those situations, NIH maybecome advantageous because it will then provide certainty ofcashflows and not just of an accounting balance in group equity.Companies often use the payback period as a measurement todecide whether a project is viable. Considering an acquisition orbuilding of a foreign subsidiary as a project, it would make senseto hedge the investment so that the payback period can beaccurately forecast and only subsequent profit is subjected to FXvolatility. As soon as the first dividends are repatriated, the hedge

can be scaled back to a level more consistent with subsequentEBITDA contribution.

Second, revaluation of foreign currency debt when the group’sfunctional currency depreciates can affect the debt covenantheadroom significantly, especially net debt vs EBITDA, as EBITDAfrom foreign sources is calculated based on an annual or monthlyaverage FX rate, whereas net debt is typically calculated at theyear-end FX rate. This has the potential to lead to a covenantbreach and a technical default. A pre-authorised solution by theboard coupled with monitoring procedures would ensure correctiveactions can be taken in a timely manner. However, the bestsolution to this problem is to negotiate a covenant that, as far aspossible, neutralises the accounting asymmetries caused by FXvolatility. For example, use the same FX rate to translate EBITDA,and net debt as the leverage ratio is the main culprit. Headroom onmulti-currency banking facilities can also suffer from currencyvolatility. The answer would be always to draw in one currency anduse longer-dated currency swaps. However, this solutionsometimes reduces flexibility and creates exposure to currencybasis risk, which has become larger and more volatile since 2008.

BEWARE THE PITFALLS The accounting treatment of NIH isrelatively straightforward, but not without its pitfalls. Hedgeaccounting is available up to the net book value of overseasinvestments, which includes the equity investment and any long-term intercompany accounts. To the extent that an entity wishes tohedge a larger amount due to EBITDA flows, or a strategic exitdecision of a low book value but high intrinsic value business, hedgeaccounting is not available. For example, overseas businessespurchased cheaply and non-capital intensive foreign businesseswould suffer from this problem.

Even when a group reports and comments on “underlying profit”in addition to IFRS profit, NIH numbers are typically large andcould still cause a dividend trap – a situation where an unrealisedloss on a hedge for an individual entity is not offset by the gain onthe (as yet) unrecognised underlying hedged item, and reduces orwipes out distributable reserves, thereby limiting the entity’s abilityto pay a dividend.

NOVEMBER 2010 THE TREASURER 35

risk managementNET INVESTMENT HEDGING

Figure 1: Hedging benefit of currency diversification

Figure 2: FTSE 100 FX hedging policies

* Source: Lloyds Banking Group. Data from a sampling of FTSE 100 non-financial corporates, June 2010

(% of total companies surveyed* – previous years in brackets)

Source: Lloyds Banking Group

36 THE TREASURER NOVEMBER 2010

risk managementNET INVESTMENT HEDGING

Care should be taken with fixedfor float currency swapsas splitting the currency andinterest rate elements atexecution is necessary to achievehedge accounting.

Furthermore, treasurers need totake into account the impact ofinterest rate differentials. Theevidence of forward bias in FXmarkets suggests that incurringdebt in lower interest currenciesreduces the expected interestcosts and over the medium tolong term those currencies do nottend to depreciate in line withwhat interest differentialssuggest. In other words,companies should aim to beunderexposed to debt in highcoupon currencies, whichpresently includes the Australianand New Zealand dollars as wellas the Norwegian krone andoverweight debt in low couponcurrencies such as the US dollar,the euro or the Japanese yen,especially when those currenciesare at cyclical highs. Althoughhistorically sterling interest rateshave not been as low, current lowmarket forward interest ratesposition the UK currency as aborrowing currency, whichsuggests UK companies withoverseas investments can affordto have a GBP debt portfolio evenif they are active in othermarkets.

Finally, FX risk is not additive.Any NIH programme should take account of natural offset anddiversification benefits due to the less than perfect correlation ofcurrency pairs. For example, a company that has factories in Chinaand Malaysia and sales in the US, Europe and the UK may find thatthere is significant offset between the cost and revenue currencies (interms of EBITDA flows) as well as diversification benefits because USdollars, euros and sterling are not perfectly correlated relative to itsbase currency. Figure 1 shows (for a model portfolio with the euro asthe base currency and given certain assumptions on correlation andvolatility) how diversification benefits could reduce the total amountof hedge required. The lower the correlation between currency pairs,the less hedging is required. Since correlations change over time it isusually best only to take credit for a portion of the calculateddiversification benefit.

CHOOSE YOUR STRATEGY Implementation of NIH requires achoice of instruments and strategies. The most commonly used

instruments are straightforwardborrowing, rolling forwardcontracts and cross-currency swaps– all standard instruments for mosttreasurers. Occasionally,companies will use optionsstrategies, such as cylinders, thesimultaneous purchase of an out-of-the-money put and the sale ofan out-of-the-money call on equalnotional principal amounts.

From a cashflow perspective it isalways most conservative to use alonger-dated cross-currency swap,because of its low cashflowvolatility. When the fundingcurrency is historically very strongrelative to the parent companycurrency it may make sense to usea rolling forward contractprogramme until the foreigncurrency has weakened to closerto historic averages and then flipinto a cross-currency swap. Thiscan provide a useful fundingbenefit upon close-out of the last forward contract. However,when the funding currency ishistorically weak, using short-dated forward contracts can havevery severe adverse fundingconsequences if and when itstrengthens and returns to thelonger-term average.

The heightened currencyvolatility of the last few years andthe need for companies to furtherexpand in export markets hastested treasurers’ enthusiasm foradopting net investment hedging.

As detailed in this article, the NIH approach can yield tangiblebenefits to companies, such as better risk management and potentialcosts savings. Nevertheless, treasurers must think carefully about theprocesses and practical implications of implementing NIH as theappropriateness of adopting the strategy will depend on the situationthe business finds itself in. Seeking advice and problem-solvingexpertise in this area is a step treasurers ought to take.

Johann Kruger is IFRS and financial risk management consultant atLloyds Banking Group.johann.kruger@lloydsbanking.comwww.lloydstsbcorporatemarkets.com

THE NIH APPROACH CANYIELD TANGIBLE BENEFITS TOCOMPANIES, SUCH AS BETTER

RISK MANAGEMENT ANDPOTENTIAL COSTS SAVINGS.