Designing a Net Investment Hedging Program That Makes Sense

How one NeuGroup member company tackled hedging net investments denominated in foreign currencies.

The process of preparing to launch a net investment hedging (NIH) program to manage risk requires assessing necessity and exposure, a determination of hedge accounting capacity, deciding between instrument alternatives, and early, effective communication between treasury, tax, outside auditors and other stakeholders. Those insights emerged from a member presentation at the fall meeting of NeuGroup for Mega-Cap Assistant Treasurers.

• The NIH process followed by the presenting member’s company may prove useful to other multinationals; but he made clear that one size does not fit all in what is a very company-specific and mission-specific initiative.
• “As you go about evaluating bank proposals, these are some of the things we learned to consider upfront, evaluating the metrics, such as capacity and the size of the program, that were important to us,” he said by way of introduction.

NIH basics. Companies typically hedge investments in foreign operations by issuing debt in a foreign currency (called organic debt) or using derivatives such forwards or cross-currency swaps (called synthetic debt). Like most corporates that disclose net investment hedging, the member’s company uses both synthetic and organic debt in its program.

• A Deloitte paper on NIH explains that “companies also have an opportunity to reduce overall interest expense when hedged investments in foreign operations are domiciled in a region with comparatively lower interest rates and qualifying cross-currency interest rate swaps are used as the hedging instrument.”
• In describing his company’s motivation, the member said, “For us, by designating debt as a net investment hedge, we were leveraging the ability to manage and offset the potential balance sheet fluctuations and receive the economic benefit of lower interest rates on foreign currency debt.”
• He and other members noted that the decision to engage in net investment hedging is usually more complicated because it involves both FX and debt capital markets and the tenors involved are generally longer than cash flow or balance sheet hedging. In many cases, it is viewed as a less tactical and more strategic form of hedging FX risk.

Determine net investment exposure. The member outlined the steps to determine net investment exposure through the lens of accounting considerations. “You’re looking for those foreign functional subsidiaries and your equity position on a book value basis in aggregate across your organization,” he said. He showed a slide prepared by a bank that made these additional points:

• Book value is adjusted for earnings minus dividends paid from the subsidiary to the parent.
• There should be no intervening subsidiary with a non-functional foreign currency between the USD parent and the subsidiaries with functional foreign currencies. “You really have to have a clear line from your parent or wherever you decide to do the hedge down to that foreign subsidiary,” the member said.
• Companies may be able to gross up the net investment exposure for tax to designate a larger notional amount as a hedge.

Determine NIH program size. The first step in determining the size of the NIH program, focusing on risk management considerations, involves looking at the capacity of the exposure eligible for hedge accounting, according to one of the member’s slides provided by a bank. “You have to have a pretty good understanding of your organizational structure, your functional currencies and what your capacity is,” he said.

• Hedge accounting for foreign debt (be it organic or synthetic) is important, of course, to reduce earnings volatility. Electing the spot or forward method to judge hedge effectiveness will dictate how the hedge affects earnings.

Next, according to a slide from a bank that the member showed, the corporate needs to “rightsize” its FX liabilities. This involves:

• Forecasting the amount of FX cash that will be generated to support debt service (EBITDA).
• Applying the company’s leverage ratio to EBITDA.
• Multiplying the two numbers produces the amount of foreign debt needed to match cash flows and desired leverage.
• The member noted the importance of managing risk by building in “buffers” to account for possible changes in entity structures and divestment of businesses so that the size of the NIH solution is less than the capacity for hedge accounting.
• The slide raises the question of whether companies should incur foreign debt above the leverage target for currencies where interest rates are lower and/or increased EBITDA is projected.

Focus on the cash flow statement treatment. The member said that different accounting firms may have contrasting views on the classification of cash flows from net investment hedges. Free cash flow and cash conversion are key metrics for his company, one reason treasury got input from technical accountants and auditors early in the process.

• “We wanted all of the solutions we were evaluating, be it direct issuance, forwards or cross-currency swaps to run through the financial statements in a relatively consistent manner,” he said. The company has now achieved consistent treatment after initially facing obstacles with its auditor in using synthetic solutions.

NIH alternatives. The member mentioned “spot risk at maturity” as a focal point for many companies weighing NIH programs and alternative instruments. His company is confident that given the size of its program it can access foreign currency should it need to settle a contract, he said.

The member’s presentation included a detailed comparison, prepared by a bank, of the benefits and considerations of various ways to execute net investment hedges. Those methods and some of the points made:

1. Direct issuance of debt in a foreign currency. Organic debt provides a natural hedge to foreign-denominated assets but is subject to market conditions in the foreign market; and pricing may be less attractive than synthetic. Debt market capacity for certain currencies can also be a constraint, the member said.
2. Swapping new USD debt to foreign currency debt. Cross-currency swaps offer flexibility on the foreign currency leg of the swap. The member company asked all of its banks for pricing information and credit charges—a big component of cross-currency swaps because of longer tenors.
3. Enter into an FX forward. This offers the least amount of transaction cost and upfront cash. A rolling and layering strategy can be used to smooth volatility of the USD value of foreign revenues. But mismatches in FX forward maturity and dividend payments or asset sales can result in cash settlement costs.
4. FX options to create synthetic foreign exposure. Combining swaps or forwards with options creates bespoke cash flow to limit settlement exposure and/or mitigate credit charges. But they require premium payments and purchasing options reduces the interest rate differential which can be recognized through the income statement.

Key learnings. The member’s presentation listed these suggestions and lessons:

1. Get your accounting team and auditors involved early in the process. “Getting people involved early in the idea phase is a best practice,” the member said.
2. Make sure to build in lots of time to understand the alternatives; the first solution may not be the best one for your organization. Treasury needs to articulate clearly to senior management why NIH makes sense.
3. Involve the stakeholder group at the idea stage; build redundancy in bank partners so that if pricing changes you have options.
4. Understand the full spectrum of FX risk and its ongoing impact.