Why getting your debt by currency mix right can be crucial
19 Sep 2018
Is your organisation refinancing? Are you the FD for a semi-autonomous business that is going to be sold soon, or is already owned by private equity? Does your business face FX risk that might affect your short-term financial performance or the longer-term value that your owner will receive when the sale occurs?
Borrowing external debt isn’t just about raising finance, negotiating covenants, minimising your interest cost and generating a debt shield. A shrewd debt by currency choice can also enable FX risk being faced by a business to be substantially mitigated at two different levels. While the cash-flow FX exposure can be reduced by diverting EBITDA to service the debt, the key benefit arises from hedging equity value and, if possible, minimising the debt being borrowed (which otherwise reduces the equity in that asset) in the currency of the owner.
Operating as an international business can be inconvenient. Day to day, you need to buy and sell currencies with the (cash flow) risk that exchange rates will go against you. Moreover, if a business will be sold in the medium term, its divestment valuation will be a function of local currency EBITDA that may rise or fall in terms of the return currency of its shareholder (PE or corporate divestment). This can happen even if the underlying local currency EBITDA remains unchanged.
So, if you run an international business (let’s call it ABC Ltd) that will refinance soon, the debt by currency mix that you opt for could substantially affect how much FX risk your business is exposed to, at both the cash flow and equity level. This position is made more complicated if the return currency of your owner differs from your own.
Let’s assume ABC is UK based, has GBP as its functional currency but is owned by a PE Sponsor using EUR as its return currency. Operationally, ABC is materially ‘long’ (i.e. has more income than costs) in EUR and AUD, but is ‘short’ USD and GBP. With no tax, accounting or bank lending constraints, all four currencies are viable for financing purposes, but issuing USD or GBP debt wouldn’t be sensible because they will worsen ABC’s ‘short’ position in both cash flow and equity terms.
Choice and objectives
However, the choice between EUR and AUD is much less clear, being driven more by ABC’s EBITDA mix in these two currencies and, to the extent they are not the same, the FX objectives of management and its owner.
On a ‘par’ or EBITDA matched basis, we might pro rata split the debt between EUR and AUD, enabling cash flow to be evenly diverted between them for debt servicing purposes. ABC’s management would likely want this debt mix because, as a GBP functional currency business, it reduces the requirement to hedge the cash flow exposure arising in these currencies.
But what about the equity hedge? To gauge its effectiveness, let’s assume ABC’s owner holds the business for commercial reasons (it’s not a currency play), but still wants to minimise the FX risk impacting on its divestment value as measured in its own currency. From the owner’s perspective, the refinancing decision may be focused on maximising the amount of post-financing equity that is denominated in EUR.
On that basis, the operational convenience of managing cash flow FX risk is surely outweighed by the wider aim of maximising the ‘EUR like’ nature of ABC’s equity value for its owner. In this case, the business should maximise its quantum of AUD debt (potentially with it all being denominated in AUD) and so the EUR-centric equity value of the business.
All this needs to be sense checked for accounting and tax constraints. It also may need further ‘tweaking’ in the event that debt financiers have a limited capacity in certain currencies. But these caveats aside, structuring your debt mix using this approach can be a powerful way to reduce FX risk, protecting cash flows and equity value.