Why passive FX management could fall short

Global companies and investors end up with currency risk somewhat by accident. It’s a by-product of doing business or investing internationally, created the moment your operations or your capital crosses domestic borders. Currency risk cannot be destroyed; it can only be dealt with, managed, and transferred. Unfortunately, it is often ignored.

• Foreign exchange risk affects companies and investors, and can be material to business results, firm valuations and internal rates of return.

• An active FX management plan involves helping to remove uncertainty through the deployment of natural remedies and, if necessary, financial instruments.

• Active management of FX risk can help stabilise performance, enable more confident planning, and minimise maximum regret.

What is passive FX management?

Many growing companies buy or sell currencies only as triggered by operational needs. The cost of an unexpected FX rate change is usually absorbed as if the expense is unimportant, handled like tourists waiting to buy euros until they are actually in Europe.

Along similar lines, when venture funds call for capital, they may buy the currency they need to close an overseas transaction at the time of the demand, without considering the expense of unplanned losses due to currency fluctuations.

This approach is called passive FX management.

What’s wrong with buying currency as you need it?

If your company is moving enough money to result in significant currency risk, a passive strategy may not be enough. Currencies move, and they can move against you. The foreign asset that you thought would cost you a fixed amount of pounds can end up costing more pounds than you planned for. This unexpected expense is purely from changes in exchange rates that would be considered “typical” based on historical patterns.

Similarly, foreign currency-denominated assets, expected cash flows and future unpaid dividends are also at risk of erosion. Some innovation sector companies have the luxury of billing and collecting in GBP for the products and services they sell outside the UK, but some do not, due to competitive pressures. Thus they must price products and services to overseas markets in foreign currencies. A fall in the value of foreign currencies will affect key business management metrics, including top line revenue, EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation), and sales margins. The impact may be high enough to be material, ultimately jeopardising the valuation of the company.

A fast growing software company that takes in GBP for annual subscriptions and decides to set up an R&D facility in Asia could quickly find that an unexpected change in the foreign currency rates will eat into its runway, causing capital to run out earlier than planned.

The impact on valuation is especially important to any growing company eyeing an initial public offering. The moving currency exchange rate that had been a simple by-product of doing business internationally, and considered a nuisance, could suddenly affect the company’s Rule-of-40 metric, an important pre-IPO benchmark in the software-as-a-service space.

Active FX management can reduce risk

Active FX management is about awareness, analysis and quantification. Start with risk discovery: identification of the areas of the business or investment portfolio that may be adversely impacted by movement. The first question to answer is whether foreign currency exchange rates present a material risk to the business.

Is FX material to your business?

Do you need to worry about whether fluctuations in FX rates will affect your business performance? This depends on some basic attributes which determine the materiality of the potential expense of FX.

One way to analyse FX materiality specific to your current business operations is to examine your budgeted FX revenues/expenses against actual revenues/expenses. Was the difference material? If so, the value-add of going from a passive to an active FX management strategy may be well worth the effort.

FX is material to my business. What do I do now?

Is derivative-based hedging the answer? Not always. Another type of hedging, called natural hedging, is also available and should be evaluated first for possible implementation for your business. You may want to explore the possibility of applying some of the strategies listed below before you consider derivatives or any other financial instruments to manage FX risk.

Actively using natural hedging

Natural hedges are mitigation strategies driven by your business’ operational decisions.

Some examples of active natural hedges:

• To the extent possible and without damaging your competitive position, price goods and services in GBP, or pay vendors in GBP.

• If you anticipate having to buy foreign currency for payment of goods/services or investment assets, you can buy and hold the currency today.

• Refine your repatriation strategy. For instance, set aside excess euros and use them for European expansion or future euro-denominated costs.

• Establish a liability stream in the country where you have revenues and vice versa. Explore the merits of non- GBP borrowing or credit cards for procurement.

• If you have global funds in the UK that you plan to deploy outside of the country, but you have not yet identified any acquisition targets, you could buy and hold the target currency now before you participate in any deal negotiations.

• Hold a diversified portfolio of currencies now as an appropriate strategy for positioning for future asset acquisitions, in case the target countries have not yet been identified.

These opportunities for natural remedies arise from decisions that you control for your business. However, they may not be enough to reduce your possible costs to the point where you are comfortable.

Active hedging, using financial instruments

After considering appropriate natural hedges, if your company’s exposure to currency swings is still too high in the context of the business valuation, top line revenue targets, or desired internal rate of return (IRR) metrics, then other strategies may be needed to protect your bottom line.

For instance, your company can incorporate derivatives or financial instruments which can further reduce the uncertainty of FX movements. Handled actively and strategically, active management of FX can help transform an unpredictable drag on your performance into earnings, margin improvement and increased total returns.

Conclusion

Exchange rate changes are not within your span of control. Nor are they predictable with respect to any other factor, as they may move independently of any other value stream. You can’t eliminate the risk of currency swings, so you should consider designing a way to hold your exposure to a level you can live with.

Implementing an appropriate active FX management strategy into your company’s financial planning and analysis (FP&A) process can help mitigate currency risk, provide more accurate reporting, and establish benchmarks against which to measure performance. For global investors, an active approach to managing currencies may translate into better pre-deal close return visibility and, ultimately, greater control of realised IRR.

Questions?

We’d love to speak with you about your specific needs and how we can help.

For more information about our foreign exchange solutions, call the Market Risk Solutions Team at 0800 023 1440 from within the UK and +44 207367 7880 from overseas. You can also email us at: UKFXTraders@svb.com.