Published: March 01, 2008
Acquisitions in emerging countries are never easy for numerous reasons. For example, the acquirer has to overcome local legal issues which can sometimes be extremely complex given the absence of written rules and procedures, compared with Western Europe. Moreover, the group acquirer could also face political issues. It often has to satisfy irrational constraints with which it is not always familiar. Having said that, we would like to underline other types of difficulty and risks it could encounter in investing in such countries with highly volatile currencies, high interest rates and inflation in parallel with over-performing growth.
These issues very often oblige investors to organize their funding in a stronger currency with lower interest rates. However, it also confronts them with foreign exchange risks. These are the types of problems the acquirer will have to solve. By using different leverages and mixing products, it will be in position to optimize return on assets purchased. The financial issues are pre- and post-acquisition.
Before the acquisition, after having signed a long form agreement, a shareholder agreement or any type of committing documents, the company will be exposed to the purchase currency until the payment flows are processed. This could last up to a couple of months, depending on conditions or due diligences to be performed. Some companies hedge the forex exposure even before they have been committed. They then use a series of options which are combined to finance purchased ones. This can be extremely expensive and recovery of the costs is never guaranteed. Some companies then consider that these costs are directly linked to the acquisition project, which is at risk. They could be viewed as costs related to the project, keeping in mind the risk of losing everything (expenses as well as hedging costs). Other groups prefer to wait until a committing document has been signed before undertaking any hedging strategy. [[[PAGE]]]
Consolidation treatment issue
One of the first issues is to define the consolidation treatment to be applied to the Joint Venture (JV). The accounting method adopted could impact the group financial statements. In some cases, with a minority participation or ‘at equity’ consolidation treatment, the accounting impact is nil, although financially they remain exposed. In other cases, the consolidation will be proportional or full (if at least it can demonstrate a de facto control). Very often, treasurers think in terms of accounting volatility before deciding the adequate hedging / funding solution to be adopted. With inter-company (partial) funding, there is also the issue of the accounting qualification of the loan. Is the group funding an interest bearing repayable loan or a non repayable one (at least within the next five years)? In other words, could we benefit from IAS 21 favorable treatment and ‘freeze’ into CTA (Change in Translation Adjustments - equity accounting) the change in fair value of the inter-company loan? It is a very interesting treatment but dangerous in the long run if and when it is repaid, as the CTA will be released and could severely impact the P&L statement.
Funding currency
The assumption is a local external funding given co-shareholders. Often, local partners do not want to finance it directly. Therefore, in order to balance shareholders’ efforts, the local company has recourse to local bank funding. In this type of country (e.g. in Turkey, Russia, Brazil), a local currency funding could be very expensive as interest rates are extremely high. On the other hand, the funding in a stronger currency (and therefore cheaper interest rates) also presents disadvantages as the repayment could become expensive, especially if the local currency is devalued, vis-à-vis the strong one (usually the functional currency of acquirer). It could be a dilemma for treasurers: the cost of funding versus currency risk. The treasurer will have to take into account the cash flows in foreign currencies, which could reduce forex exposure and offset risks with a sort of natural hedge. In these cases, the mixed-funding model can be applied, offering a cheaper funding solution, compared to an entirely local one.
Hedging of funding currency (if necessary)
If the acquirer opts for the foreign currency funding (which could be for example USD for a EUR functional currency based company), it will have to consider a part hedging or capping of the risks, to the maximum level. [[[PAGE]]]
The Net Change in Cash (NCC) over the couple of years of the financing (tenor) has to be determined precisely (1). If the local asset has some in flows in USD or in EUR, it will automatically reduce the net funding exposure. The variability of this NCC should be minimized at a 95% confidence level. Then we need to define the impact of FX on NCC and its variability, on average and worst case scenario (2). The treasurer should evaluate risk (variability of NCC)/return (expected NCC) in each scenario. From this analysis the efficient frontier scenario with highest return and lowest risk can be determined(3). The last phase consists in evaluating tactical options as well as pricing and timing implications (4). By running different assumptions on percentage of USD (or EUR) funding, you can find the most adequate proportion of currency financing, with a 95% confidence level.
The treasurer must start from a cash flow statement for the number of years corresponding to the financing (i.e. from revenue minus operating costs, to determine EBITDA minus taxes, Capex, to determine Free Cash Flow (pre-interest), interest paid, FCF available for debt, senior debt repayment and then the Net Change in Cash). From the business model, the treasurer will have to analyze the currency risk from a cash-flow perspective. The variability of NCC depends on local currency, USD and EUR debt currency mix used. When the Cash Flow is set up, the treasurer could play with funding assumptions and FX rates (or even IR) to define optimum strategy.
The treasurer will have to take into account the cash flows in foreign currencies, which could reduce forex exposure and offset risks with a sort of natural hedge.
The factors, like correlations of USD versus local currency and EUR versus local currency, are important. The hedging should not be full of course - if not there is no advantage in borrowing in a cheaper currency. The right level of hedging is more complex to delimit. The financial products to be dealt depend on cost. Some zero-cost structures should be envisaged (e.g. strip of options; strip of collars or strip of cancellable forwards). With help and support from large banks, like BNP Paribas, for example, the treasurer could run the scenario to determine the appropriate combination of products and hedging percentage. The idea is to benefit from part of the upside if any while protecting against major downsides and to define the boundaries of possible movements (according to VaR analysis with a 95% confidence level).
In each case, depending on the countries analyzed, it is essential to start from market assumptions and expectations (e.g. HRK, HUF or TRY to converge with EUR at a certain moment in time; weakness of USD in general, lower interest rates in coming years). The carry trades are supporting the emerging currencies but are also sources of risk. The local positive developments of the economy support local currency but imply risks of inflation, and do not exclude huge swings up and down, cycles and risks of political instability (for example the former republics in ex-USSR, Kurds in Turkey and Islamist terrorists in Pakistan).
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There is no single solution applicable to any acquisition in emerging countries, but there are recommended approaches as described above. In general, we can admit that FX is the main financial risk, more than the interest rate (IR), even in Turkey where real rates are the highest in the world. It is also recommended to borrow in a cheaper currency, than in the local one. However, such cheaper funding generates FX risk which should be partly hedged.
Notice that, at settlement, spot rates very often appear lower than initial forward rates would have been. Therefore the forward strategy may be very expensive and not really appropriate. The hedging instruments should be zero-cost types to reduce the up-front cost of plain vanilla options. Mixed solutions for funding and for hedging are a way to weight the impact and the potential volatility. The IR must also be partly fixed in the early years (at least) to guarantee the debt service.
The transaction risk should be hedged with optional products until the cash payment of the acquisition price. For the local currency cash flows, it is advisable to consider hedging the first couple of years and to continue in future on a roll-over basis in order to have the next year(s) cash flows always covered.
When your funding and hedging strategies are decided, you also need to sell them to (local) co-shareholders. Bear in mind, they could have different views and be exposed to different risks. You also need to sign an ISDA agreement and, if you are hedging and funding at local holding level, you need to negotiate credit facilities with local banks. By modeling the cash flows and determining the NCC, a treasurer can design the most adequate strategy to implement for the acquisition. In addition he/she can run a stress scenario to measure the sensitivity of the acquisition. The adopted strategy should be aligned and incorporated into the global group risk profile to gain any possible benefit from natural hedging. Investing in a foreign emerging country can be financially challenging and requires much attention from group treasurers.
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